VOLATILE EXCHANGE RATES CAN PUT OPERATIONS AT RISK: The Importance, Measurement and Management of Operating Exposure

MAIN QUESTIONS WHY DOES AN OPERATIONS MANAGER NEED TO WORRY ABOUT EXCHANGE RATE FLUCTUATIONS? ARE FINANCIAL INSTRUMENTS ADEQUATE TO HEDGE AGAINST OPERATIONAL RISKS FROM VOLATILE EXCHANGE RATES?

PRINCIPAL WAYS THAT FOREIGN EXCHANGE FLUCTUATIONS AFFECT A COMPANY’S FINANCIAL PERFORMANCE TRANSACTION EXPOSURE –changing expected results of transactions denominated in non-domestic currencies TRANSLATION EXPOSURE –changing the domestic currency value of net assets held in foreign currencies OPERATING (OR ECONOMIC) EXPOSURE –future exposure: changing the domestic currency value of future cash flows to be earned in foreign currencies –competitive exposure: changing a company’s future competitive position

PURCHASING POWER PARITY Theory of PPP: Main Message –Changes in competitiveness between countries, which would otherwise arise because of unequal inflation rates, tend to be offset by corresponding changes in exchange rates (in the long run) Two versions of the theory –Absolute Form: Equilibrium Exchange Rate = e = P d /P f = Dom. P/For. P –Relative Form:  e   P d -  P f  e = Expected Percentage Change in Exchange Rates  P d = Expected Percentage Change in Domestic Prices  P f = Expected Percentage Change in Foreign Price

PURCHASING POWER PARITY (cont.) Real Exchange Rates –From Absolute Form: Real Exchange Rate = s = eP f /P d –From Relative Form:  s ~  e +  P f -  P d

EXAMPLES EX 1: –Deutsche Mark (DM) strengthens by 4% –Inflation in Germany 1% –Inflation in U.S. 4% –Real Exchange Rate Change =  s = 4% + 1% - 4% = 1% appreciation of DM EX 2: –Japanese Yen appreciates by 40% –Inflation in Japan 30% –Inflation in U.S. 5% –Real Exchange Rate Change =  s = 40% + 30% - 5% = 65% appreciation of Yen

DIFFERENCES IN VARIOUS TYPES OF CURRENCY EXPOSURE

A STORY ABOUT OPERATING EXPOSURE EVENT: The $ Appreciates (in Real Terms) –Scenarios #1: German Prices Constant –Same Sales Volume –U.S. Firm less Revenue in Dollars #2: U.S. Firm Adjusts Prices in Germany to Account for $ Appreciation –Drop in Sales Volume –U.S. Firm Less Revenue in Dollars –NEGATIVE OPERATING EXPOSURE –If $ Depreciates  POSITIVE OPERATING EXPOSURE GERMAN MARKET U.S. FIRM Sources locally Sells to German & U.S. Markets

COMPLICATING FACTORS TO THE SIMPLISTIC STORY CONSUMER REACTIONS –German Consumers Lose Purchasing Power  German Demand decreases –U.S. Consumers Gain Purchasing Power  U.S. Demand increases  Hard to Predict Net Effect COMPETITOR REACTIONS –German Competitors: Might Increase Mkt. Share; Increase Price –U.S. Exporters: None has Relative Cost Advantage

COMPLICATING FACTORS TO THE SIMPLISTIC STORY (cont.) SUPPLIER REACTIONS –Look at how $ appreciation affects Sourcing Structures (imported Raw Materials) –German Suppliers (and workers) realize diminishing purchasing power and react GOVERNMENT REACTIONS –protectionist legislation, capital flow controls and currency transactions –tax breaks to attract investments

CHARACTERISTICS OF OPERATING EXPOSURE NO NECESSARY RELATION TO ACCOUNTING OR CONTRACTUAL EXPOSURE THE STRUCTURE OF THE MARKET IN WHICH THE COMPANY AND ITS COMPETITORS SOURCE LABOR AND MATERIALS AND SELL PRODUCTS DETERMINES OPERATING EXPOSURE NO NECESSARY RELATION TO THE COUNTRY IN WHICH GOODS ARE SOLD OR INPUTS SOURCED NOT NECESSARILY LINKED TO THE CURRENCY IN WHICH PRICES ARE QUOTED OPERATING PROFIT VARIES WITH REAL EXCHANGE RATE CHANGES

CHARACTERISTICS OF OPERATING EXPOSURE (cont.) DIFFERENCES BETWEEN COMPETITORS IN SOURCING, TECHNOLOGY, OR COUNTRY OF MANUFACTURING INTRODUCE OPERATING EXPOSURE MARKET LEADERS WILL USUALLY HAVE LOWER OPERATING EXPOSURE OPERATING EXPOSURE IS PECULIAR TO PARTICULAR BUSINESSES COMPANIES FACING THE SAME REAL EXCHANGE RATE MAY HAVE OPPOSITE OPERATING EXPOSURES

OPERATING EXPOSURE MIX SPECIALTY CHEMICALS: –Canadian Subsidiary of U.S. Firm –Sells in Canada, Sources from U.S. –All competition has similar structure HOME PRODUCTS: –Canadian Subsidiary of U.S. Firm –Sells in Canada, Sources from U.S. –Competitors have Mfg. Facilities in Canada ECONOMY MOTORS: –U.S. Firm –Sells in U.S., Sources from U.S. –Competes with Foreign Exports

OPERATING EXPOSURE MATRIX PRICE RESPONSIVENESS COST RESPONSIVENESS LOW MODERATE HIGH Small Large Exposure LOWMODERATEHIGH HOME PRODUCTS Large Exposure Small Exposure ECONOMY MOTORS SPECIALTY CHEMICALS

HOW DO YOU MEASURE OPERATING EXPOSURE? USE OF AN EXPOSURE AUDIT WITH OPERATIONS MANAGERS IMPORTANT QUESTIONS TO ASK –Who are competitors in various markets? –Who are low cost producers? –Who are price leaders? –What happened to operating profit when real exchange rates shifted? –What is operating flexibility of company and its competitors? A STATISTICAL APPROACH TO MEASURING OPERATING EXPOSURE –Regression of Changes in Firm’s Value on Changes in Real Exchange Rates

EXPOSURE MANAGEMENT EXPOSURE ACCOUNTING OPERATING Nominal EXCHANGE RATE BUSINESS OPTIONS FINANCIAL OPTIONS Real Forward Contracts/ Futures Contracts/ Foreign Currency Debt Operating Exposure Hedge Invoicing Currency Structural Hedge

HOW DO YOU MANAGE OPERATING EXPOSURE? APPROPRIATE CONFIGURATION OF THE BUSINESS (manufacturing site selection, sourcing arrangements, ownership structure, choice of distribution channels, product mix, etc.) AND EXPLOITATION OF OPERATIONAL FLEXIBILITY production shifting (excess capacity in global network) portfolio of global suppliers extent of local vs. global outsourcing mix of products in various stages of PLC control over distribution channels ability to expand product line

HOW DO YOU MANAGE OPERATING EXPOSURE (cont.) PARENT COMPANIES SELECT A PORTFOLIO OF INDIVIDUAL BUSINESSES THAT MINIMIZES OPERATING EXPOSURE FOR THE PARENT COMPANY USE FINANCIAL METHODS TO HEDGE OPERATING EXPOSURE (financial contracts, long-term borrowing of foreign currency) –difficult to hedge something that is hard to estimate –most instruments hedge with the use of nominal exchange rates