transaction and operating exposure

Multinational Business Finance [email protected]

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Transaction Exposure

• Foreign exchange exposure is a measure of how a firm’s profitability, net cash flow, and

market value will change because of a change in exchange rates.

• An important task of the financial manager is to measure foreign exchange exposure and to manage it so as to maximize the profitability, net cash flow, and market value of the firm.

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Types of Foreign Exchange Exposure

• Transaction exposure measures changes in the value of outstanding financial obligations

• This type of exposure deals with changes in cash flows the result from existing contractual obligations.

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Economic Exposure

• Operating exposure, and transaction exposure are called economic exposure, measures the change in the expected value of the firm resulting from an unexpected change in exchange rates.

• Expected changes in exchange rate can be calculated through Parity conditions. The rest is unexpected.

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• Transaction exposure and operating exposure exist because of unexpected changes in future cash flows due to a exchange rate change.

• The difference between the two is that transaction exposure is a contractual obligation, while operating exposure focuses on foreign currency cash flows generated from operation that might change because a change of exchange rates.

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• Translation exposure, also called accounting exposure, is the potential for accounting-derived changes in owner’s equity to occur because of the need to “translate” the owners equity to home currency to report consolidated financial statements.

• The exposure is not real, it is called Balance sheet loss or gain.

• It only becomes material when the subsidiary closes.

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Exhibit 11.1 Conceptual Comparison of Transaction, Operating, and Translation Foreign Exchange Exposure

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Why Hedge?

• MNEs possess a multitude of cash flows that are sensitive to changes in exchange rates, interest rates, and commodity prices.

• These three financial price risks are the subject of the growing field of financial risk management.

• Many firms attempt to manage their currency exposures through hedging.

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Why Hedge?

• Hedging is the taking of a position, i.e. a cash flow, an asset, or a contract (including a forward contract) that will rise (fall) in value and offset a fall (rise) in the value of an existing position.

• While hedging can protect the owner of an asset from a loss, it also eliminates any gain from an increase in the value of the asset.

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Why Hedge? • The value of a firm, according to financial theory, is the net

present value of all expected future cash flows. • Nothing is certain yet. • Currency risk is defined roughly as the changes in expected cash

flows arising from unexpected exchange rate changes. • A firm that hedges these exposures reduces some of the variance

in the value of its future expected cash flows.

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Exhibit 11.2 Impact of Hedging on the Expected Cash Flows of the Firm

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Why Hedge? • However, is a reduction in the variability of cash flows

sufficient reason for currency risk management? Opponents of hedging state (among other things): – Shareholders are much more capable of diversifying currency risk than

the management of the firm – Currency risk management does not increase the expected cash flows

of the firm – Management often conducts hedging activities that benefit

management at the expense of the shareholders (agency conflict) – Managers cannot outguess the market

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Why Hedge?

• Proponents of hedging cite: – Reduction in risk in future cash flows improves the planning capability

of the firm

– Reduction of risk in future cash flows reduces the likelihood that the firm’s cash flows will fall below a necessary minimum (the point of financial distress)

– Management has a comparative advantage over the individual shareholder in knowing the actual currency risk of the firm

– Management is in better position to take advantage of disequilibrium conditions in the market

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Measurement of Transaction Exposure

• Transaction exposure measures gains or losses that arise from the settlement of existing financial obligations whose terms are stated in a foreign currency.

• The most common example of transaction exposure arises when a firm has a receivable or payable denominated in a foreign currency.

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Exhibit 11.3 The Life Span of a Transaction Exposure

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• Foreign exchange transaction exposure can be managed by contractual, operating, and financial hedges.

• The main contractual hedges employ the forward, money, futures, and options markets.

• Operating and financial hedges employ the use of risk-sharing agreements, leads and lags in payment terms, swaps, and other strategies.

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• The term natural hedge refers to an off-setting operating cash flow, a payable arising from the conduct of business.

• A financial hedge refers to either an off-setting debt obligation (such as a loan) or some type of financial derivative such as an interest rate swap.

• Care should be taken to distinguish operating hedges from financing hedges.

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Trident’s Transaction Exposure

• With reference to Trident’s Transaction Exposure, the CFO, Maria Gonzalez, has four alternatives: – Remain unhedged;

– hedge in the forward market;

– hedge in the money market, or

– hedge in the options market.

• These choices apply to an account receivable and/or an account payable.

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• A forward hedge involves a forward (or futures) contract and a source of funds to fulfill the contract.

• In some situations, funds to fulfill the forward exchange contract are not already available or due to be received later, but must be purchased in the spot market at some future date.

• This type of hedge is “open” or “uncovered” and involves considerable risk because the hedge must take a chance on the uncertain future spot rate to fulfill the forward contract.

• The purchase of such funds at a later date is referred to as covering.

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• A money market hedge also involves a contract and a source of funds to fulfill that contract.

