Managing Economic/ Operating Exposure International Corporate Finance P.V. Viswanath For use with Alan Shapiro “Multinational Financial Management”

Learning Objectives To define economic exposure and exchange risk and distinguish between the two To identify the basic factors that determine the forex risk faced by a particular company or project. To calculate economic exposure given a particular exchange rate change and cost/revenue scenarios To describe marketing, production & financial strategies appropriate for coping w/ econ exposure. Contingency plans to cope with forex risk. P.V. Viswanath

Operating Exposure Operating Exposure is the firm’s uncertainty with respect to its future operating cash flows. If PV = present value of a firm, then the firm is exposed to currency risk if ΔPV/Δe  0. Operating exposure derives from the operating analysis; hence planning for operating exposure involves the interaction of strategies in finance, marketing, purchasing and production. P.V. Viswanath

Real Exchange Rates and Exposure Currency changes are usually preceded by/accompanied by changes in relative price levels, which can offset the impact of the currency change. Hence, it is impossible to determine exposure to a given currency change without considering simultaneously the offsetting effects of these price changes. If relative prices remain constant and the law of one price holds, then the rate of change in the exchange rate equals the difference in inflation rates between the two countries. That is, the real exchange rate is constant, and PPP holds. The firm’s foreign cash flows will vary with the foreign rate of inflation. The exchange rate also depends on the differential rates of inflation; the movement of the exchange rate will cancel out the effect of the change in the foreign price level. Real dollar cashflows will be unaffected. P.V. Viswanath

Contracts fixed in foreign currency If the firm has contracts fixed in foreign currency terms, it will be affected by exchange rate risk even if relative prices are unaffected and PPP holds. Examples are debt with fixed interest rates, long-term leases, labor contracts and rent. However, if real exchange rates do not change, what we see here is really inflation risk and not forex risk. That is, the same effect can occur domestically, as well. If contracts are indexed and if the real exchange rate remains constant, forex risk is eliminated. P.V. Viswanath

Effects of Real Exchange Rate Changes A decline in the real value of a nation’s currency makes its exports and import-competing products more competitive. E.g. if Brazil’s inflation rate stays high, but its exchange rate stays constant, the real exchange rate will be rising and its products will be at a competitive disadvantage. Hence there could be exchange risk even without changes in nominal rates. An increase in the real value of a currency acts as a tax on imports and a subsidy for exports. If the domestic production cost of a product rises, but exchange rates remain the same, its cost in foreign currency will rise and it will be disadvantaged relative to producers in other countries whose costs have not gone up. Hence the correlation between domestic production costs and exchange rates is important. P.V. Viswanath

Real Exchange Rate Changes P.V. Viswanath

Operating Exposure In evaluating the impact of an exchange rate change on the firm, we cannot assume that local currency cost and revenue streams remain constant. Measuring the likely exchange gain (loss) by multiplying the pre-devaluation (pre-revaluation) local currency cashflows by the projected devaluation (revaluation) will usually lead to upwardly biased numbers. This is partly because inflation and exchange rate changes are related, as shown by PPP. Also, the firm itself, its competitors and customers have flexibility in terms of the decisions that they make. P.V. Viswanath

Pricing Flexibility The key issue for a domestic firm, when the dollar appreciates is its pricing flexibility. Can it maintain its dollar margins both at home and abroad? Can it maintain its dollar price on domestic sales in the face of lower-priced foreign imports? In the case of foreign sales, can the firm raise its foreign currency selling price to preserve its dollar profit margin? P.V. Viswanath

Price Elasticity of Demand The less price elastic the demand for the company’s products, the more price flexibility the company has. Price elasticity depends on the degree of competition and the location of key competitors. The more differentiated a company’s products are, the less competition it will face. (e.g. Mercedes Benz cars) If most competitors are based in the home country, then all will face the same change in their cost structure, and no one producer will be at a disadvantage vis-à-vis any other domestic producer. Commodity exporters are very vulnerable to real exchange effects because of the non-differentiated nature of their products. P.V. Viswanath

More about Flexibility The firm’s susceptibility to exchange rate risk depends also on its ability to shift production and the sourcing of inputs among countries. A foreign subsidiary selling goods in its local market cannot increase local prices enough to make up for a local currency devaluation. However, the devaluation will also help in fending off import competition. the dollar value of local production costs will drop; however, the higher the import content of local inputs, the less dollar production costs will decline. if the firm can substitute local inputs for imported inputs, it can cope better with the devaluation. if the firm can sell in other markets, it can keep dollar revenues high. P.V. Viswanath

The term export sales is interpreted as follows: Let the home country of the MNC be A, B is the country where the goods are produced, either for local sales in B or for export to C. P.V. Viswanath

