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Module - 26 Operating Exposure Measurement
Module - 26 Operating Exposure Measurement
International Finance
Vinod Gupta School of Management , IIT. Kharagpur.
Module - 26
Operating Exposure Measurement
Email: prabina@vgsom.iitkgp.ernet.in
Lesson - 26
Operating Exposure Measurement
Hence companies spend considerable time and effort to measure and manage the operating
exposure.
Learning Objectives:
In this session, the following aspects have been dealt in greater detail:
26.1: Introduction.
Sessions 22 and 23 deals with how change in foreign exchanges affects the contractual cash
flows i.e. transaction exposure. Transaction exposure arises due to exchange loss or gain on
foreign currency denominated short term contractual obligations like
• Borrowing or lending in foreign currency
• Purchasing and selling where payment/receipt is denominated in foreign
currency.
• Lease/Rental payment in foreign currency
• Other contractual payments which a firm may have agreed to pay/receive
before the change in exchange rate.
Session 22 and 23 also focus on how companies manage various kinds of transaction
exposure (hedge the risk emanating from change in foreign exchange rate) through
forward and futures contracts, money market and through options contracts.
Change in the foreigner exchange risk affects firms in many other major ways. Change in
foreign exchange not only affects individual transactions, it affects the firm value as a
whole. Change in the exchange rate can affect the competitiveness of the firm and may
have a bearing on the survival of the firm. The impact of change in foreign exchange rate
on firm value is known as the operating exposure.
Translation exposure arises when companies report and consolidate its financial
statements requiring conversion from foreign to local currency for foreign operations.
In this session, how operating and translation exposure are measured and how firms
manage these two exposures are discussed in detail.
Let us elaborate little more on this aspect even though these have been discussed in greater
detail in Session 22 and 23.
Transaction exposure involves with the cash flows which a company has already contracted
but the value of these cash flows has changed due to change in foreigner exchange. For
example, an Indian company has agreed to supply 2000 units (within in coming 12 months)
of bed linen to Wal-Mart. Wal-Mart has agreed to pay USD20 per piece. On the date of the
contract, the spot rate is INR 45 per USD. It translates to INR 900 per piece. Direct cost per
unit of linen is INR 700. The fixed cost is INR 300,000 per year. For every 1 unit of bed
linen the Indian exporter sells, the contribution margin is Rs. 200. Hence it takes 1500 units
to cover the fixed cost. With a sales figure of 200, 000 units, the Indian company is making
a profit of INR 100,000 (INR 200 per unit * 500 units).
Indian company is happy to receive a gross profit of INR 200 per unit. Indian exporter buys
all raw materials from other Indian companies.
Suppose after supply one lot of 5,000 units, Indian company receives USD 125,000 on 25th
day from agreement. On this date, suppose INR has appreciated to INR 40 per USD. With
this rate, Indian company gross profit reduces to INR 100. Suppose INR still appreciate to
INR 37 USD by the time Indian company receives the payment for second lot export.
Indian company is incurring a loss of INR 60 per piece of bed linen it exports. Transaction
exposure measures the effect of change in cash flow for such kind of transactions. These
cash flows are easy to identify, measure hence manage.
Let us go back to the previous example of Indian exporter exporting bed linen to Wal-Mart.
With INR appreciating, exporting is becoming an unviable proposition for Indian company.
The Indian company may renegotiate raw material price it pays to its suppliers. However,
they may agree provided these suppliers are making enough profit at the renegotiated price.
Indian company may consider revising the price, but there could be some other company
from Bangladesh which is happy to export to Wal-Mart at USD 20. So increasing price it
charges to Wal-Mart is not an option as it makes the Indian exporter uncompetitive. Indian
exporter may start sourcing raw material from other countries. For this it may have to scout
for different vendors, check their quality standard, check whether they have capacity to
deliver raw material as per the requirement. The Indian company also has to consider the
customs duties levied by Indian government to import raw-material to India and political
relationship between the two countries.
