1. Foreign Exchange Operating Exposure Dr. Himanshu Joshi FORE School of Management

2. Foreign Exchange Operating Exposure Foreign Exchange operating exposure, or FX operating exposure is the long term FX exposure of a firm’s anticipated operating profit stream (or operating cash flow stream). The main components of FX operating exposure are: – FX Revenue Exposure – FX Cost Exposure

3. Foreign Exchange Operating Exposure Here we cover the source of FX operating exposure and explains how it is measured. This exposure is ‘real’, whether or not it is reflected in balance sheet. We will also cover the operational hedging, which is having operating costs with an FX exposure that offsets the FX exposure of the revenues.

4. Foreign Exchange Operating Exposure To understand FX operating exposure, we will first look at a European Firm’s FX operating exposure to US dollar. Then we will look at the same firm as it were owned by a US multinational and examine the FX operating exposure to euro.

5. Foreign Exchange Operating Exposure EPF an European Co. Euro Pipe Fittings (EPF), produces aluminum pipe fittings at a plant outside Dublin, Ireland. In addition to local wages and marketing expenses, production at Irish facility requires purchase of raw aluminum. Sales are predominantly to “German” construction companies. This year EPF is expected to sell 600 fittings at € 1 per fitting. Production and marketing expenses amount to € 0.40 per fittings, each fitting requires one pound of aluminum. Aluminum is priced in US dollars, and the price is currently $0.20 per pound. Let us assume the spot FX rate is 1$/€. Let us assume 20% of tax rate. Assume also that EPF has a depreciation expense of €40.

6. Foreign Exchange Operating Exposure What happens to EPF’s projected cash flows if the spot FX rate changes from 1$/€ to 0.8$/€. EPF has a short FX operating exposure to foreign currency $. (similar to transaction exposure) EPF can hedge this exposure by taking a long forward position on foreign currency $ where amount is fixed in euro cost of aluminum A € = €120.

7. Foreign Exchange Operating Exposure:Measure Real worlds companies are not as simple as EPF. For this reason, it will be useful to measure a company’s overall FX operating exposure as an elasticity: The percentage change in after-tax operating cash flows, given the percentage change in the FX value of the foreign currency.

8. Foreign Exchange Operating Exposure: Measure For EPF home currency is Euro, foreign currency is US dollar. We denote FX operating exposure as: Ę o$ € = percentage change in the operating cash flows in home currency (€)/ percentage change in FX value of foreign currency.

9. Do it Yourself.. Assume that the cost of a pound of aluminum is $0.25 instead of $0.20. assume a 25% rise in the FX value of the US dollar as the FX rate changes from 1$/€ to 0.8$/€. Find the EPF’s FX operating exposure to the US dollar.

10. FX Operating Exposure of a Foreign Subsidiary Let us now assume that a foreign firm now owns Euro Pipe Fittings. In US dollars, the revenues, production costs, and depreciation change with the changes in the FX rate, but the cost of aluminum does not. Thus US owner of the EPF cares about EPF’s financial results in US dollars. For simplicity we assume that effective tax rate stays the same if EPF has the US owners. 20%. X 0 $/€ = 1$/€, X 1 $/€ = 0.8$/€

11. FX Operating Exposure of a Foreign Subsidiary Ę O€ $ = o $ /x $ (solve) Even if EPF’s cash flows were reinvested in its own growth and not repatriated to US, the parent still has the same FX operating exposure as if cash flows were actually converted to US dollars. The reason is that FX changes affect the intrinsic value of EPF’s operating cash flows in US dollars, that is the value the parent could get by selling EPF as an entity.

12. Do it Yourself… Assume the FX value of the euro rises by 10% from 1$/€ to 1.10 $/€. Find the EPF’s new projected after tax operating exposure to the euro is +1.48.

13. Ę O$ € + Ę O€ $ = 1 -0.48 +1.48 = 1

14. Do it Yourself.. Assume that the cost of a pound of aluminum is $0.25 instead of $0.20. assume a 20% drop in the FX value of the euro as the spot FX rate changes from 1$/€ to 0.80$/€. Find the EPF’s FX operating exposure to the euro and show that this FX operating exposure to the euro and the FX operating exposure to the US dollar sum to 1.

15. FX Revenue and FX Cost Exposure & FX Pass- Through FX revenue and FX cost exposure are the main components of FX operating exposure, and are defined similarly as elasticities. FX Revenue Exposure (R $ ) is the elasticity of a firm’s anticipated revenue to FX changes, viewed from the perspective of the firm’s base currency. FX Cost Exposure (C $ ) is the elasticity of a firm’s anticipated cost to FX changes.

