Operating Exposure

• Operating exposure, also called economic exposure,

competitive exposure, and even strategic exposure, on
occasion, measures any change in the present value of
a firm resulting from changes in future operating cash
flows caused by an unexpected change in exchange
rates.
• Ganado Corp. is a U.S.-based multinational firm. Exhibit
12.1 shows Ganado’s basic structure and currencies of
operation.

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 Exhibit 12.1 Ganado Corporation: Structure
and Operations

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 Ganado Corporation Cash Flows

• Operationally the functional currencies of the

individual subsidiaries in combination determine the
overall operating exposure of the firm in total.
• Net operating cash flow is the source of value created
by the firm over time
• Ganado in Germany buys and sells in euros, Ganado
U.S. buys and sells in dollars, but Ganado China has
sales based in dollars, euros, and renminbi—the latter
being the dominant cash flow for Ganado China

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 Static versus Dynamic Operating Exposure

• Measuring exchange rate exposure required analysis of short and

intermediate term fixed or static) contracts, and longer term (more dynamic)
forecasting
• Using Ganado as an example, we have 3 divisions of roughly equal size and
we assume the dollar is depreciating against the euro while the reminbi is
slowly revaluing.
– Ganado China: In the short-term, fewer profits, may need to raise prices in the
long-term
– Ganado Germany: No change in the short–term, may also be affected by eventual
higher prices from China
– Ganado U.S.: No change in the short–term, may also be affected by eventual
higher prices from China

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 Operating and Financing Cash Flows

• The cash flows of the MNE can be divided into operating cash
flows and financing cash flows.
• Operating cash flows arise from intercompany (between
unrelated companies) and intra-company (between units of the
same company) receivables and payables, rent and lease
payments, royalty and license fees and assorted management
fees.
• Financing cash flows are payments for loans (principal and
interest), equity injections and dividends of an inter and intra-
company nature.
• Exhibit 12.2 summarizes cash flow possibilities for Ganado U.S.
and China.

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 Exhibit 12.2 Financial and Operating Cash Flows
Between Parent and Subsidiary

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 Expected versus Unexpected Changes in Cash
Flow
• Operating exposure is far more important for the long-run
health of a business than changes caused by transaction or
translation exposure.
• 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 total management
responsibility because it depends on the interaction of strategies
in finance, marketing, purchasing, and production.

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 Expected versus Unexpected Changes in Cash
Flow
• An expected change in foreign exchange rates is not included in the definition of
operating exposure, because both management and investors should have factored
this information into their evaluation of anticipated operating results and market
value.
• From a manager’s perspective, budgeted financial statements already reflect
information about the effect of an expected change in exchange rates.
• From a debt service perspective, expected cash flow to amortize debt should already
reflect the international Fisher effect.
• 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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 Measuring Operating Exposure

• Exhibit 12.3 shows how a change in exchange rates can

impact expected cash flows at four levels:
– Short Run
– Medium Run (equilibrium)
– Medium Run (disequilibrium)
– Long Run

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 Exhibit 12.3 Operating Exposure’s Phases of
Adjustment and Response

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 Measuring Operating Exposure: Ganado
Germany
• Exhibit 12.4 presents the impact on the firm given an
unexpected change in exchange rates.
• Exhibit 12.5 summarizes the current baseline forecast for
Ganado Germany’s income and operating cash flows
– Case 1: Depreciation, 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
– Case 4: Sales price, cost, and volume increase

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 Exhibit 12.4 Ganado and Ganado
Germany

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 Exhibit 12.5 Ganado Germany’s Valuation:
Baseline Analysis

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 Ganado Germany, Case 4: Price, Cost, and
Volume Increases
• Exhibit 12.6 is a combination of possible outcomes
– Price increases by 10% to €14.08,
– direct cost per unit increases by 5% to €10.00,
– and volume rises by 10% to 1,100,000 units.
• Revenues clearly rise by more than costs, and net income for
Ganado Germany rises to €2,113,590.
• Operating cash flow rises to €2,623,683 in 2014 (after NWC
increase), and €2,713,590 for each of the following four years.
• Ganado Germany’s present value is now $9,018,195.

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 Exhibit 12.6 Ganado Germany: Case 4—Sales Price,
Volume, and Costs Increase

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 Measurement of Loss

• Exhibit 12.7 summarizes the change in Ganado’s German

subsidiary value across our small set of simple cases from an
instantaneous and permanent change in the value of the euro
from $1.20/€ to $1.00/€.
– Case 1: Ganado’s German subsidiary’s value falls by the percent change in the
exchange rate, -16.7%.
– Case 2: Volume increased by 40% as a result of increasing price competitiveness,
the German subsidiary’s value increased 22.5%.
– Case 3: The change in the exchange rate was completely passed-through to a
higher sales price, which resulted in a massive 66% increase in subsidiary value.
– Case 4: The resulting change in subsidiary valuation of +24.2% may be creeping
toward a “realistic outcome.”

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 Exhibit 12.7 Summary of Ganado Germany Value
Changes to Depreciation of the Euro

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 Proactive 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 most commonly employed proactive policies
include:
– Matching currency cash flows
– Risk-sharing agreements
– Back-to-back or parallel loans
– Cross-currency swaps
– Contractual approaches

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 Proactive Management of Operating
Exposure

• Matching Currency Cash Flows (Exhibit 12.8)

– One way to offset an anticipated continuous long exposure to
a particular company is to acquire debt denominated in that
currency (matching).
– An alternative would be for the US firm to seek out potential
suppliers of raw materials or components in Canada as a
substitute for U.S. or 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 12.8 Debt Financing as a Financial
Hedge

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 Proactive Management of Operating
Exposure

• Risk-Sharing Agreements
– An alternate method for managing a long-term cash flow
exposure between firms is risk-sharing.
– 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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 Proactive Management
of Operating Exposure

• Back-to-Back or Parallel Loans (Exhibit 12.9)

– 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 each other’s currency for a
specific period of time.
– 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 12.9 Back-to-Back Loans for Currency
Hedging

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 Proactive Management
of Operating Exposure

• There are two fundamental impediments to

widespread use of the back-to-back loan:
– It is difficult for a firm to find a partner, termed a
counterparty for the currency amount and timing desired.
– 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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 Proactive Management
of Operating Exposure

• Cross-Currency Swaps (Exhibit 12.10)

– 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 12.10 Using Cross-Currency Swaps

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