III.2 Economic/Operating Exposure : III.2 Economic/Operating Exposure 6F:130 International Finance Prof. David S. Bates Lecture #19


Outline: Outline Operating Exposure Example Measuring operating exposure Managing operating exposure financial hedges business strategies


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


Slide5: E[$ CF] $5 mln $5 mln $5 mln ... V 10% 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


Slide6: E[$ CF] $5 mln $5 mln $5 mln ... 10% What if SF depreciates 2%, to .49 $/SF? Year 1 2 3 ... SF SF10 mln SF10 mln SF10 mln ... forecast: .50 $/SF .50 $/SF .50 $/SF ... $50 mln


Slide7: E[$ CF] V 10% New exchange rate implies new X-rate forecasts Year 1 2 3 ... SF SF10 mln SF10 mln SF10 mln ... forecast: .49 $/SF .49 $/SF .49 $/SF ...


Slide8: E[$ CF] $4.9 mln $4.9 mln $4.9 mln ... V 10% and new projected dollar cash flows Year 1 2 3 ... SF SF10 mln SF10 mln SF10 mln ... forecast: .49 $/SF .49 $/SF .49 $/SF ...


Slide9: 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 ... SF SF10 mln SF10 mln SF10 mln ... forecast: .49 $/SF .49 $/SF .49 $/SF ...


Slide10: Year 1 2 3 ... SF SF10 mln SF10 mln SF10 mln ... Operating exposure: $1 mln change in firm value for every 2% change in the current $/SF rate


Measuring operating exposure: 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: 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: Measuring operating exposure Types of firms: Price-taking firms Price-setting firms with market power


Price-taking firms: Price-taking firms 1. Analyze impact of unexpected, persistent exchange rate changes upon local-currency foreign 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: 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: 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: 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: Example: 1985-87 dollar depreciation of 50% against DM 1 1.5 2 2.5 3 3.5 Plaza Louvre DM/DOLLAR EXCHANGE RATE, 1974-97 DM/$ 74 76 78 80 82 84 86 88 90 92 94 96


Example: 1985-87 dollar depreciation of 50% against DM: 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: Managing Operating Exposure Financial management contractual hedges Strategic management marketing initiatives production initiatives


Financial Management of Operating Exposure: 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: 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


Slide23: 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 Financial Management of Operating Exposure


Slide24: Financial Management of Operating Exposure 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 interest liabilities -SF9 mln -SF9 mln -SF9 mln ... Net SF revenues SF1 mln SF1 mln SF1 mln ...


Example: Swiss subsidiary of U.S. firm: 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


Currency swap: 1. U.S. firm issues $ debt U.S. firm $ liabilities Currency swap


Currency swap: 2. U.S. firm enters into a currency swap U.S. firm $ liabilities swap dealer Pays SF Receives $ Currency swap


Currency swap: $ revenues cover $ liabilities U.S. firm $ liabilities swap dealer Pays SF Receives $ Currency swap


Currency swap: Currency swap Net effect: U.S. firm has effectively issued SF debt to finance its foreign subsidiary (& hedge its SF revenues) U.S. firm $ liabilities swap dealer Pays SF Receives $


Strategic Management of Operating Exposure: 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


Slide31: 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


Slide32: Goodyear-Mexico 37% Mexico peso devaluation 12/94 Previously sold tires in Mexico Became major exporter to U.S., Europe, South America Examples


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: 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


Slide35: 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: 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: 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: 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: Production Initiatives Raising productivity closing inefficient plants automation negotiating wage & benefit cutbacks alternate production processes Example: U.S. paper & pulp industries (Brazilian competition)


Slide40: 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: 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