16. FX Revenue Exposure Ę R€ $ = %∆R $ /x $/€

17. FX Cost Exposure Ę C€ $ = %∆C $ /x $/€

18. FX Revenue and Cost Exposure for EPF.. (Euro Perspective) From the euro perspective in EPF example, FX Revenue exposure is 0. that is, FX rates change does not affect EPF’s revenues in the Euros. Similarly, the FX cost exposure to the US dollar is zero for the production costs, and depreciation. For the aluminum, FX cost exposure to the US dollar is 1. this FX cost exposure is an example of pure FX Conversion Exposure. If the US dollar appreciates by 25%, the cost of the aluminum in Euros increases by 25%, since the cost of aluminum is stable in US dollars.

19. FX Revenue and Cost Exposure for EPF.. (Dollar Perspective) When US dollar is assumed to be base currency in the EPF example, the FX revenue exposure to the Euro is 1. This is another example of pure FX conversion exposure. In US dollars, EPF’S production/marketing costs and depreciation also have an FX cost exposure to the Euro of 1, While the cost of aluminum has an FX cost exposure to the Euro is 0, since the cost of the aluminum is stable in US dollar.

20. FX Cost Exposure.. A firms cost exposure depends on the international locations of its own operations and those of its suppliers and potential suppliers.

21. Are Revenue Stable in Real World? In our EPF scenarios, there is no change in selling price and or sales volume when the FX rate changes, which is why revenues in Euros are stable. In fact, firms typically do experience changes in selling price or sales volume when FX rates Change. The influence of FX rate changes on product’s local currency selling price is known as FX-Pass Through.

22. FX Pass Through..A Case of Dow Chemical Dow Chemical Corporation uses to assess the FX exposures of each of its products sold in Europe. Dow’s point of view is its home currency, US Dollars. The euro is the currency to which Dow’s European revenues are exposed to. The more changes in the FX value of the euro are passed through to the Dow’s European customers, in the form of changes in a product’s local price in Euros (with no assumed impact on sales volume), the lower is the product’s price stability in Euros. And the lower is the FX exposure of Dow’s revenues (measured in USD) to Euros.

23. FX Pass Through..A Case of Dow Chemical Dow’s marketing managers are asked to use a price stability rating of 0 to 100 to rate the stability of the local currency prices of each European products. A stability rating of 100 means a product’s price in euro is 100% stable; it is expected to be unaffected by changes in the FX rate, and Dow cannot or does not pass through FX changes to customers in Europe. Thus Dow bears 100% of the exposure to FX changes, because all the FX risk is retained by the seller, not passed through to the buyer. Dow’s FX revenue exposure in US Dollar to changes in FX value of Euro is 1.

24. FX Pass Through..A Case of Dow Chemical A Price stability rating of Zero (0) implies that the product’s price in euros has zero stability when the FX rate changes. Zero stability in local price is good for Dow, since FX changes are entirely passed through to European customers in the product’s local price in eoros, So Dow’s revenues (in US dollars) are not exposed to changes in the FX value of the euro. For example, when the spot FX value of the euro rises, the euro price of a product rated 0 is dropped (and vice-versa for drops in euro), in precisely the right amount to leave Dow’s revenues unaffected when viewed in US dollars.

25. FX Pass Through..A Case of Dow Chemical Thus a rating of 0 implies that 0% of the euro price is stable, so 0% of US dollar revenues is exposed to FX changes. The 0-rating represents full pass through and corresponds to an FX revenue exposure of 0. It is possible for product’s for which Dow has no competition and have price inelastic demand.

26. FX Pass Through..A Case of Dow Chemical Of course, most Dow products had a stability rating between 0 and 100. A Dow stability rating of 60 means that 60% of the foreign currency price is stable, and not subject to FX pass through changes, while 40% of any FX Change is passed through in the form of a partially offsetting change in local euro product prices.

27. FX Pass Through..A Case of Dow Chemical MagnesiumRatingFX Revenue Exposure to Euro ($) Magnesium00 Caustic Soda600.60 Propylene Glycol800.80 Agricultural900.90

28. Do it Yourself.. (1) what would be the stability rating of the EPF’s Revenues (in Euros)? (2) if the Stability rating of EPF’s revenues in euro is 75, what is the FX revenue exposure to the euro, given a US dollar perspective. (3) what percentage of FX changes are passed through?