• In this instance, the contract is a loan agreement.

• The firm seeking the money market hedge borrows in one currency and exchanges the proceeds for another currency.

• Funds to fulfill the contract – to repay the loan – may be generated from business operations, in which case the money market hedge is covered.

• Alternatively, funds to repay the loan may be purchased in the foreign exchange spot market when the loan matures (uncovered or open money market hedge).

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• Hedging with options allows for participation in any upside potential associated with the position while limiting downside risk.

• The choice of option strike prices is a very important aspect of utilizing options.

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Exhibit 11.5 Trident’s Hedging Alternatives, Including an ATM Put Option

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Presenter

Presentation Notes

ATM: at the money

Risk Management in Practice

• The treasury function of most private firms, the group typically responsible for transaction exposure management, is usually considered a cost center.

• The treasury function is not expected to add profit to the firm’s bottom line.

• Currency risk managers are expected to be conservative when managing the firm’s money.

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• As might be expected, transaction exposure management programs are generally divided along an “option-line”; those that use options and those that do not.

• Firms that do not use currency options rely almost exclusively on forward contracts and money market hedges.

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• Many MNEs have established rather rigid transaction exposure risk management policies that mandate proportional hedging.

• These contracts generally require the use of forward contract hedges on a percentage of existing transaction exposures.

• The remaining portion of the exposure is then selectively hedged on the basis of the firm’s risk tolerance, view of exchange rate movements, and confidence level.

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Exhibit 11.4 Valuation of Cash Flows by Hedging Alternative for Trident

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Exhibit 11.6 Valuation of Hedging Alternatives for an Account Payable

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OPERATING EXPOSURE MANAGEMENT

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What is Operating Exposure?

Operating exposure (also called competitive exposure, and strategic exposure)

measures the change in the firm´s present value resulting from the expected changes in future operating cash flows denominated in foreign currency (caused by an unexpected change in exchange rates).

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How to measure Operating Exposure? Two difficulties

• Measuring the operating exposure of a firm requires forecasting and analyzing all the firm’s future individual transaction exposures together with the future exposures of all the firm’s competitors and potential competitors worldwide.

• To analyze the longer term exchange rate changes that are unexpected and its impact on the firm– is the goal of operating exposure analysis.

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Operating cash flows and financing cash flows

Differentiating cash flows of MNEs:

•Operating cash flows arise from business activities: that is, from intercompany (between unrelated companies) and intracompany (between units of the same company) receivables and payables, rent and lease payments, royalty and license fees and management fees.

•Financing cash flows are from financing activities, that is payments for loans (principal and interest), equity injections and dividends.

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Exhibit 12.1 Financial and Operating Cash Flows Between Parent and Subsidiary

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Attributes of Operating Exposure • Operating exposure is important for the long-run health

of a business. • However, operating exposure is inevitably subjective

because it depends on estimates of future cash flow changes over an arbitrary time horizon.

• Planning for operating exposure is a management responsibility because it relates to the interaction of strategies in finance, marketing, purchasing and production.

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Attributes of Operating Exposure An expected change in foreign exchange rates

is not of concern. From an investor’s perspective, if the foreign

exchange market is efficient, information about expected changes in exchange rates should be reflected in a firm’s market value.

Only unexpected changes in exchange rates, or an inefficient foreign exchange market, should cause market value to change.

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Example:

• We discuss the dilemma facing Trident as a result of an unexpected change in the value of the euro, €, the currency of denomination for Trident´s German subsidiary.

• There is concern over how the subsidiary´s revenues (price and volumes in euro terms), costs (input costs in euro terms), and competitive landscape will change with a fall in the value of the euro.

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Exhibit 12.2 Trident Corporation and Its European Subsidiary: Operating Exposure of

the Parent and Its Subsidiary

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Measuring the Impact of Operating Exposure

• Trident Europe: – Case 1: Euro Devaluation €, no change in any

variable. – Case 2: Increase in sales volume; other variables

remain constant. – Case 3: Increase in sales price; other variables

remain constant.

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The objective of the Operating Exposure management

The objective of both operating and transaction exposure management is to anticipate and influence the effect of unexpected changes in exchange rates on a firm’s future cash flows.

To meet this objective, management can diversify the firm’s operating and financing base.

Management can also change the firm’s operating and financing policies.

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Benefits of diversification

Management team is prepositioned both to recognize disequilibrium when it occurs and to react competitively if the firm´s operations are diversified internationally .

Recognizing a temporary change in worldwide competitive conditions permits management to make changes in operating strategies.

Domestic firms do not have the option to react in the same manner as an MNE.

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Benefits of diversification

• If a firm’s financing sources are diversified, it will be prepositioned to take advantage of temporary deviations from the international Fisher effect. i$ –i€ =PUS -PEU

• However, to switch financing sources from one capital market to another, a firm must have the ability to operate in the international investment community.

