Economic Operating Exposure

III.2 Economic/Operating Exposure

6F:130 International Finance

Prof. David S. Bates

Lecture #19

Outline

• Operating Exposure– Example– Measuring operating exposure– Managing operating exposure

• financial hedges

• business strategies

Operating exposure(a.k.a. economic, competitive or strategic exposure)

• The impact of unexpected exchange rate changes upon known and unknown but expected future cash flows of the firm, for indefinite future.

• Firm value = discounted expected future cash flows• Operating exposure therefore measures how firm value

changes with unexpected changes in exchange rates

Simple example

• U.S. firm expects 10 mln SF/year from exports to Switzerland, indefinitely.

• Long-term exchange rate forecast = current spot exchange rate

• Current rate: 2 SF/$ (.50 $/SF)

• Required rate of return: 10%/year

• What if the SF depreciates?

E[$ CF] $5 mln $5 mln $5 mln ...

V10%

Perpetuity formula: V = C / r

Year 1 2 3 ...

SF SF10 mln SF10 mln SF10 mln ...

forecast: .50 $/SF .50 $/SF .50 $/SF ...

So V = $5 mln / .10 = $50 mln

E[$ CF] $5 mln $5 mln $5 mln ...

10%

What if SF depreciates 2%, to .49 $/SF?

Year 1 2 3 ...


forecast: .50 $/SF .50 $/SF .50 $/SF ...

$50 mln

E[$ CF]

V

10%

New exchange rate implies new X-rate forecasts

Year 1 2 3 ...


forecast: .49 $/SF .49 $/SF .49 $/SF ...

E[$ CF] $4.9 mln $4.9 mln $4.9 mln ...

V

10%

and new projected dollar cash flows

Year 1 2 3 ...


forecast: .49 $/SF .49 $/SF .49 $/SF ...

E[$ CF] $4.9 mln $4.9 mln $4.9 mln ...

$49 mln

10%

and reduces the value of the firm by $1 mln.

Year 1 2 3 ...


forecast: .49 $/SF .49 $/SF .49 $/SF ...

Year 1 2 3 ...


Operating exposure:$1 mln change in firm value for every 2% change in the current$/SF rate

Measuring operating exposure

• Requires a longer-term perspective: viewing the firm as an ongoing concern with price and cost competitiveness affected by exchange rate changes

• Requires an overall assessment of the industry:– Nationality of competitors & suppliers– firm’s degree of market power

Example: Volvo

• Structure:• Imports supplies from Germany

• produces in Sweden

• Sells in U.S.

• Major competition:• German cars (BMW, Mercedes, Audi)

• Most important risks• Swedish krona vs. DM (not especially vs. $)

• Swedish interest rates

• German producer prices

Measuring operating exposure

• Types of firms:• Price-taking firms• Price-setting firms with market power

Price-taking firms

1. Analyze impact of unexpected, persistentexchange rate changes upon local-currencyforeign market prices, for indefinite future– Who’s the competition?

2. Analyze impact on home-currency cash flows

3. Decide what to do about the exchange rate- related operating exposure.

Simple example, revisited• U.S. firm expects 10 mln SF/year from exports

to Switzerland, indefinitely.

• Assumptions:– Competing with Swiss firms.– SF price unaffected by $/SF fluctuations

• Consequently, $ revenues heavily affected by $/SF changes:

10% SF depreciation lowers discounted expected revenues 10%.

• SF appreciation has the opposite effect.

Example #2: U.S. chemical firm exporting to Canada

• Major competition: other U.S. firms.

• Chemical industry sets C$ prices based on U.S. $ costs.

• IF the Canadian dollar depreciates 10%:– C$ prices rise overall by 10%. – Reduction in total Canadian sales by 2%.– Local currency result: C$ revenues up 8%.

– U.S. $ revenues for this firm fall 2%.

• Operating exposure not severe.

Price-setting firms with (some) market power

• Some ability to raise local-currency prices in foreign markets to offset FX depreciation.

• How much ability?

Depends on the price elasticity of demand for that firm’s products.

Example: 1985-87 dollar depreciation of 50% against DM

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Louvre

DM/DOLLAR EXCHANGE RATE, 1974-97

DM

/$

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Example: 1985-87 dollar depreciation of 50% against DM

• Mercedes, BMW:– Raise $ prices to (partly) maintain DM revenues?– Leave $ prices unchanged to maintain market

share/sales volume?

• Policy: – Raised $ prices 30-40%– Intense advertising campaign to differentiate

German cars.

