International Financial Management P G Apte

1. CHAPTER - 14 Management of Operating Exposure • International Financial Management • P G Apte

2. Introduction • How to assess and manage the impact of exchange rate changes on the firm's future cash flows from operations which are not fixed in either the home currency or the foreign currency • Impact of operating exposure can be felt well beyond just pricing and invoicing decisions. It can threaten a firm’s competitive position and may force the firm to rethink its entire business strategy • A firm is subject to operating exposure even when it has little or no direct involvement in international markets – through its suppliers and customers • The analysis and management of operating exposure are at the same time more important and considerably more difficult than contractual transactions exposure

3. Following the reunification of Germany, DEM depreciated against most major currencies (as also against the Indian rupee). Indian exporters of nontraditional items like machinery parts, tools and castings found that exports to Germany were becoming unattractive because of local competition.  When the European currency markets were plunged into chaos following the withdrawal of sterling and lira from the ERM in September 1992, Dow Chemical Corporation decided to invoice all its sales in Europe in DEM.  Due to the rising dollar during the first half of eighties, a number of US companies shifted their sourcing of components and materials abroad rather than buy from US suppliers  During the same period, some US corporations shifted manufacturing facilities abroad in order to retain their cost competitiveness.

4. Operating Exposure • Operating exposure depends upon • Change in nominal exchange rate • Change in the selling price (output price) • Change in the quantity of output sold • Change in operating costs i.e. quantities and prices of inputs Some of these effects will be captured in the Real Exchange Rate. If the firm can raise output price in line with foreign inflation without reduction in sales, its costs keep pace with home inflation and nominal exchange rate moves in line with relative PPP, there would be no operating exposure.

5. Changes in real exchange rates are among the consequences of real macroeconomic shocks • Consumers, firms, labour and governments react to such shocks by altering their buying patterns, wage demands, input choices, technologies, taxes, subsidies. • Real exchange rate changes alter both the relative prices faced by consumers and their incomes. • Real exchange rate changes may also give a relative cost advantage to some firms over their competitors. • Real exchange rate changes will generally have an impact on the costs of a firm's suppliers. Their reactions will be determined by the degree of market power they enjoy and availability of substitutes.

6. Long lasting changes in real exchange rates produce persistent trade imbalances forcing governments to take corrective actions such as import restraints, export subsidies, controls on capital flows and shifts in monetary policies. Some or all of these can affect a firm's cash flows. • Finally, changes in real exchange rates do not occur in isolation. Usually they are accompanied by changes in real interest rates. This factor may influence not only expected future cash flows but also the discount rate used to find the PV of these cash flows. • Exchange rate is one of a set of macroeconomic risk factors; when all the risk factors change simultaneously, it is difficult to sort out their individual impacts and hence a firm’s exposure to each factor

7. Economic Exposure • Economic exposurerefers to the degree to which the present value of a firm’s future cash flows can be influenced by exchange rate fluctuations. • Cash flows that do not require conversion of currencies do not reflect transaction exposure. Yet, these cash flows may also be influenced significantly by exchange rate movements.

8. Transactions that Influence the Firm’s Local Currency Inflows Impact of Local Currency Appreciation on Transactions Impact of Local Currency Depreciation on Transactions Decrease Decrease Decrease Decrease Increase Increase Increase Increase Local sales (relative to foreign competition in local markets) Firm’s exports denominated in local currency Firm’s exports denominated in foreign currency Interest received from foreign investments Economic Exposure

9. Transactions that Influence the Firm’s Local Currency Outflows Impact of Local Currency Appreciation on Transactions Impact of Local Currency Depreciation on Transactions No Change Decrease Decrease No Change Increase Increase Firm’s imported supplies denominated in local currency Firm’s imported supplies denominated in foreign currency Interest owed on foreign funds borrowed Economic Exposure

10. Economic Exposure • Even purely domestic firms can be affected by economic exposure if there is foreign competition within the local markets. However, their degree of exposure is likely to be much less than MNCs. • One method of measuring economic exposure is by reviewing how the earnings forecast in the income statement changes in response to alternative exchange rate scenarios.

