International Operations Management

International Operations Management MGMT 6367 Lecture 12 Instructor: Yan Qin Fall 2012

Outline – Risk Management • Foreign Exchange Rates • Nominal • Real • Impacts of exchange rate fluctuations on a company’s financial performance • Transaction exposure • Translation exposure • Operational exposure • Managing foreign exchange risks • Three types of foreign exchange markets • Alternative managing approaches

Nominal Foreign Exchange Rates • The nominal foreign exchange rate is the nominal price of one nation’s money in terms of another, usually determined by the supply and demand in the exchange markets. • The nominal price can be quoted either directly or indirectly. • Direct quote: how much domestic currency it takes to buy one unit of foreign currency. • Indirect quote: how much foreign currency it takes to buy one unit of domestic currency.

Sample direct/indirect quotes

Currency depreciation/appreciation • Let denote the nominal exchange rate (direct quote if not specifically mentioned). Then • An increase in implies domestic currency depreciation. • A decrease in implies domestic currency appreciation. • Examples: • Suppose the exchange rate between USD and EUR increases from 1.3678 $/€ to 1.4 $/€ • Suppose the exchange rate between USD and EUR decreases from 1.3678 $/€ to 1.3 $/€.

Real foreign exchange rate • The Real foreign exchange rate is the nominal foreign exchange rate with inflation effects factored in. • While the nominal exchange rate tells how much domestic currency it takes for a unit of foreign currency, the real exchange rate tells how much the goods and services in the domestic country can be exchanged for the goods and services in a foreign country.

Nominal Vs. Real • AMERICAN manufacturers complain that China undervalues its exchange rate. But which one? The nominal exchange rate is now 6.67 yuan to the US dollar, having strengthened by almost 2% since September 5th. • But China’s real exchange rate with America has strengthened by almost 50% since 2005, according to calculations by The Economist Source: The Economist (Nov 4th 2010)

One way to calculate exchange rates • Purchasing power parity (PPP) is a theory of exchange rate determination and a way to compare the average costs of goods and services between countries. • The theory assumes that the actions of importers and exporters, motivated by cross country price differences, induces changes in the spot exchange rate. • There are several existing theories of exchange rate determination. None is proved 100% accurate though. You can check out this article if interested: http://www.adbi.org/book/2006/05/16/1819.renminbi.exchange.rate/existing.theories.of.exchange.rate.determination/

PPP – Nominal exchange rate • Let P denote the domestic price level, which can be some price index such as Consumer Price Index (CPI). Let P* denote the price level in a foreign country. • Then the nominal exchange rate can be calculated as • The equation means that the exchange rate between two countries should equal the ratio of the two countries' price levels of a fixed basket of goods and services.

PPP – Real exchange rate • Using the same dotation as in the equation for nominal, the real exchange rate, s, can be calculated as follows based on PPP theory: s

PPP – Using inflation rates • Let denote the percentage change in domestic price level (i.e., domestic inflation rate) and denote the percentage change in foreign price level (i.e., foreign inflation rate). • Let and denote the percentage change in the nominal and real exchange rates, respectively. • Then, by taking the logarithm and then carrying out a differential operation on both sides, we can get

PPP – Using inflation rates • Examples: • Suppose the inflation in China is 5% and the inflation in the US is 3%. Then what is the nominal exchange rate change from the US perspective? • Suppose the Chinese Renminbi strengthens by 6%, the inflation in China is 5%, and the inflation in the US is 3%. Then what is the real exchange rate change? • What can we observe in terms of currency depreciation/appreciation?

PPP makes mistakes! This column contains the indirect quotes of the nominalexchange rates computed based on PPP. That is, P*/P, instead of P/P* as for the direct quotes. Source: “International price comparisons based on purchasing power parity” By Michelle Vachris and James Thomas

Outline – Risk Management • Foreign Exchange Rates • Impacts of exchange rate fluctuations on a company’s financial performance • Transaction exposure • Translation exposure • Operational exposure • Managing foreign exchange risks

Impacts of exchange rate fluctuations • There are 3 main ways in which foreign exchange rate fluctuations affect a company’s financial performance: • Transaction Exposure: by changing the expected results of transactions denominated in non-domestic currencies; • Translation Exposure: by changing the domestic currency value of net assets held in foreign countries. • Operating Exposure: by changing the domestic currency value of future cash flows to be earned in foreign currencies or by changing a firm’s future competitive position.

