Multinational Business Finance 723g33 yinghong.chen@liu.se Chapter 12 Operating Exposure

What is Operating Exposure? Operating exposure, (also called economic exposure, competitive exposure, and strategic exposure,) measures the change in the firm´s present value resulting from the changes in future operating cash flows caused by an unexpected change in exchange rates.

How to measure Operating Exposure? Two difficulties 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. To analyze the longer term exchange rate changes that are unexpected and its impact on the firm– is the goal of operating exposure analysis.

Operating cash flows and financing cash flows Differentiating cash flows of MNEs: Operating cash flows arise from business activities: that is, 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 management fees. Financing cash flows are from financing activities, that is payments for loans (principal and interest), equity injections and dividends.

Exhibit 12.1 Financial and Operating Cash Flows Between Parent and Subsidiary

Attributes of Operating Exposure Operating exposure is important for the long-run health of a business. 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 management responsibility because it relates to 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. 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.

Example: We discuss the dilemma facing Trident as a result of an unexpected change in the value of the euro, €, the currency of denomination for Trident´s German subsidiary. There is concern over how the subsidiary´s 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.

Exhibit 12.2 Trident Corporation and Its European Subsidiary: Operating Exposure of the Parent and Its Subsidiary

Measuring the Impact of Operating Exposure Trident Europe: Case 1: Euro Devaluation €, 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.

The objective of the Operating Exposure management 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. 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.

Benefits of diversification Management team is prepositioned both to recognize disequilibrium when it occurs and to react competitively if the firm´s operations are diversified internationally . Recognizing a temporary change in worldwide competitive conditions permits management to make changes in operating strategies. Domestic firms do not have the option to react in the same manner as an MNE.

Benefits of diversification If a firm’s financing sources are diversified, it will be prepositioned to take advantage of temporary deviations from the international Fisher effect. i$ –i€ =PUS -PEU However, to switch financing sources from one capital market to another, a firm must have the ability to operate in the international investment community. Again, this would not be an option for a domestic firm.

6 Proactive policies of 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 ( parallel loans), or credit swaps. Currency swaps Leads and lags Reinvoicing center

Proactive Management of Operating Exposure Example: a US firm has a continuing export sales to Canada. In order to compete effectively in Canadian markets, the firm invoices all export sales in Canadian dollars. This policy results in a continuing receipt of Canadian dollars month after month. This series of transaction exposures could be continually hedged with forwards, futures or options, etc. Or using operating exposure management methods described as follows:

Matching currency cash flows One way to offset an anticipated continuous long exposure to a particular company is to acquire debt denominated in that currency (matching). Alternatively, the US firm could seek out potential suppliers of raw materials or components in Canada as a substitute for US and other foreign firms. In addition, the company could engage in currency switching, in which the company would pay foreign suppliers with Canadian dollars.

Exhibit 12.4 Matching: Debt Financing as a Financial Hedge

Proactive Management of Operating Exposure: Risk Sharing Currency Risk-Sharing: a method to manage a long-term cash flow exposure. 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.

Risk Sharing: Ford and Mazda Risk Sharing Agreement between Mazda and Ford. Ford agrees to pay all purchases in Japanese Yen to Mazda as long as the spot exchange rate on the day of invoice is between 115 yen/$ to 125 yen/$. If however the exchange rate falls out of this range, Mazda and Ford will share the difference equally. What happens if the rate falls to 110 yen/$?

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 foreign currency for a specific period of time, but totally circumvent the foreign exchange market . See the following slides. 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 12.5 Using a Back-to-Back Loan for Currency Hedging

Proactive Management of Operating Exposure There are risks involved in the 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 Currency Swaps: A currency swap resembles a back-to-back loan except that it does not appear on a firm’s 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 12.6 Using a Cross-Currency Swap to Hedge Currency Exposure

Proactive Management of Operating Exposure Leads and Lags: Re-timing the transfer of funds Firms can reduce both operating and transaction exposure by accelerating or decelerating the timing of payments that must be made or received in foreign currencies. Intracompany leads and lags is more feasible as related companies presumably embrace a common set of goals for the consolidated group. Intercompany leads and lags requires the time preference of one independent firm to be imposed on another.

Proactive Management of Operating Exposure Reinvoicing Centers: There are three basic benefits arising from the creation of a reinvoicing center: Managing foreign exchange exposure Guaranteeing the exchange rate for future orders Managing intrasubsidiary cash flows

Exhibit 12.7 Use of a Reinvoicing Center

Proactive Management of Operating Exposure 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 firm’s future cash flows Predictability of the firm’s competitor’s responses to exchange rate changes

Mini-Case Questions: Toyota’s European Operating Exposure Why do you think Toyota waited so long to move much of its manufacturing for European sales to Europe? If Britain were to join the European Monetary Union, would the problem be resolved? How likely do you think it is that Britain will join? If you were Mr. Shuhei, how would you categorize your problems and solutions? What was a short-term and what was a long-term problem? What measures would you recommend Toyota Europe take to resolve the continuing operating losses?

Exhibit 12.3 Trident Europe

Exhibit 1 Toyota Motor’s European Currency Operating Structure

Exhibit 2 Daily Exchange Rates: Japanese Yen per Euro

Exhibit 3 Daily Exchange Rates: British Pounds per Euro