11. Operating Exposure • Operating exposure can be looked upon as a combination of two effects - the conversion effect and the competitive effect • Conversion effect refers to the changes in home currency value of a given foreign currency cash flow • Competitive effect refers to changes in foreign currency cash-flows. • These reflect the impact on sales revenues and costs arising due to changes in prices consequent upon changes in exchange rates

12. The Price and Quantity Effects of Exchange Rate Changes • The aspects of market structure which influence the behavior of prices and the resultant quantity response of various goods and services are • The geographical extent of the market- Localized or Global • Whether the market is segmented or integrated – Aircrafts vs.Pharmaceuticals • Who are the dominant producers and consumers of the good in question- In which currency are prices more likely to be stable? • Market power and demand elasticities – Seller’s pricing freedom

13. The Price and Quantity Effects of Exchange Rate Changes • The quantity impact of a given price change is determined by price elasticities of demand • Exchange rate changes affect prices of a firm's inputs • The degree of mismatch between the currency composition of a firm's variable costs and that of its major competitors • The diagram below summarises the effects of the above factors on the severity of operating exposure faced by a firm

14. 1 Determinants of Operating Exposure

15. Assessing Operating Exposure: Scenario Approach • Consider alternative exchange rate scenarios and under each specify how prices, quantities and costs will behave • Based on considerations of competitive behaviour and the response of the various cost components to domestic and foreign inflation and changes in exchange estimate operating cash-flows under different scenarios • Assess likelihood of different scenarios

16. Assessing Operating Exposure: Scenario Approach • The firm needs to know the structure of its output markets, demand elasticities and competitive reactions as well as detailed information about its cost structure and the response of the various cost components to changes in exchange rate and other macroeconomic shocks • Simultaneous changes in several variables complicates the task further since precise identification of the impact of each becomes difficult

17. Operating Exposure: Regression Approach • Use a business model to estimate at time t0 (today) the firm's cash flows in its home currency denoted CFt1-t2 for the period t1 to t2 for various values of the spot rate St1 at time t1 • Regression equation CFt1-t2(i) = t0,t1 + t0,t1St1(i) + ut1(i) • The coefficient t0,t1 measures the impact of a unit change in exchange rate on the cash flows and has the dimension of foreign currency

18. Operating Exposure: Regression Approach (contd.) • The part of cash flow measured by (t0,t1 + ut1) is unexposed to exchange rate while t0,t1 measures the exposed cash flow or exposure • The firm can hedge itself by selling an amount t0,t1 of the foreign currency forward • If today's forward rate for contracts maturing at t1 is Ft0,t1 the gain from the forward sale is t0,t1[Ft0,t1-St1(i)] • For simplicity we are assuming that the entire cash flow will be realized at time t1

19. Operating Exposure: Regression Approach • The value of the hedged cashflow is given by CFt1-t2,hedged(i) = t0,t1+t0,t1St1(i)+ut1(i)+t0,t1[Ft0,t1 - St1(i)] = t0,t1+t0,t1Ft0,t1+ut1(i) which is independent of the spot rate at time t1 • The regression approach can in principle be extended to identifying several exposures simultaneously • The impact of each of these risk factors can be estimated using historical data on budgeted and actual cash flows

20. An Exporter Firm • Real depreciation will increase the profitability - measured in home as well as foreign currency - of an exporter provided again that relative price shifts are not significantly adverse • This would be generally true unless the costs rise faster than inflation at home.

21. An Exporter Firm: In Competitive Markets

22. An Exporter Firm: Competitive Market Post-Depreciation

23. An Exporter Firm: Oligopolistic

24. A' B' MC' MC B A MR E' E D' MR' D O C C' An Exporter Firm: Oligopoly, Post-Depreciation

25. An Importer Firm • A real depreciation of the home currency will reduce importer's profits measured in either currency • The case of a firm which imports raw materials and components for further processing at home and sells the output in the home market is more difficult since the effect of a real depreciation on profit depends upon the share of imported inputs in total costs, the elasticity of demand and the behavior of other costs

26. An Importer Firm: Effect of Real Appreciation

27. A Producer with Imported Raw Materials

28. Exporter’s Operating Exposure Unit cost = c(S) dc(S)/dS = c(S) > 0 Define the elasticity of unit cost c(S) with respect to S : cs = [dc(S)/dS][S/c(S)] = c(S)[S/c(S)] The total revenue in home currency is given by TR = SPfQ TC = c(S)Q A profit maximizing exporter should set the price such that marginal revenue (MR) equals marginal cost (MC) : MR = d(TR)/dQ = SPf + SQ(dPf/dQ) = SPf[1 + (Q/Pf)(dPf/dQ)]

29. d = -(dPf/dQ)(Q/Pf) MR = SPf[1 - (1/d)] Marginal cost is given by MC = d(TC)/dQ = c(S) Equating MR to MC we have

30. We now examine the effect of changes in exchange rate on revenues, costs and profits. (d/dS) = [d(TR)/dS] - [d(TC)/dS]

31. Substituting for dPf/dS, after some manipulation we get the following relations

32. Importer’s Exposure TR = (Pd/S)Q and TC = cfQ where Pd is the domestic currency price he charges to his customers and cf is his fixed foreign currency unit cost. The usual profit maximising condition MR = MC yields :

33. The change in the revenue denominated in foreign currency is given by : Substituting for (dPd/dS) Appreciation of the home currency will unambiguously raise the importer's revenue measured in foreign currency.

