1. Operating Exposure
(or chapter 9)

2. Agenda Operating exposure? How does operating exposure arise?
Forex change: Impact on sales volume, price, & cost variable changes?
Managing operating exposure
Matching cash flows.
Currency clauses.
Back-to-back loans.
Cross-currency swaps.
Contractual Hedges.

3. Operating Exposure
Analyze change in PV of firm resulting from changes in future operating cash flows & competitive position caused by any unexpected change in exchange rates.
Operating cash flows arise from inter-company and intra-company receivables & payables, rent & lease payments, royalty & licensing fees.
Financing cash flows are payments for use of inter- and intra- company loans & stockholder equity.

4. Operating & Financing Cash Flows
Financial Cash Flows
Dividend paid to parent
Parent invested equity capital
Interest on intrafirm lending
Intrafirm principal payments
Subsidiary
Parent
Operational Cash Flows
Payment for goods & services
Rent and lease payments
Royalties and license fees
Management fees & distributed overhead

5. Operating Exposure Lucent US US$ Reporting US$/€ Lucent Europe Euro
Lucent Suppliers
LucentCustomers
Will costs change
w/ $/EUR?
How sales, costs,
& profits of German
subsidiary change w/ $/EUR?
Will altered profits of
German subsidiary, in euro,
translate into more/ less
US $?
Will prices & sales volume change
Lucent Europe
Euro
Lucent US
US$ Reporting
US$/€

6. Lucent’s Operating Exposure
Manufactures w/ European material & labor.
Half production sold w/in Europe.
All sales invoiced EUR & average collection period 90 days.
Inventory 25% of annual direct costs.
Depreciation €600,000 per annum.
Corporate tax 34% in Germany.
Assume on Jan euro unexpectedly drops 17% from $1.20/€ to $1.00/€
Case 1: Devaluation, no change in costs, prices, sales volume.
Case 2: Devaluation, increase in sales volume only.
Case 3: Devaluation, increase in sales price only.

7. LUCENT’S OPERATING EXPOSURE

8. Managing Operating Exposure
Can diversify firm’s operating & financing base.
Diversifying operations:
diversifying firm sales.
diversifying location production facilities.
diversifying raw material sources.
If firm diversified, management can profit from change in worldwide competitive conditions.
Diversifying financing: raising funds in more capital markets & currencies.
If financially diversified, management can take advantage of deviations from Fisher open.

9. How to manage operation exposure?
Can partially manage exposure by operating/ financing policies offsetting anticipated currency exposures.
Common policies:
Matching currency cash flows.
Risk-sharing agreements.
Back-to-back (parallel) loans.
Currency swaps.

10. Matching Cash Flows
Offset anticipated exposure by same currency denominated debt.
Results in continuous same currency receipt of payment & outflow.
Preferred for relatively stable & predictable cash flow.
Can occur through regular operations (natural hedge)
Combine A/R & A/P in the same currency.
Currency switching.

11. Matching Currency Cash Flows
U.S.
Corporation
Canadian
(buyer of goods)
Exports
goods to
Canada
Payment for goods
in Canadian $
Exposure: Inflow of Canadian $
Principal & interest
payments on debt
in Canadian $
Canadian
Bank
(loans funds)
US Corp borrows
Canadian $ debt
from Canadian Bank
Hedge: Canadian $ debt payments act as financial
hedge - an outflow of Canadian $

12. Risk-sharing Currency Clauses
Contractual arrangement: buyer & seller agree to “share” (split) currency movement impacts on payments
E.g.: Ford has to pay Mazda ¥ 25,000,000.
Ford purchases from Mazda in current spot if spot $ is b/n ¥115 & ¥125.
If spot rate falls outside range, Ford & Mazda share difference.
So, if spot ¥110/$, Mazda gets payment of

13. Currency Clauses: Risk-sharing
If spot ¥110/$, risk-sharing favors Ford
If spot ¥130/$, risk-sharing favors Mazda
Risk-sharing rare during Bretton Woods years.

14. Back-to-Back (Parallel) Loans
Two firms in different countries arrange to borrow each other’s currency for a specific period of time (credit swap).
Two loans for equal current spot.
At maturity return borrowed currency.
Maintenance-of-principal clause.
Conducted outside forex markets, but use spot quotes as reference.
Creates covered hedge
Each company borrows same currency as it repays.
No need for collateral. Why?
Difficult to find counterparty.
Counterparty risk.

15. Back-to-Back Loans British Petroleum Shell UK subsidiary Royal Dutch
1. British firm wishes to invest funds
in its Dutch subsidiary
Shell UK
subsidiary
3. British firm loans British pounds
directly to the Dutch firm’s British
Direct loan
in pounds
Royal Dutch
Shell
2. British firm identifies a Dutch firm wishing
to invest funds in its British subsidiary
BP Holland
subsidiary
4. British firm’s Dutch subsidiary loans
euros to the Dutch parent
Direct loan
in euros
Indirect
Financing
Provides method for parent-subsidiary cross border financing
w/out incurring direct currency exposure.

16. Currency Swaps
Dealer & firm agree to exchange equivalent amount of two different currencies for a specified period of time.
Can negotiate wide range of maturities.
Can have fee to compensate for interest rate differential.
Like back-to-back loans, except it does not appear on a firm’s balance sheet (FAS 52 & 133).
Typically requires two firms to borrow funds in the markets & currencies which they are best known or get best rates (cross-currency swap).
Maintenance-of-principal clause.
Via swap both translation & operating exposure are avoided.
Currency swap is treated as forex transaction.
Reversing the swap is treated as a forward contract.

17. Cross-Currency Swaps Honda Japan Boeing US Swap Dealer Swap
“pay dollars” & “receive yen”
Honda Japan
Assets Liabilities & Equity
Debt in yen
Sales to US
Swap
“pay yen” & “receive dollars”
Boeing US
Debt in US$
Assets Liabilities & Equity
Sales to Japan
Inflow
of US$
Inflow
of yen
Swap Dealer
Receive
dollars
Pay
yen

18. Contractual Approaches
Undertake long-term currency option hedges to offset lost earnings from adverse changes in forex.
Ability to hedge dependent upon strategic predictability of future cash flow & competitor responses
Merck (US)
Highly predictable sales levels.
Highly centralized R&D, production.
Holder OTC put on forex.
Eastman Kodak (US)
Price driven market for its products necessitate forex hedge.
If US$ appreciates, what happens to market share?
Holder put on forex.
What value to hedge?
Loss of net earnings from exchange rate losses.
Gross sales revenues.
Costly & ineffectual. Why?

19. Things to remember… Operating Exposure?
How does operating exposure arise?
Managing operating exposure
Matching currency of cash flow.
Currency risk sharing clauses.
Back-to-back loans.
Cross currency swaps.
Contractual approach.