• Again, this would not be an option for a domestic firm.

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6 Proactive policies of Management of Operating Exposure

• Operating and transaction exposures can be partially managed by adopting operating or financing policies that offset anticipated foreign exchange exposures.

• The six most commonly employed proactive policies are: – Matching currency cash flows – Risk-sharing agreements – Back-to-back ( parallel loans), or credit swaps. – Currency swaps – Leads and lags – Reinvoicing center

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Proactive Management of Operating Exposure

Example: a US firm has a continuing export sales to Canada. In order to compete effectively in Canadian markets, the firm

invoices all export sales in Canadian dollars. This policy results in a continuing receipt of Canadian dollars

month after month. This series of transaction exposures could be continually

hedged with forwards, futures or options, etc. Or using operating exposure management methods

described as follows:

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Matching currency cash flows One way to offset an anticipated continuous long

exposure to a particular company is to acquire debt denominated in that currency (matching). Alternatively, the US firm could seek out potential

suppliers of raw materials or components in Canada as a substitute for US and other foreign firms. In addition, the company could engage in currency

switching, in which the company would pay foreign suppliers with Canadian dollars.

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Exhibit 12.4 Matching: Debt Financing as a Financial Hedge

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Proactive Management of Operating Exposure: Risk Sharing

• Currency Risk-Sharing:

– a method to manage a long-term cash flow exposure.

– This is a contractual arrangement in which the buyer and seller agree to “share” or split currency movement impacts on payments between them.

– This agreement is intended to smooth the impact on both parties of volatile and unpredictable exchange rate movements.

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Risk Sharing: Ford and Mazda

Risk Sharing Agreement between Mazda and Ford.

Ford agrees to pay all purchases in Japanese Yen to Mazda as long as the spot exchange rate on the day of invoice is between 115 yen/$ to 125 yen/$. If however the exchange rate falls out of this range, Mazda and Ford will share the difference equally. What happens if the rate falls to 110 yen/$?

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Back-to-Back Loans: A back-to-back loan, also referred to as a parallel loan

or credit swap, occurs when two business firms in separate countries arrange to borrow foreign currency for a specific period of time, but totally circumvent the foreign exchange market . See the following slides. At an agreed terminal date they return the borrowed

currencies. Such a swap creates a covered hedge against

exchange loss, since each company, on its own books, borrows the same currency it repays.

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Exhibit 12.5 Using a Back-to-Back Loan for Currency Hedging

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• There are risks involved in the widespread use of the back-to-back loan: 1. It is difficult for a firm to find a partner, termed a

counterparty for the currency amount and timing desired.

2. A risk exists that one of the parties will fail to return the borrowed funds at the designated maturity – although each party has 100% collateral (denominated in a different currency).

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• Currency Swaps: – A currency swap resembles a back-to-back loan

except that it does not appear on a firm’s balance sheet.

– In a currency swap, a firm and a swap dealer or swap bank agree to exchange an equivalent amount of two different currencies for a specified amount of time.

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Exhibit 12.6 Using a Cross-Currency Swap to Hedge Currency Exposure

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• Leads and Lags: Re-timing the transfer of funds – Firms can reduce both operating and transaction exposure by

accelerating or decelerating the timing of payments that must be made or received in foreign currencies.

– Intracompany leads and lags is more feasible as related companies presumably embrace a common set of goals for the consolidated group.

– Intercompany leads and lags requires the time preference of one independent firm to be imposed on another.

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• Reinvoicing Centers: There are three basic benefits arising from the creation of a reinvoicing center: – Managing foreign exchange exposure – Guaranteeing the exchange rate for future orders – Managing intrasubsidiary cash flows

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Exhibit 12.7 Use of a Reinvoicing Center

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• Some MNEs now attempt to hedge their operating exposure with contractual hedges.

• Merck and Eastman Kodak have undertaken long-term currency option positions hedges designed to offset lost earnings from adverse exchange rate changes.

• The ability to hedge the “unhedgeable” is dependent upon: – Predictability of the firm’s future cash flows – Predictability of the firm’s competitor’s responses to exchange rate

changes

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Mini-Case Questions: Toyota’s European Operating Exposure

• Why do you think Toyota waited so long to move much of its manufacturing for European sales to Europe?

• If Britain were to join the European Monetary Union, would the problem be resolved? How likely do you think it is that Britain will join?

• If you were Mr. Shuhei, how would you categorize your problems and solutions? What was a short-term and what was a long-term problem?

• What measures would you recommend Toyota Europe take to resolve the continuing operating losses?

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Exhibit 12.3 Trident Europe

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Exhibit 1 Toyota Motor’s European Currency Operating Structure

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Exhibit 2 Daily Exchange Rates: Japanese Yen per Euro

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Exhibit 3 Daily Exchange Rates: British Pounds per Euro

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