Transaction exposure • Transaction exposure exists during the normal course of international business transactions whenever • Two or more currencies are involved, and • There is a lag between the date a contract is signed or goods delivered and the date of payment. • The risk is that the nominal exchange rate will fluctuate before the transaction is completed and the currency exchange occurs. • Easy to hedge with the use of financial instruments.

Transaction exposure - Example • If a US electronics company contracted to sell 10,000 semiconductors to a French computer manufacturer at a sales price of € 1.5 per unit with delivery in 90 days and payment due on delivery. • If the exchange rate of USD to EUR on the date of the contract signing was 1.3 $/€, how much would the US company expect to receive? • If the exchange rate of USD to EUR on the date of delivery was 1.2 $/€, how much would the US company would receive in this case?

Translation exposure • Translation exposure occurs because of the need to translate the financial statements of foreign subsidiaries and affiliates into the currency of the parent company in order for consolidated financial statements to be prepared. • Translation exposure is solely the result of the financial accounting and reporting process.

Operating exposure • Operating exposure can be thought of as comprising two separate but potentially related components: Future Exposure and Competitive Exposure. • Future exposure deals with the impact on the domestic value of an income stream denominated in a different currency when exchange rates change. • Competitive exposure deals with the impact on the ability of a domestic company to compete in the domestic economy by changes in exchange rates when it has foreign customers, foreign suppliers, or even foreign competitors.

Outline – Risk Management • Foreign Exchange Rates • Impacts of exchange rate fluctuations on a company’s financial performance • Managing foreign exchange risks • Managing transaction risks • Three types of foreign exchange markets • Alternative managing approaches • Managing translation risks • Managing operating risks

Managing transaction risks • There are three types of foreign exchange markets, each distinguished by the type of contract involved. • Spot market • Forward market • Futures market

Financial exchange markets • In the spot market, the parties agree to exchange one currency for another at a fixed ratio to be delivered immediately. • Typically, individuals and companies exchange at the spot market through banks. • In the forward market, the buyer and the seller agree to exchange currency at a fixed ratio at some specified future date. • Forward contracts are usually between a bank and a buyer/seller.

Financial exchange markets • Futures markets are organized markets for trading contracts for the future delivery of currency. • They differ from the forward markets in that the contracts are standardized in terms of time of delivery and size of contract (i.e., amount of one currency to be exchanged).

Forward/Futures rates • The forward and futures rates are usually quoted at a premium or discount to spot rates based on the financial communities’ assessment of the future of the exchange rate. • The discount/premium in annual percentage terms can be calculated as follows: FR = forward/futures rate SR = spot rate N = months to maturity

Forward/Futures rates – Example • Suppose the current exchange rate between British pound and US dollar is 1.58 $/£. And based on the assessment of the future of this exchange rate, a U.S purchaser of a 90-day forward contract is willing to buy at a 1.2 percent discount. Then what is the forward rate in this case? • What if the purchaser is willing to buy at a 1.2 percent premium?

Forward Contracts Vs. Futures Contracts

Approaches to hedge transaction risks • We’ll next describe 5 approaches to hedging against transaction risks. • The first two approaches are examples of ways of creating riskless hedges; Just pick the one that is less expensive; • The 3rd and 4th approaches serve to reduce but not to eliminate the risk; • The 5th approach can be an effective way of eliminating risk but may be difficult to implement.

Approach 1 & 2 • Hedging through foreign exchange market contracts • This approach simply requests the agreement of two parties to exchange currencies at a stated rate (known when the contract is made) at some future point of time. • Hedging through money market loans • One possible way: A money market hedge is essentially an immediate conversion of loaned funds. Funds are borrowed by the payer in local currency on a discounted basis and immediately converted to the recipient’s currency and usually placed in an interest-bearing account. When payment is due, the remittance is transferred from the interest-bearing account to the recipient.

Approach 2 – Example • May 2012: Suppose a US company delivers the £100,000 worth of semi-conductor to a British computer manufacturer. Payment is due in August, 2012. To protect against the adverse change of the British pound to the US dollar, the U.S. company borrows £100,000 from a Paris bank at an annual interest rate of 9% on a discount basis. • A discount basis is a loan that at maturity, three months in this case, requires a payment of principal plus interest exactly equal to the intended payment in the payer’s currency, which is £100,000 in this case. The US company gets a loan of £97,800. Because, £97,800 * (1 + 0.09/4) = £ 100,000, where 4 refers to 4 quarters

Approach 2 – Example (Cont.) • Suppose the exchange rate on the date of delivery is 1.4 $/£. The US company got a loan that worth $136,920. Converted immediately into US dollar, the money is invested in a 3-month Treasury bill in the US at an annual interest rate of 8%. Then 3 month later, the U.S. company can get $136,920 * (1 + 0.08/4) = $139,658 • August 2011: The US company receives a check of £100,000 from the British company and uses the check to pay the loan. By taking the series of actions, the US company knows the exact amount of dollar it will receive when the payment is due.

