Chapter 12

Operating Exposure
 Operating Exposure

• Operating exposure, also called economic exposure,

competitive exposure, and even strategic exposure,
on occasion, measures any change in the present
value of a firm resulting from changes in future
operating cash flows caused by an unexpected
change in exchange rates.
• Ganado Corp. is a U.S.-based multinational firm.
Exhibit 12.1 shows Ganado’s basic structure and
currencies of operation.
 Exhibit 12.1 Ganado
Corporation: Structure and
Operations
 Ganado Corporation Cash
Flows
• Operationally the functional currencies of the
individual subsidiaries in combination determine the
overall operating exposure of the firm in total.
• Net operating cash flow is the source of value
created by the firm over time
• Ganado in Germany buys and sells in euros, Ganado
U.S. buys and sells in dollars, but Ganado China has
sales based in dollars, euros, and renminbi—the
latter being the dominant cash flow for Ganado
China
 Static versus Dynamic
Operating Exposure
• Measuring operating exposure required analysis of short
and intermediate term (fixed or static) contracts, and
longer term (more dynamic) forecasting
• Using Ganado as an example, we have 3 divisions of
roughly equal size and we assume the dollar is
depreciating against the euro while the renminbi is slowly
revaluing.
– Ganado China: In the short-term, fewer profits, may
need to raise prices in the long-term
– Ganado Germany: No change in the short–term, may
be affected by eventual higher prices from China
– Ganado U.S.: No change in the short–term, may also
be affected by eventual higher prices from China
 Operating and Financing
Cash Flows
• The cash flows of the MNE can be divided into operating
cash flows and financing cash flows.
• Operating cash flows arise from intercompany (between
unrelated companies) and intracompany (between units
of the same company) receivables and payables, rent and
lease payments, royalty and license fees and assorted
management fees.
• Financing cash flows are payments for loans (principal
and interest), equity injections and dividends of an inter
and intracompany nature.
• Exhibit 12.2 summarizes cash flow possibilities for
Ganado U.S. and China.
Exhibit 12.2 Financial and Operating
Cash Flows Between Parent and
Subsidiary
 Expected versus Unexpected
Changes in Cash Flow
• Operating exposure is far more important for the
long-run health of a business than changes caused by
transaction or translation exposure.
• However, operating exposure is inevitably subjective
because it depends on estimates of future cash flow
changes over an arbitrary time horizon.
• Planning for operating exposure is a total
management responsibility because it depends on
the interaction of strategies in finance, marketing,
purchasing, and production.
 Expected versus Unexpected
Changes in Cash Flow
• An expected change in foreign exchange rates is not included in the
definition of operating exposure, because both management and
investors should have factored this information into their evaluation
of anticipated operating results and market value.
• From a manager’s perspective, budgeted financial statements
already reflect information about the effect of an expected change
in exchange rates.
• From a debt service perspective, expected cash flow to amortize
debt should already reflect the international Fisher effect.
• From an investor’s perspective, if the foreign exchange market is
efficient, information about expected changes in exchange rates
should be reflected in a firm’s market value. Only unexpected
changes in exchange rates, or an inefficient foreign exchange
market, should cause market value to change.
 Measuring Operating
Exposure
• Exhibit 12.3 shows how a change in exchange rates
can impact expected cash flows at four levels:
– Short Run
– Medium Run (equilibrium)
– Medium Run (disequilibrium)
– Long Run
 Exhibit 12.3 Operating
Exposure’s Phases of
Adjustment and Response
 Measuring Operating
Exposure: Ganado Germany
• Exhibit 12.4 presents the impact on the firm given an
unexpected change in exchange rates.
• Exhibit 12.5 summarizes the current baseline forecast for
Ganado Germany’s income and operating cash flows. We
assume that the euro drops from 1.20 to 1.00 $/€
– Case 1: Depreciation, no change in any variable
– Case 2: Increase in sales volume; other variables
remain constant
– Case 3: Increase in sales price; other variables remain
constant
– Case 4: Sales price, cost, and volume increase
Exhibit 12.4 Ganado and
Ganado Germany
Exhibit 12.5 Ganado
Germany’s Valuation:
Baseline Analysis
 Ganado Germany, Case 4:
Price, Cost, and Volume
Increases
• Exhibit 12.6 is a combination of possible outcomes
– Price increases by 10% to €14.08,
– direct cost per unit increases by 5% to €10.00,
– and volume rises by 10% to 1,100,000 units.
• Revenues clearly rise by more than costs, and net income for
Ganado Germany rises to €2,113,590.
• Operating cash flow rises to €2,623,683 in 2014 (after NWC
increase), and €2,713,590 for each of the following four years.
• Ganado Germany’s present value is now $9,018,195.
 Exhibit 12.6 Ganado Germany:
Case 4—Sales Price, Volume, and
Costs Increase
 Measurement of Loss
• Exhibit 12.7 summarizes the change in Ganado’s German
subsidiary value across our small set of simple cases from an