On top of this Indian exporter will be exposed to foreign exchange risk from the input side
if it changes the vendor from Bangladesh to let us say Pakistan. Indian company may
consider exporting to another company rather than to Wal-mart.
All these changes may require change in manufacturing process, raw material sourcing
process, getting hang of design trend, basically competing with another set of competitors
who may be having formidable brand names in curtains and durries segment.
The kind of change the Indian exporter decides to bring in requires reorientation at strategic
level and requires a relook at the way the Indian exporter is doing business. Unlike
transaction exposure, which is predominantly managed by the firm’s finance division (of
course with a broad policy direction regarding the types of hedging instruments to be
chosen and the quantum of foreign exposure to be hedged), operating exposure requires
involvement of each and every unit of the firm i.e, marketing , finance, purchase, sales,
manufacturing etc. As the changes required to tackle operating exposure is multifaceted,
projecting future cash flow becomes an extremely difficult proposition if not impossible.
From the above discussion it is amply clear that quantifying operating exposure is difficult
to measure as well as manage as change in exchange rate affects future cash flows of the
company. Also management of operating exposure is done at operational level as well as at
strategic level.
Operating cash flows can be categorized into two categories i.e, cash flows arise from
intercompany and intracompany receivables and payables, lease, rent and royalty payments
and receipts and financing cash flows. Financing cash flows involve payment and receipt of
loans, equity investments and dividend payments and receipts.
The cash flows occurring between Indian exporter and Wal-mart are categorized as inter-
company cash flow. Suppose Indian company has joint venture with a Srilankan company
and Srilankan Company exports raw material to the Indian company with invoice being in
Srilankan Rupees. When the exchange rate between INR and Srilankan Rupees changes, it
also affects the Indian exporter. This will be an example of intracomapny transfer or
intracompany cashflows.
To sum up, operating exposure measurement requires a company to analyze the following
aspect of its operation.
• From which country/currency the company is generating revenue.
• Who are the main competitors? Are they going to be affected by the currency
risk similar way or not? For example, if the Indian Exporter’s main competitors
are also from India, these competitors are also facing the similar kind of risk.
Competitors will also be affected by the exchange rate movement in a similar
fashion. But if competitors are from other countries, then Indian company is
facing a bigger hurdle.
• How sensitive is the company’s sales volume to price? Can Indian exporter
afford to pass on the exchange rate risk to Wal-mart? If the bed-linen demand is
sensitive to price, then Indian exporter will loose the sales revenue if it increases
the price. In that case what should be the strategy of Indian exporter?
• In which currency the company’s expenses are? Where does the company
produce its goods, source its raw materials? How the input costs change with
the change in exchange rate?
For example on July 12th 2007, Infosys top executives gave the following guidelines (
details given in Box 26.1) for the financial year ending 2007-08. Expecting appreciation of
INR, Infosys has hedged USD revenue at a price of INR 40.58.
Stung by the sharp rise of rupee against dollar, Infosys Technologies Ltd for the first
time ever reduced its profit and revenue outlook for the fiscal 2008.
“The sharp appreciation of the rupee against all major currencies impacted our
operating margins,” said Mr V. Balakrishnan, Chief Financial Officer. “However, our
robust and flexible operating and financial model enabled us to maintain our net
margins while absorbing the impact of appreciating currency, higher wages and visa
costs,” he said.
Infosys was assuming a rate of Rs 40.58 to a dollar in its forecast and has not factored
any large deals. It has hedged $925 million at Rs 40.58, and “if required we will
increase the hedging” Mr Balakrishnan said.
Hence it can be concluded here that if a company knows that fluctuations in currency rates
is going to affect the firm negatively, the company will be able to take proactive action to
protect against such fluctuations.
As mentioned earlier, an Indian company has agreed to supply 2000 units (within in
coming 12 months) of bed linen to Wal-Mart. Wal-Mart has agreed to pay USD20 per
piece. On the date of the contract, the spot rate is INR 45 per USD. It translates to INR 900
per piece. Direct cost per unit of linen is INR 700. The fixed cost is INR 300,000 per year.