Approach 3 & 4 • Leading and Lagging • This involves speeding up, even prepayment, and slowing down the exchange of funds between companies in order to transfer the funds at relatively advantageous (to the exposed party) exchange rates given forecasts of future rates. • Invoicing Currency • It may be advantageous for a company to bill customers in a currency other than the customer’s local currency to alleviate transaction exposure. It is especially useful if a company has a major customer in one country and a major supplier in another. The customer might be billed in the supplier’s currency.

Approach 5 • Swaps • Loan swaps, currency swaps, and credit swaps are all basically the same. They allow companies to provide financing to a foreign affiliate without having to channel the funds through the foreign exchange market. • For example, suppose the French subsidiary of a US parent company needs to borrow £100,000 with the intention to repay the same amount to the parent company three months later. At the same time, the US subsidiary of a French parent company needs to borrow an amount in US dollar that is equivalent to £100,000 that will be repaid 3 months later. Then the two companies can swap to eliminate their exchange rate risks.

Managing translation risks • Balance sheet adjustments • This technique involves maintaining a net zero exposure (or if desired, a net asset or liability exposure) through the management of account balances. • Licensing • In some cases, if a foreign affiliate may retain high exposure to the detriment of the parent company, it may be wise for the company to consider licensing its product to an independent foreign company rather than maintaining a subsidiary.

Managing operating risks • The risks associated with operating exposure are the most difficult to measure and hedge against. • We’ll next introduce • Factors that complicates the assessment of operating exposure; • Customer reactions • Competitor reactions • Supplier reactions • Government reactions • Operation options in managing this type of risk;

Complicating factors – 1 • Customer reactions • Customer reaction is reflected in the price elasticity of demand (PED), which gives the percentage change in quantity demanded in response to a one percent change in price. • When PED is less than 1, we say customers are insensitive to changes in price. Companies are able to charge higher price with little effect on demand. (The authors made a mistake in the textbook regarding the insensitivity.) • Competitor reactions • Just as consumers respond to exchange rate changes, so do competitors.

Complicating factors – 2 • Supplier Reaction • Whether a firm realizes an advantage from an exchange rate change depends on how the firm’s suppliers react to the exchange rate change. • Government Reaction • A government may intervene in the capital market to stabilize the currency if it perceives that it is beneficial to the home country economy as a whole. • A government may protect domestic exporting firms by capping the amount of foreign imports or assess tariffs to foreign imports.

Complicating factors – Example • Consider a US company that manufactures domestically and sells products mainly in the UK and in the US. Now what happens when the US dollar appreciates unexpectedly against the British pound? • Customer reactions: • The US company has two options in the British market: (1) Remain the current price; or (2) increases the price to fully account for the depreciation of the British pound to the US dollar. • How about in the US market?

Complicating factors – Example (Cont.) • Competitors reactions • What can the company’s UK competitors do in reaction to the US company’s two options? • What can other US exporters do in the UK markets? • Suppliers’ reactions • The company’s UK suppliers? • Can the company benefit from the suppliers’ reactions?

Operation options to hedge • Develop a global network of production facilities with excess capacity. • This allows the flexibility of increase production in countries where currencies become strongly undervalued in real terms. • The downsides include the cost of switching production locations, cost of adjusting product mix at a location, and the cost of establishing/maintaining excess capacities. • Develop a portfolio of global suppliers • Again, this allows the flexibility of sourcing from countries where currencies become strongly undervalued in real terms.

Operation options to hedge (Cont.) • Design a flexible, creative, and fast product development process • An effective new product development process enables a firm to increase prices with minimal market share loss. • When a company introduces a new product class, the operating exposure starts out small and then grow as competing products enter the market. • Develop the ability of offering a balanced mix of products in price-controlled and non-price-controlled categories in a hyperinflation environment.

Next Week • Product Launch • Information Systems • Review for the Final

International Operations Management