Chapter 11
Operating
Exposure
Learning Objectives
• Examine how operating exposure arises through
the unexpected changes in both operating and
financing cash flows
• Analyze the sequence of how unexpected exchange
rate changes alter the economic performance of a
business unit though the sequence of volume,
price, cost and other key variable changes
• Evaluate strategic alternatives to managing
operating exposure
• Detail the proactive policies firms use in managing
operating exposure
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A Multinational's Operating Exposure
• Operating exposure, also called economic
exposure, competitive exposure, or strategic
exposure, 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.
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A Multinational's Operating Exposure
• Measuring the operating exposure of a firm
requires forecasting and analyzing all the firm’s
future individual transaction exposures together
with the future exposure of all the firm’s
competitors and potential competitors
• Goal is to identify the operating techniques the
firm might wish to adopt to enhance its value
• Operating exposure also analysis the impact of
changing exchange rates on a firm’s operations
over coming month and years
• Goals is to identify the strategy or operating
techniques the firm might wish to adopt
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A Multinational's Operating Exposure
• Trident Corp. as a U.S.-based publicly traded
company, ultimately all financial metrics and
values have to be consolidated and expressed in
U.S. dollars.
Net operating = Receivables over - Payables over time
cash flow time from sales for inputs and labor
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A Multinational's Operating Exposure
• Exhibit 11.1: the functional currencies of the individual
subsidiaries in combination determine the overall operating
exposure of the firm
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Exhibit 11.1 Trident Corporation:
Structure and Operations
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A Multinational's Operating Exposure
• Operating cash flows arise from intercompany
(between unrelated companies) and intracompany
receivables and payables, rent and lease
payments, royalty and licensing fees, and other
associated fees
• Financing cash flows are payments for the use of
intercompany and intracompany loans (principals
and interest) and stockholder equity (new equity
investments and dividends)
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Exhibit 11.2 Financial and Operating Cash
Flows Between Parent and Subsidiary
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A Multinational's Operating Exposure
• Operating exposure is far more important for the
long-run health of a business than changes caused
by transaction or translation exposure
• Planning for operating exposure is management
responsibility
• An expected change in exchange rates is not
included in the definition of operating exposure
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Measuring Operating Exposure
• An unexpected change in exchange rates impacts
a firm’s expected cash flows at four levels
– Short Run
– Medium Run (equilibrium)
– Medium Run (disequilibrium)
– Long Run
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Exhibit 11.3 Operating Exposure’s
Phases of Adjustment and Response
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Measuring Operating Exposure:
Trident Germany
• Trident derives much of its reported profits from
its German subsidiary and there has been an
unexpected change in the value of the euro thus
affecting Trident significantly
• How would the value of Trident Germany’s
business change?
• Changes in prices, costs, and volume of sales.
Competitors?
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Exhibit 11.4 Trident & Trident
Germany
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Measuring Operating Exposure:
Trident Germany
• Trident Germany manufacturers in Germany, sells
domestically, and exports and all sales are
invoiced in euros
• Exhibit 11.5 summarizes the current baseline
forecast for income an operating cash flows for
2014-2018
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Exhibit 11.5 Trident Germany’s Valuation:
Baseline Analysis
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Exhibit 11.6 Trident Germany: Case 4 – Sale
Price, Volume & Cost Increase
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Measuring Operating Exposure:
Trident Germany
• Exhibit 11.7 summarizes the change in Trident’s
German subsidiary value across our small set of
simple cases from an instantaneous and
permanent change in the value of the euro drops
from $1.20/€ to $1.00/€.
• On January 2014, the value of the euro from
$1.20/€ to $1.00/€.
• Operating exposure depends on whether an
unexpected change in exchange rates causes
unanticipated changes in sales volume, sales
prices or operating costs
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Measuring Operating Exposure:
Trident Germany
• Tridents might maintain domestic sales prices, in
euro term, or might raises prices because of more
expensive imported raw materials
• Strategy undertaken depends on management’s
assessment
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Measuring Operating Exposure:
Trident Germany
• Operating cash flows arise from intercompany
(between unrelated companies) and intracompany
receivables and payables, rent and lease
payments, royalty and licensing fees, and other
associated fees
• Exhibit 11.7 illustrate the effect of various post-
depreciation scenarios on Trident Germany’s
operating exposure, consider four simple cases
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Exhibit 11.7 Summary of Trident Germany
Value Changes to Depreciation of the Euro
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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
• 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
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Strategic Management of Operating
Exposure
• Managing operating exposure
• Diversifying operations means diversifying the firm’s
sales, location of production facilities, and raw material
sources
• If a firm is diversified, management is prepositioned to
both recognize disequilibrium when it occurs and react
competitively
• Recognizing a temporary change in worldwide
competitive conditions permits management to make
changes in operating strategies
• E.g. management notice a change in comparative cost
in the firm’s plans in different countries
• Management might make marginal shifts in sourcing
raw materials, components or finished products
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Strategic Management of Operating
Exposure
• Diversifying the financing base means raising
funds in more than one capital market and in
more than one currency
• If a firm is diversified, management is
prepositioned to take advantage of temporary
deviations from the International Fisher effect
• Diversifying sources of financing can lower the
firm’s cost of capital and increase its availability of
capital
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Proactive Management of Operating
Exposure
• Operating and transaction exposures can be
partially managed by adopting operating or
financing policies that offset anticipated currency
exposures
• Four of the most commonly employed proactive
policies are
– Matching currency cash flows
– Risk-sharing agreements
– Back-to-back or parallel loans
– Currency swaps
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Proactive Management of Operating
Exposure
• Matching Currency Cash Flows - offset an
anticipated continuous long exposure to a
particular currency by acquiring debt denominated
in that currency
• This policy results in a continuous receipt of
payment and a continuous outflow in the same
currency
• Natural hedge when occurs through the conduct of
regular operations (e.g. suppliers)
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Exhibit 11.8 Debt Financing as a
Financial Hedge
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Proactive Management of Operating
Exposure
• Risk-sharing is a contractual arrangement in which
the buyer and seller agree to “share” or split
currency movement impacts on payments
• Example:
– Ford purchases from Mazda in Japanese yen at the spot rate
if between ¥115/$ and ¥125/$.