29. Application of FX Pass- Through Example.. DDM Ltd. Is the British Subsidiary of US parent firm. The currency of determination is mainly British pound. DDM’s British pound revenues have stability rating of 60. assume that revenues are £ 1000 and operating costs are £ 750. ignore taxes and depreciation. Assume that currency of determination of the operating costs is pound. What is the US parent’s FX operating exposure to the pound? What would be the FX operating exposure to the pound if the price stability rating was 75 instead of 60? Assume X 0 $/£ = 1.60$/£.

30. Do it Yourself.. DDM Ltd. Is the British subsidiary of a US parent firm. The currency of determination of DDM’s product is mainly, but not entirely, the British pound. DDM’s British pound revenue’s have a stability range of 60. Assume that revenues are £1000 and operating costs are £ 750. Ignore taxes and depreciation. Assume that the currency of determination of the operating costs is the pound? (2) what would be the FX operating exposure to the pound if the price stability rating were 75 instead of 60? Although the answer does not depend on the spot FX rate, it may help to assume a spot FX rate of 1.60 $/ £.

31. Operational Hedging and Operating Leverage.. Suppose the US parent of EPF relocates the fittings production from Ireland to the US. The firm is renamed as XPF. XPF is a US firm that makes fittings in the U.S and again exports them to Germany. XPF’s Revenues in Euros are not affected by FX changes, but all of its operating expenses, not just the cost of aluminum, are stable in US dollars. Thus XPF’s Revenue exposure to euro is 1. and FX cost exposure is 0.

32. XPF.. Assume that XPF’s Production/Marketing Cost is $0.40 per fitting. Assume that depreciation expense is $40. X0 $/€ = 1$/€ X1 $/€ = 0.8$/€

33. Operational Hedging XPF’s FX operating exposure to the euro (2.40) is higher than EPF’s (1.48) because some of EPF’s Costs are stable in Euros, so when viewed in US dollars they are exposed to changes in FX value of the Euro. Since FX Cost Exposure matches its Revenue exposure, EPF’s FX operating exposure to the euro is lower than XPF’s whose costs are entirely fixed in US dollars, and do not match the changes in revenues in US dollars.

34. Operational Hedging By producing in the Euro zone and thus fixing some costs in the same currency as the revenues (Euros), the US owner of the EPF is said to be using Operational Hedging. Both EPF and XPF have higher FX operating Exposure to the Euro than the FX Revenue exposure (1), but XPF has more fixed costs (relative to FX changes), so XPF has more FX Operating Exposure.

35. Theoretical Estimation of FX Operating Exposure Ignoring depreciation and taxes, and If there is no impact of FX changes on Volume of sales and Production, there is relatively simple relationship between FX operating exposure and its main components. Let G denote the reciprocal of the operating cash flow margin. Operating Cash flow margin is O $ /R $, so G = R $ /O $. If operating cash flow margin is 0.25 then G = 1/0.25 = 4.

36. Theoretical Estimation of FX Operating Exposure for OMPL Ę O€ $ = Ę R€ $ (G) + Ę C€ $ (G-1)

37. Example.. DDM Ltd. Is the British Subsidiary of US parent firm. The currency of determination is mainly British pound. DDM’s British pound revenues have stability rating of 60. assume that revenues are £ 1000 and operating costs are £ 750. ignore taxes and depreciation. Assume that currency of determination of the operating costs is pound. What is the US parent’s FX operating exposure to the pound? What would be the FX operating exposure to the pound if the price stability rating was 75 instead of 60? Assume X 0 $/£ = 1.60$/£.

38. DO IT YOURSELFOperating Hedging At United Technologies Corporation.docxOperating Hedging At United Technologies Corporation.docx Carrier Europe is a subsidiary of the US multinational United Technologies Corporation (UTC) selling air conditioners in the Eurozone Assume that the price of the air conditioners are stable in euros when the FX rate fluctuates, and the same is true for the 70% of Carrier-Europe’s operating costs that are incurred in the Eurozone. The other 30% of operating costs are compressor costs, which are assumed to be stable in US dollars. Assume that Carrier-Europe has an operating profit margin, O $ /R $, OF 25%. Approximate Carrier-Europe’s FX operating exposure to the euro using equation (5.3).

39. Summary of FX Operating Exposure Scenarios 1.High Positive (Ę O€ $ >1) Exporter with low FX pass through and little hedging. 2.Low Positive (Ę O€ $ <1) Exporter with some FX pass through or Operational Hedging. 3.Low Negative (-1< Ę O€ $ <0) Importer with low FX pass through and little operational hedging. 4.High Negative (Ę O€ $ <-1) Parent of foreign subsidiary like in case 1 exporting to parent’s country.