Managing Operating Exposure

• Financial management – contractual hedges

• Strategic management– marketing initiatives– production initiatives

Financial Management of Operating Exposure

If have stable, predictable FC earnings, various contractual/financial hedges are feasible for the medium term (1-5 years)

• long-term forward contracts • local-currency debt (matching)

• currency swaps

• long-term put options

Examples• Merck (pharmaceuticals)

– R&D, production in U.S.– Sales in U.S., abroad

• Sales predictable (niche-market)

• Local-currency prices often regulated abroad

• Kodak (film)– Concerned w/ maintaining foreign market share

(against Fuji)

• Pioneer Hi-Bred– Has foreign subsidiaries

Long-term forward contracts

• Waterford Crystal– Costs in Irish punt– Revenues in U.S. dollars– Sold anticipated $ revenues forward out 2 years

• Difficult to hedge forward beyond 5 years



If have stable SF revenues

want to finance them with stable SF debt

so that only net SF revenues at risk.

Year 1 2 3 ...

SF revenues SF10 mln SF10 mln SF10 mln ...

SF interestliabilities -SF9 mln -SF9 mln -SF9 mln ...

Net SF revenues SF1 mln SF1 mln SF1 mln ...

Example: Swiss subsidiary of U.S. firm

• If well-established, can directly issue SF debt

• If new, use a currency swap– U.S. firm issues dollar debt– U.S. firm swaps that debt for SF debt with a swap

dealer

1. U.S. firm issues $ debt

U.S. firm

$ liabilities

Currency swap

2. U.S. firm enters into a currency swap

U.S. firm

$ liabilities

swapdealer

Pays SF

Receives $

Currency swap

$ revenues cover $ liabilities

U.S. firm

$ liabilities

swapdealer

Pays SF

Receives $

Currency swap

Currency swapNet effect: U.S. firm has effectively issued SFdebt to finance its foreign subsidiary (& hedge its SF revenues)

U.S. firm

$ liabilities

swapdealer

Pays SF

Receives $

Strategic Management of Operating Exposure

• In medium- to long-run, all firms have exchange rate-related operating exposure.

Example: “domestic” U.S. car company (Chrysler?)– Costs in U.S. dollars– Sales, revenues in U.S. dollars

• Yen depreciation makes Japanese cars more competitive, reducing Chrysler’s revenues

• Real exchange rate movements affect the overall competitive environment– monitoring/measuring such effects important– hedging can be difficult (and questionable)

• Firms respond strategically to exchange rate-related problems and opportunities– marketing initiatives– production initiatives

• Goodyear-Mexico– 37% Mexico peso devaluation 12/94 – Previously sold tires in Mexico– Became major exporter to U.S., Europe, South

America

Examples

Examples• U.S. textile industry

– U.S. cannot compete in labor-intensive textiles– Major investment in capital-intensive textiles

niches• Industrial fabrics

• Sheets, towels

– Increased service component• Quick Reponse computerized inventory

management and ordering program for coordinating textile mills/apparel manufacturers/retailers

Strategic Management of Operating Exposure

Marketing Initiatives– Market selection– Product Strategy– Pricing Strategy– Promotional Strategy

Production Initiatives– Product sourcing– Input mix– Plant location– Raising productivity

• Market selection & diversification– Move into/out of various foreign markets,

depending on competitiveness Example: Waterford Crystal (Irish) When $ weakened in late 1980’s, went

increasingly after Asian, European markets.

Marketing Initiatives

Marketing Initiatives• Product Strategy

– Altering product niche depending on competitiveness

• New-product introduction• Product line decisions• Product innovation

• Example: Volkswagen (1970’s)– 1960’s: low-priced cars with few features

– DM appreciation in early 1970’s, rising German labor costs

– VW revised product line towards higher-priced cars for middle-income consumers

Marketing Initiatives• Pricing Strategy

– For firms with some market power: decision between

• market share

• profit margins

when setting local-currency prices following a currency appreciation/depreciation.

• Promotional Strategy Example: Early 1980’s: strong $. European countries advertised Alpine skiing

heavily in U.S.

Production Initiatives• Changing Input Mix

– foreign outsourcing of component inputs Example: Caterpillar. 50% of pistons are foreign

(Brazil)

• Shifting production among multiple international plants– Westinghouse: Plants in Canada, Spain, Britain

& Brazil. – Toyota in 1994-6

• Creating new plants abroad Example: Japanese, German car plants in U.S.

Production Initiatives• Raising productivity

• closing inefficient plants

• automation

• negotiating wage & benefit cutbacks

• alternate production processes

Example: U.S. paper & pulp industries(Brazilian competition)

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U.S. Direct Investment Abroad($ trillion)

Foreign Direct Investment in U.S.

Production and marketing initiatives have substantially internationalized U.S. business over the last 20 years.

Summary• Unexpected exchange rate fluctuations generally

affect the short-term and longer-term prospects of the firm -- operating exposure

• There exist some financial tools for managing identifiable operating exposure

• currency swaps, ...

• Firms typically respond strategically to exchange rate-related shifts or potential shifts in relative competitiveness

• Marketing initiatives• Production initiatives

Economic Operating Exposure

Business

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