– If it falls outside the range, they share the difference equally
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Proactive Management of Operating
Exposure
• Ford’s payment to Mazda would therefore be
¥25,000,000 ¥25,000,000
$222,222.22
¥5.00/$ ¥112.50/$
¥115.00/$ -
2
• Note that this movement is in Ford’s favor,
however if the yen depreciated to ¥130/$ Mazda
would be the beneficiary of the risk-sharing
agreement
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Proactive Management of Operating
Exposure
• A back-to-back loan, also referred to as a parallel
loan or credit swap, occurs when two firms in
different countries arrange to borrow each other’s
currency for a specific period of time
– Conducted outside the FOREX markets
– This swap creates a covered hedge against exchange loss
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Exhibit 11.9 Back-to-Back Loans for
Currency Hedging
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Proactive Management of Operating
Exposure
• Two fundamental impediments to widespread use
of the back-to-back loan:
– It is difficult for a firm to find a partner (counterparty) for
the currency amount and timing desired
– One of the parties may fail to return the borrowed funds at
the designated maturity – although each party has 100%
collateral (denominated in a different currency)
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Proactive Management of Operating
Exposure
• Cross-Currency swaps resemble back-to-back
loans but it does not appear on a firm’s balance
sheet
• A dealer and a firm agree to exchange an
equivalent amount of two different currencies for a
specified period of time
• They borrow funds in the markets and currencies
in which they get the best rates
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Proactive Management of Operating
Exposure
• Example of cross-currency swap
– a Japanese firm exporting to the US wanted to construct
a matching cash flow swap, it would need USD
denominated debt
– If the cost were too great, then it could seek out a US
firm who exports to Japan and wanted to construct the
same swap
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Proactive Management of Operating
Exposure
• Example of cross-currency swap cont.
– The US firm would borrow in dollars and the Japanese
firm would borrow in yen
– With the swap, the US firm would end up “paying yen”
and “receiving dollars” and the Japanese firm “paying
dollars” and “receiving yen”
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Exhibit 11.10 Using Cross Currency
Swaps
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Proactive Management of Operating
Exposure
• MNEs now attempt to hedge their operating
exposure with contractual hedges
• Taking long-term currency option positions hedges
designed to offset lost earnings from adverse
changes in exchange rates
• The ability to hedge the “unhedgeable” depends
on:
– Predictability of the firm’s future cash flows
– Predictability of the firm’s competitor responses to
exchange rate changes
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Summary of Learning Objectives
• Foreign exchange exposure is a measure of the
potential for a firm’s profitability, cash flow, and
market value to change because of a change in
exchange rates.
• The three main types of foreign exchange risk are
operating, transaction, and translation exposures.
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Summary of Learning Objectives
• Operating exposure measures the change in value
of the firm that results from changes in future
operating cash flows caused by an unexpected
change in exchange rates
• Operating strategies for the management of
operating exposures emphasize the structuring of
firm operations in order to create matching
streams of cash flows by currency: this is termed
matching
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Summary of Learning Objectives
• An unexpected change in exchange rates impacts
a firm’s expected cash flow at four levels:
1) short run;
2) medium run, equilibrium case;
3) medium run, disequilibrium case; and
4) long run.
• Operating strategies for the management of
operating exposure emphasize the structuring of
firm operations in order to create matching
streams of cash flows by currency. This is termed
natural hedging.
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Summary of Learning Objectives
• The objective of operating exposure management
is to anticipate and influence the effect of
unexpected changes in exchange rates on a firm’s
future cash flows, rather than being forced into
passive reaction
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Summary of Learning Objectives
• Proactive policies include matching currency of
cash flow, currency risk sharing clauses, back-to-
back loans, and cross currency swaps
• Contractual approaches have occasionally been
used to hedge operating exposure but are costly
and possibly ineffectual
• Strategies to change financing policies include
matching currency cash flows, back-to-back loans
and currency swaps
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