Explaining Exhibit 11.5 Let the home country of the MNC be A, B is the country where the goods are produced, either for local sales in B or for export to C (or A itself). (Re)Devaluation occurs in country B. Row 1 (Revenue/Export Sales) refers to production in B for sale in C. If B’s currency is devalued, the good can be sold at a cheaper price in C and this will increase revenue in terms of A’s currency. Row 2 (Revenue/Local Sales): if there is weak prior import competition, then local prices will not be affected and hence the revenue in terms of A’s currency will drop. Row 4 (Costs/Domestic inputs): if import content is low, then dollar denominated costs are going to drop, since costs are constant in terms of B’s currency. P.V. Viswanath

What affects Exchange Rate Risk? P.V. Viswanath

Operating and Financing Cash Flows Operating Cash flows arise from receivables and payables, rent and lease payments for the use of facilities and equipment, royalty and license fees for the use of technology and intellectual property and assorted management fees for services provided. Financing Cash flows are payments for the use of loans (principal and interest), and stockholder equity (new equity investments and dividends). P.V. Viswanath

Intracompany MNE Operating and Financing Cash Flows P.V. Viswanath

Operating Exposure Expected foreign exchange rate changes are not relevant for the definition of operating exposure because management and investors should have already factored this information into their evaluation of anticipated operating results and market value. For example, the forward rate might be used as a the future spot rate estimate in preparing operating budgets. Similarly, expected cash flow to amortize debt should already reflect the international Fisher effect. The level of expected interest and principal payments should be a function of expected exchange rates, rather than existing rates. P.V. Viswanath

Factors Affecting Operating Exposure: An Example Operating exposure is not restricted to foreign exchange exposure. Example: Volvo’s operating exposure can be traced to: Swedish Krona/DM Exchange Rate uncertainty The uncertainty of future Swedish Krona short-term interest rates (which is related to the demand for cars). German producer price uncertainty Still, exchange rate uncertainty is very important and is characteristic of the operating exposure of global firms. P.V. Viswanath

Operating Exposure: Short Run Impact The first level impact is on the one-year operating budget; the gain or less depends on the currency of denomination of expected cash flows In the short run, it is difficult to change the exposure due to implied obligations, such as purchase or sales commitments, because the currency of denomination cannot be changed. It is also difficult to change sales prices or to renegotiate factor costs P.V. Viswanath

Operating Exposure: Medium Run –Parity Conditions Hold The second level impact is on expected medium-term cash flows. If parity conditions hold, the firm should be able to adjust prices and factor costs over time to maintain the expected level of cash flows, if no real variables have changed. The country of cash flow origination and its monetary, fiscal, and balance of payments policies will determine whether firms can adjust prices and costs. Example: If Volvo is selling cars to Germany and the DM depreciates because the German money supply rises, Volvo will be protected if it can raise its DM prices, so that the Krona price is maintained. Suppose the inflation rate in the US was 10% over the last year. If real relative prices did not change, nobody would be affected. Both costs and prices would rise by 10%. On the other hand, if it is not a pure monetary event, the average inflation might be 10%, but costs might have risen 12% and prices might only have risen 8%. P.V. Viswanath

Operating Exposure: Medium Run – Change in Real Variables If the firm is not able to adjust prices and costs because the change in exchange rates has been accompanied by real changes, so that relative prices have been altered. Example: If the DM has depreciated relative to the Krona because German investors have lost confidence in the German economy and are moving their capital to Sweden, the wealth of German investors has dropped, the real price of a Swedish car has risen and Volvo may not be able to raise its prices proportionately. There is less than perfect pass-through. P.V. Viswanath

Operating Exposure: Long Run Long-run cash flows beyond five years could be affected. Cash flows will be influenced by the reactions of existing and potential competitors to exchange rate changes when real variables are affected. In principle, all firms subject to international competition, domestic or multinational, are subject to foreign exchange operating exposure in the long run, whenever real variables are affected. P.V. Viswanath

Instruments du Rhone – 1 P.V. Viswanath

Instruments du Rhone -- 2 P.V. Viswanath

Managing Operating Exposure Strategically – Diversifying Operations The key to operating exposure management is to anticipate and influence the effect of unexpected changes in exchange rates on a firm’s future cash flows. Management can diversify the firm’s operating and financing base. Diversifying operations means diversifying sales, location of production facilities and raw material sources. Diversifying financing means raising funds in more than one capital market and in more than one currency. It can change the firm’s operating and financing policies. P.V. Viswanath

Strategic Diversification of Operations There might be a change in comparative costs in the firms’ own plants located in different countries. Management can make marginal shifts in sourcing raw materials, components, or finished products. If spare capacity exists, production runs can be lengthened in one country and reduced in another. There might be a change in profit margins or sales volume in one area compared to another, depending on price and income elasticities of demand and competitor’s reactions. Marketing efforts can be strengthened in export markets where the firms’ products have become more price-competitive. P.V. Viswanath