instantaneous and permanent change in the value of the euro
from $1.20/€ to $1.00/€.
– Case 1: Ganado’s German subsidiary’s value falls by the percent change in the
exchange rate, -16.7%.
– Case 2: Volume increased by 40% as a result of increasing price
competitiveness, the German subsidiary’s value increased 22.5%.
– Case 3: The change in the exchange rate was completely passed through to a
higher sales price, which resulted in a massive 66% increase in subsidiary
value.
– Case 4: The resulting change in subsidiary valuation of +24.2% may be
creeping toward a “realistic outcome.”
Exhibit 12.7 Summary of Ganado
Germany Value Changes to
Depreciation of the Euro
 Strategic Management of
Operating Exposure
• The objective of both operating and transaction exposure
management is to anticipate and influence the effect of
unexpected changes in exchange rates on a firm’s future cash
flows, rather than merely hoping for the best.
• To meet this objective, management can diversify the firm’s
operating and financing base.
• Management can also change the firm’s operating and
financing policies.
• A diversification strategy does not require management to
predict disequilibrium, only to recognize it when it occurs.
 Strategic Management of
Operating Exposure
• If a firm’s operations are diversified internationally,
management is pre-positioned both to recognize
disequilibrium when it occurs and to react competitively.
• Recognizing a temporary change in worldwide competitive
conditions permits management to make changes in operating
strategies.
• Domestic firms may be subject to the full impact of foreign
exchange operating exposure and do not have the option to
react in the same manner as an MNE.
 Strategic Management of
Operating Exposure
• If a firm’s financing sources are diversified, it will be
pre-positioned to take advantage of temporary
deviations from the international Fisher effect.
• However, to switch financing sources, a firm must
already be well-known in the international
investment community.
• Again, this would not be an option for a domestic
firm (if it has limited its financing to one capital
market).
 Proactive Management of
Operating Exposure
• Operating and transaction exposures can be partially
managed by adopting operating or financing policies
that offset anticipated foreign exchange exposures.
• The most commonly employed proactive policies
include:
– Matching currency cash flows
– Risk-sharing agreements
– Back-to-back or parallel loans
– Cross-currency swaps
– Contractual approaches
 Proactive Management of
Operating Exposure
• Matching Currency Cash Flows (Exhibit 12.8)
– One way to offset an anticipated continuous long
exposure to a particular currency is to acquire
debt denominated in that currency (matching).
– An alternative would be for the US firm to seek
out potential suppliers of raw materials or
components in Canada as a substitute for U.S. or
other foreign firms.
– In addition, the company could engage in currency
switching, in which the company would pay
foreign suppliers with Canadian dollars.
Exhibit 12.8 Debt Financing
as a Financial Hedge
 Proactive Management of
Operating Exposure
• Risk-Sharing Agreements
– An alternate method for managing a long-term
cash flow exposure between firms is risk-sharing.
– This is a contractual arrangement in which the
buyer and seller agree to “share” or split currency
movement impacts on payments between them.
– This agreement is intended to smooth the impact
on both parties of volatile and unpredictable
exchange rate movements.
 Proactive Management
of Operating Exposure
• Back-to-Back or Parallel Loans (Exhibit 12.9)
– A back-to-back loan, also referred to as a parallel
loan or credit swap, occurs when two business
firms in separate countries arrange to borrow each
other’s currency for a specific period of time.
– At an agreed terminal date they return the
borrowed currencies.
– Such a swap creates a covered hedge against
exchange loss, since each company, on its own
books, borrows the same currency it repays.
 Exhibit 12.9 Back-to-Back
Loans for Currency Hedging
 Proactive Management
of Operating Exposure
• There are two fundamental impediments to
widespread use of the back-to-back loan:
– It is difficult for a firm to find a partner, termed a
counterparty for the currency, amount and timing
desired.
– A risk exists that one of the parties will fail to
return the borrowed funds at the designated
maturity—although this risk is minimized as each
party has 100% collateral (denominated in a
different currency).
 Proactive Management
of Operating Exposure
• Cross-Currency Swaps (Exhibit 12.10)
– A currency swap resembles a back-to-back loan
except that it does not appear on a firm’s balance
sheet.
– In a currency swap, a firm and a swap dealer or
swap bank agree to exchange an equivalent
amount of two different currencies for a specified
amount of time.
Exhibit 12.10 Using Cross-
Currency Swaps
 Contractual Approaches:
Hedging the Unhedgeable
• Some MNEs now attempt to hedge their operating
exposure with contractual hedges.
• Merck has purchased long-term currency put options
in order to offset lost earnings from adverse
exchange rate changes.
• The ability to hedge the “unhedgeable” is dependent
upon:
– Predictability of the firm’s future cash flows
– Predictability of the firm’s competitor’s responses
to exchange rate changes