For every 1 unit of bed linen the Indian exporter sells, the contribution margin is Rs. 200.
Hence it takes 1500 units to cover the fixed cost. With a sales figure of 200, 000 units, the
Indian company is making a profit of INR 100,000 (INR 200 per unit * 500 units). Let us
term this as base case.
With INR appreciating there could be three scenarios. The Indian exporter can
1. Increase per unit USD price and the company knows that price increase will not
have any impact on volume sales. (Case 1).
2. Increase per unit USD price and the company knows that price increase will
negatively affect the unit sales (Case 2).
3. Decrease price and the company knows price decrease will be accompanied by
volume increase (Case 3).
Nestlé is a Swiss company, founded in 1866 by Henri Nestlé. Nestlé markets its
products in 130 countries across the world. Nestlé manufactures around 10,000
different products and employs some 250,000 people. Around 3,500 people from over
50 countries work in Nestlé’s worldwide network of 17 research, development and
product testing centers. To the average number of employees in Nestlé’s factories is
270, and the average number of employees in any single country is around 3,000.
Although Nestlé’s doesn’t have control over the farms, it supports sustainability in the
supply of agricultural raw materials and agricultural best practices. \
To put these words into action, Nestlé’s has 800 of its own agronomists, technical
advisers and field technicians. Their job is to provide technical assistance to more than
400,000 farmers throughout the world to improve their production quality, as well as
their output and efficiency. They do this on a daily basis in as many as 40 countries
including Inner Mongolia, China, Pakistan, Ethiopia and Colombia. Above all,
Nestlé is genuinely international. One simple example is that around 80 different
nationalities are represented among the 1,600 people in Nestlé Head Office.
To summarize, change in foreign exchange rate not only affects a firm’s already committed
foreign currency payables or receivables, but also has a bigger ramification by affecting the
firm’s competitiveness in the long run. Change in foreign exchange rate affects the present
and future cash flows of the company, thus affecting a very survival of a company. Firms
have to continuously evaluate their operating and financing strategy to tackle the negative
impact of forex movement on the firms’ competitiveness. These aspects are discussed in
Sessions 27 and Session 28.
Questions:
True/False Questions
1. A purely domestic firm with no operations abroad does not face any operating
exposure.
2. Only when a company exports and competes against foreign companies exporting
from other countries face operating exposure.
3. If a firms’ all payables and receivable, borrowing and lending are denominated in
home currency, it does not face operating exposure.
4. Firms enjoying monopolistic power have lesser operating exposure as these firms
can change their pricing policy keeping suiting the exchange arte movement.
5. Firms enjoying monopolistic power have lesser operating exposure if their product
is price inelastic.
3. Risk exposure that measures the change in net present value of a firm due to
changes in future operating cash flows is known as
a) transaction exposure
b) operating exposure
c) translation exposure
d) None of the above
1. a
2. d
3. b
4. b
References:
1. Operating Exposure, Multinational Business Finance, Eiteman, Moffett, Stonehill
and Pandey, 10th Edition, Pearson Education, ISBN, 81-7758-449-9.
2. Techniques for managing economic exposure, class note by Prof. Gordon Bodnar,
http://finance.wharton.upenn.edu/~bodnarg/courses/readings/hedging.pdf
3. Rupee impact: Infosys cuts earnings guidance.
http://www.thehindubusinessline.com/2007/07/12/stories/2007071252380100.htm
4. Nestle’s global operation, Source:
http://www.nestle.com/Resource.axd?Id=602C42FE-04D6-4669-BEE1-
1027492FE5E8
5. Currency Swap deals by Maruti Udyog Limited,Source: Annual report 2006-07
http://www.marutisuzuki.com/annual-reports-archives.aspx
6. Greece facing Goldman Sachs debt deal scrutiny
http://beta.thehindu.com/news/international/article109067.ece
7. Japan, India agree on $6 bn currency swap deal
http://www.financialexpress.com/news/Japan-India-agree-on-6-bn-currency-
swap-deal/257678/