Managing Operating Exposure – Diversifying Financing Interest rates differentials might not adjust fully to expected changes in interest rates. In this case, provided the firm is established and known in different markets, it can change the source of its short and long-term financing. Diversifying financing per se can also help diversify risks of restrictive capital market policies or government borrowing competition in the capital market It can help diversify political risks – expropriation, war, blocked funds, or unfavorable changes in laws. P.V. Viswanath

Changing Operating Policies – Leads and Lags Firms can reduce transaction and operating risk by accelerating (lead) or decelerating (lag) the timing of payments. This will depend on expected changes in exchange rates. Firms can also try to accelerate or decelerate the collection of receivables, for the same reason, and in the same way. Suppliers/Clients may not want to go along. This may require incentive payments. P.V. Viswanath

Intracompany Leads and Lags Leading and lagging between related firms is more feasible. When done between subsidiaries, it has the effect of an intracompany loan and represents an alternative way of shifting capital, that is less subject to government interference. However, it is unfair if each unit has minority stockholders separate from the corporate family, since leading/lagging will affect the relative rate of return of the different units. Widespread leading/lagging can affect exchange rates. Hence, governments that want to affect exchange rates may put limits on lagging. P.V. Viswanath

Intracompany leads and lags Suppose a multinational company faces the following after-tax borrowing and lending rates: Borrowing Rate Lending Rate US 3.8% 2.9% Germany 3.6% 2.7% If the US unit requires funds and the German unit has excess funds, then leading funds owed by the German unit to the US unit or lagging funds owed by the US unit to the German unit has the effect of a loan by the German unit to the US unit with a saving of 110 basis points. If both units have excess funds, it would be profitable to move funds to the US, with an interest differential of 20 basis points (2.9 versus 2.7). P.V. Viswanath

Risk Sharing Risk-Sharing is a contractual arrangement in which the buyer and seller agree to share or split currency movement impacts on payments that pass between them. This is worthwhile if the relationship between the two firms is long-term. For example, Ford and Mazda may agree that all purchases by Ford will be made in Japanese yen at the current rate, as long as it is between 115 and 125 yen/$. If the rate falls outside this range, they may agree to share the difference equally. Of course, if the equilibrium rate level changes drastically, the agreement will have to be changed. P.V. Viswanath

Reinvoicing Centers A reinvoicing center is a separate corporate subsidiary that manages in one location all transaction exposure from intracompany trade. Effectively, the reinvoicing center centralizes transaction exposure risk, and diversifies the exposure of the parent company to transaction exposure. It need only hedge residual exposure risk. This method releases individual company subsidiaries from having to worry about transaction exposure for intracompany trades. The reinvoicing center can manage intra-affiliate cash flows, including leads and lags of payments. P.V. Viswanath

Reinvoicing Centers P.V. Viswanath

Modifying Financing Policies – Natural Hedges One way to offset an anticipate continuous long exposure to a particular currency is to acquire debt denominated in that currency. If stable (in foreign currency) and continuing receipts from sales are expected, debt in the foreign currency could be issued; the sales receipts would be used to make interest payments on the debt. This is a form of matching. The firm could also seek raw material suppliers in Canada, so that sales receipts could be used to pay for purchases. The firm could arrange to pay raw material suppliers from a third country using the foreign currency of the sales receipts. P.V. Viswanath

Natural Hedges – An Example P.V. Viswanath

Back to Back Loans Also known as a parallel loan or credit swap. Two firms in separate countries agree to borrow each other’s currency for a specified period of time. At an agreed terminal date, they return the borrowed currencies. Principal parity might be required – akin to marking to market. The advantage is that there is no foreign exchange risk, and it doesn’t require the approval of any government body regulating the use of foreign exchange. However, a counterparty must be found for the currency, amount and timing desired. P.V. Viswanath

Back to Back Loans P.V. Viswanath

Currency Swaps P.V. Viswanath

Currency Swaps Accountants in the US treat currency swaps as foreign exchange transactions rather than as debt and treat the obligation to reverse the swap at some later date as a forward exchange contract. Forward exchange contracts can be matched against assets, but they are entered in a firms’ footnotes rather than as balance sheet items. Hence, both accounting and operating exposures are avoided. P.V. Viswanath

Contractual Hedging and Long-term Exposure Normally, firms take contractual positions like forward contracts and options in order to hedge positions that do not have quantity risk (but only exchange rate risk), such as hedging transaction exposure. However, firms that have relatively predictable cash flows might use contractual strategies to hedge operating exposure as well. This is usually difficult because it is necessary for the firm to be able to predict competitor response as well. Another question with contractual hedging to protect against changes in strategic position is that it is purely a short-term hedge. A change in strategic posture would be a longer-term response. Hence contractual hedging would be effective only if the “strategic” impacts are temporary. P.V. Viswanath