34. Coming to the costs, it is easily seen that Appreciation of HC i.e. fall in S will increase total costs denominated in FC. Coming to profits

35. Currency of Invoicing, Quantity Criteria and Operating Exposure • In practice, a substantial amount of trade involves contractual arrangements between the exporter and the importer wherein both the quantities supplied and prices - in either party's currency - are fixed for sometime • While prices respond to exchange rate changes rather quickly, quantity response to price changes is likely to be considerably slower

36. Currency of Invoicing, Quantity Criteria and Operating Exposure • If the importer does not have easy access to forward markets or if bid-ask spreads in forward markets are very large, an exporter insisting on invoicing in his own currency will face a competitive disadvantage if other exporters who are willing to accommodate the importer by invoicing in the latter's currency • Invoicing preferences would depend upon the strength of the currency of invoicing, competitive factors, invoicing practices of competitors etc. Exporters in weak currency countries would prefer to invoice in FC; their importers might prefer to be invoiced in exporter’s currency. Trading off operating and transactions exposure

37. Coping with Operating Exposure • None of the financial instruments used to reduce transactions exposure are of much use in reducing operating exposure • To the extent the firm can correctly identify and estimate its operating exposure to exchange rates, it can in principle use forward contracts to hedge • The difficulty is in identifying and estimating the exposure coefficients • Operating exposure covers a much longer horizon that contractual transactions exposures • Too many uncertainties

38. Coping with Operating Exposure • Operating exposure must be managed by altering the firm's operations - pricing, choice of markets, sourcing, location of production etc. • The firm can reduce the adverse effects of exchange rate changes on its revenue by moving into product lines which are less price sensitive and by countering the effect of higher prices by means of other competitive weapons such as local advertising and promotion • If inputs are purchased in markets where the local content in their costs is high, exchange rate changes will significantly alter the relative costs of sourcing from alternative sources

39. Coping with Operating Exposure • Shifting the location of production to countries whose currencies have depreciated in real terms can reduce the adverse impact of exchange rate changesprovided production costs in different locations have a large local content • Reasons for the globalization of production and sourcing may in fact be the desire on the part of MNCs to match the currencies of revenues and costs • When output markets are not perfectly competitive, the strategy of currency matching of costs and revenues might result in smaller expected profits though it will reduce the variance of profits

40. The Practice of Exposure Management • The key findingsof investigations of corporate currency exposure management practices • Very few corporations undertake an accurate, quantitative assessment of how unanticipated exchange rate changes impact on the value of their firm • Most firms find it very difficult to gauge the long-term exposure of their businesses to currency fluctuations

41. The Practice of Exposure Management • Relatively more but still a minority of firms have some reliable quantitative understanding of the exposure of their operating cash flows to currency fluctuations • A surprisingly large number of firms appear to think that they are not exposed to currency risk or that the risk is trivial • Even among firms which engage in systematic assessment of their currency risk profile and conscious currency risk management, the focus is almost exclusively on short-term transactions exposures extending up to a year

42. The Practice of Exposure Management • Long-term operating exposures are dealt with by "on-balance sheet" operating mechanisms • Firms also react to exchange rate changes after-the-fact by revising pricing policies, wage contracts etc. • Thus the practice of currency risk management, particularly long term exposure, is much less precise and sophisticated than what the development of the theory would suggest

43. Conclusion • Unlike transactions and translation exposure, operating exposure is more difficult to measure and manage but has much deeper and long-term impact on the fortunes of a firm • A firm needs to know a great deal about its product and input markets, competitive response, its customers and its cost structure • A cash flow at risk kind of framework needs to be constructed which incorporates the firm's business model which can help simulate alternative scenarios of the key risk factors • Operating exposure needs to be managed by changing the structure of operations including product-market combinations, sources of inputs and even location of production facilities