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Operating Exposure

Ch 12
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.
Trident Corp. is a U.S.-based multinational firm.
Exhibit 12.1 shows Tridents basic structure and
currencies of operation.

Exhibit 12.1 Trident Corporation:
Structure and Operations
Trident 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
Trident in Germany buys and sells in euros,
Trident U.S. buys and sells in dollars, but
Trident China has sales based in dollars, euros,
and renminbi the latter being the dominant
cash flow for Trident China
Static vs. Dynamic Operating Exposure
Measuring exchange rate exposure required analysis of short
and intermediate term fixed or static) contracts, and longer
term (more dynamic) forecasting
Using Trident 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.
Trident China: In the short-term, fewer profits, may need to raise prices
in the long-term
Trident Germany: No change in the shortterm, may also be affected
by eventual higher prices from China
Trident U.S.: No change in the shortterm, may also be affected by
eventual higher prices from China
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.
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 Trident U.S.
and China.
Exhibit 12.2 Financial and Operating Cash Flows
Between Parent and Subsidiary
Attributes of Operating Exposure
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.
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.
From a managers 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 investors perspective, if the foreign exchange market is efficient,
information about expected changes in exchange rates should be reflected
in a firms market value.
Only unexpected changes in exchange rates, or an inefficient foreign
exchange market, should cause market value to change.
Exhibit 12.3 Operating Exposures
Phases of Adjustment and Response
Measuring the Impact of Operating Exposure
Trident 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 Trident
Germanys income and operating cash flows
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 Trident and Trident
Germany
Exhibit 12.5 Trident Germanys
Baseline Valuation
Trident Germany, Case : 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
Trident 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.
Trident Germanys present value is now $9,018,195.

Exhibit 12.6 Trident Germanys
Valuation (Case)
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 firms future cash flows, rather than merely hoping
for the best.
To meet this objective, management can diversify the firms operating
and financing base.
Management can also change the firms 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 firms 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 firms 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 six most commonly employed proactive policies are:
Matching currency cash flows
Risk-sharing agreements
Back-to-back or parallel loans
Currency swaps
Proactive Management of
Operating Exposure
Matching currency cash flows.
Exhibit 12.8 depicts the exposure of a U.S. firm with continuing
export sales to Canada.
One way to offset an anticipated continuous long exposure to a
particular company 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
Currency Clauses: Risk-Sharing:
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 Loans:
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
others 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 illustrates a back-to-back loan.
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 each party has 100%
collateral (denominated in a different currency).
Proactive Management
of Operating Exposure
Cross-Currency Swaps:
A currency swap resembles a back-to-back loan
except that it does not appear on a firms 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 illustrates the use of a cross-
currency swap.


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 and Eastman Kodak have undertaken long-term
currency option positions hedges designed to offset lost
earnings from adverse exchange rate changes.
The ability to hedge the unhedgeable is dependent upon:
Predictability of the firms future cash flows
Predictability of the firms competitors responses to exchange rate
changes

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