Operating Exposure

Operating Exposure

• Operating exposure, also called

economic exposure, competitive
exposure, and even strategic exposure
• It 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.
Operating Exposure

• Operating exposure depends upon

– Change in nominal exchange rate
– Change in the selling price (output
price)
– Change in the quantity of output sold
– Change in operating costs i.e.
quantities and prices of inputs
Operating Exposure

• Operating exposure can be looked upon as a

combination of two effects - the conversion
effect and the competitive effect
– Conversion effect refers to the changes in
home currency value of a given foreign
currency cash flow
– Competitive effect refers to changes in
foreign currency cash flows.
 Attributes of 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
exposures of all the firm’s competitors and
potential competitors worldwide.
Attributes of Operating Exposure

• From a broader perspective, operating

exposure is not just the sensitivity of a
firm’s future cash flows to unexpected
changes in foreign exchange rates, but
also to its sensitivity to other key
macroeconomic variables.
• This factor has been labeled
macroeconomic uncertainty.
Attributes of Operating Exposure

• 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.
Attributes of Operating Exposure

• Financing cash flows are payments for

loans (principal and interest), equity
injections and dividends of an inter and
intracompany nature
 Financial & Operating Cash Flows Between Parent &
Subsidiary

Financial Cash Flows

Dividend paid to parent

Parent invested equity capital
Interest on intrafirm lending
Intrafirm principal payments

Parent Subsidiary

Payment for goods & services

Rent and lease payments
Royalties and license fees
Management fees & distributed overhead

Operational Cash Flows

Attributes of Operating Exposure

• Operating exposure is far more important

for the long-run health of a business than
changes caused by transaction or
accounting exposure.
• Operating exposure is inevitably
subjective, because it depends on
estimates of future cash flow changes
over an arbitrary time horizon.
Attributes of Operating Exposure

• Planning for operating exposure is a total

management responsibility because it
depends on the interaction of strategies
in finance, marketing, purchasing, and
production.
Attributes of Operating Exposure

• 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.
Attributes of Operating Exposure

• 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 the Impact
of Operating Exposure
• An unexpected change in exchange rates
impacts a firm’s expected cash flows at
four levels, depending on the time
horizon used:
– Short run
– Medium run: Equilibrium case
– Medium run: Disequilibrium case
– Long run
 Assessing Operating Exposure:
Scenario Approach

• Consider alternative exchange rate scenarios and

under each specify how prices, quantities and
costs will behave
• Based on considerations of competitive behaviour
and the response of the various cost components to
domestic and foreign inflation and changes in
exchange estimate operating cashflows under
different scenarios
• Assess likelihood of different scenarios
 Assessing Operating Exposure:
Scenario Approach

• The firm needs to know the structure of its output

markets, demand elasticities and competitive
reactions as well as detailed information about its
cost structure and the response of the various cost
components to changes in exchange rate and other
macroeconomic shocks
• Simultaneous changes in several variables
complicates the task further since precise
identification of the impact of each becomes
difficult
 An Exporter Firm

• Real depreciation will increase the profitability -

measured in home as well as foreign currency - of
an exporter provided again that relative price
shifts are not significantly adverse

• This would be generally true unless the costs rise

faster than inflation at home.
 An Importer Firm

• A real depreciation of the home currency will

reduce importer's profits measured in either
currency
• The case of a firm which imports raw materials
and components for further processing at home
and sells the output in the home market is more
difficult since the effect of a real depreciation on
profit depends upon the share of imported inputs
in total costs, the elasticity of demand and the
behavior of other costs
 Currency of Invoicing, Quantity Criteria
and Operating Exposure

• In practice, a substantial amount of trade involves

contractual arrangements between the exporter
and the importer wherein both the quantities
supplied and prices - in either party's currency -
are fixed for sometime
• While prices respond to exchange rate changes
rather quickly, quantity response to price changes
is likely to be considerably slower
 Currency of Invoicing, Quantity Criteria
and Operating Exposure

• If the importer does not have easy access to

forward markets or if bid-ask spreads in
forward markets are very large, an exporter
insisting on invoicing in his own currency
will face a competitive disadvantage if other
exporters who are willing to accommodate
the importer by invoicing in the latter's
currency
 Currency of Invoicing, Quantity Criteria
and Operating Exposure

• Invoicing preferences would depend

upon the strength of the currency of
invoicing, competitive factors, invoicing
practices of competitors etc. Exporters in
weak currency countries would prefer to
invoice in FC; their importers might
prefer to be invoiced in exporter’s
currency. Trading off operating and
transactions exposure
 Coping with Operating Exposure

• None of the financial instruments used to reduce

transactions exposure are of much use in reducing
operating exposure
• To the extent the firm can correctly identify and
estimate its operating exposure to exchange rates,
it can in principle use forward contracts to hedge
• The difficulty is in identifying and estimating the
exposure coefficients
• Operating exposure covers a much longer horizon
that contractual transactions exposures
• Too many uncertainties
 Coping with Operating Exposure

• Operating exposure must be managed by altering

the firm's operations - pricing, choice of markets,
sourcing, location of production etc.
– The firm can reduce the adverse effects of
exchange rate changes on its revenue by
moving into product lines which are less price
sensitive and by countering the effect of higher
prices by means of other competitive weapons
such as local advertising and promotion
–
 Coping with Operating Exposure

• If inputs are purchased in markets where the

local content in their costs is high, exchange
rate changes will significantly alter the relative
costs of sourcing from alternative sources
 Coping with Operating Exposure

– Shifting the location of production to countries

whose currencies have depreciated in real terms
can reduce the adverse impact of exchange rate
changes provided production costs in different
locations have a large local content
• Reasons for the globalization of production and
sourcing may in fact be the desire on the part of
MNCs to match the currencies of revenues and
costs
 Coping with Operating Exposure

• When output markets are not perfectly

competitive, the strategy of currency matching
of costs and revenues might result in smaller
expected profits though it will reduce the
variance of profits
 The Practice of Exposure Management

• The key findings of investigations of corporate

currency exposure management practices
– Very few corporations undertake an accurate,
quantitative assessment of how unanticipated
exchange rate changes impact on the value of
their firm
– Most firms find it very difficult to gauge the
long-term exposure of their businesses to
currency fluctuations
The Practice of Exposure Management

– Relatively more but still a minority of the firms

have some reliable quantitative understanding
of the exposure of their operating cash flows to
currency fluctuations
– A surprisingly large number of firms appear to
think that they are not exposed to currency risk
or that the risk is trivial
The Practice of Exposure Management

– Even among firms which engage in

systematic assessment of their currency risk
profile and conscious currency risk
management, the focus is almost exclusively
on short-term transactions exposures
extending up to a year
 The Practice of Exposure Management

– Long-term operating exposures are dealt with

by "on-balance sheet" operating mechanisms
• Firms also react to exchange rate changes after-
the-fact by revising pricing policies, wage
contracts etc.
• Thus the practice of currency risk management,
particularly long term exposure, is much less
precise and sophisticated than what the
development of the theory would suggest
Measuring the Impact
of Operating Exposure
• The following slide presents the dilemma
facing Bharti Instruments as a result of an
unexpected change in the value of the euro, the
currency of economic consequence for the
German subsidiary.
• There is concern over how the subsidiaries
revenues (price and volumes in euro terms),
costs (input costs in euro terms), and
competitive landscape will change with a fall
in the value 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
• Operations to be are diversified
internationally
• Financing sources to be diversified