Measuring and managing economic exposure

Economic Exposure: based on the extent to which the value of the firm --- as measured by the present value of its expected future cash flows --- will change when exchange rates change. Two components: Transaction Exposure and Operating Exposure. Transaction exposure: exchange gains or losses on foreign currency-denominated contractual obligations (short term . Transaction exposure arises out of the various types of transactions that re!uire settlement in a foreign currency. "uch as borrowing and lending in foreign currencies# the local purchasing and sales activities of foreign subsidiaries# lease payment# forward contracts# loan repayment and other contractual or anticipated foreign currency receipts and disbursements. Operating exposure: the future gains or losses on revenues and costs because of real exchange rate changes (long term . Operating exposure (long term

$emand "ide %revenue& 'rice (olume %'rice elasticity of $emand& Managing operating exposure: ,. .. /. 0. 2. Mar-et selection 'ayoff between price and volume 'roduct innovation. 1lobal purchasing and production. *inancial management: hedging.

"upply "ide %cost& $omestic )nput *oreign )nput %"ubstitution of +osts&

+ase: 3olls-3oyce 4imited

3olls-3oyce 4imited# the 5ritish aeroengine manufacturer# suffered a loss of 26 million in ,787 on worldwide sales of 606 million. The company9s annual report for ,787 blamed the loss on the dramatic revaluation of the pound sterling against the dollar# from ,:;,.8, in early ,788 to ,: ;..,. by the end of ,787. The most important reason for the loss was the effect of the continued weakness of the U.S. dollar against sterling. The large civil engines that Rolls-Royce produces are supplied to American air frames. Because of U.S. dominance in civil aviation, oth as producer and customer, these engines are usually priced in U.S. dollars and escalated accordingly to U.S. indices!. < closer loo- at 3olls-3oyce9s competitive position in the global mar-et for =et engines reveals the position in the global mar-et for =et engines reveals the sources of its dollar exposure. *or the previous several years 3olls-3oyce9s export sales had accounted for a stable 0>? of total sales and had been directed at the @.". mar-et. This mar-et is dominated by two @.". competitors# 'ratt and Ahitney <ircraft 1roup (@nited Technologies and 1eneral Electric9s aerospace division. <s the clients of its mainstay engine# the 35 .,,# were @.". aircraft manufacturers (5oeing9s 808 "' and 808#>> and loc--heed9s 4,>,, # 3olls-3oyce had little choice in the currency denomination of its export sales but to use the dollar. )ndeed# 3olls B3oyce won some huge engine contracts in ,786 and ,787 that were fixed in dollar terms. 3olls-3oyce9s operating costs# on the other hand# were almost exclusively incurred in sterling (wages# components# and debt servicing . There contracts were mostly pegged to an exchange rate of about ;,.6> for the pound# and 3olls-3oyce officials# in fact# expected the pound to fall further to ;,.C2. Dence# they didn9t cover their dollar exposures. )f the officials were correct# and the dollar strengthened# 3olls3oyce would en=oy windfall profits. Ahen the dollar wea-ened instead# the combined effect of fixed dollar revenues and sterling costs resulted in foreign exchange losses in ,787 on its @.". engine contracts that were estimated by The Aall "treet Eournal (March ,,# ,76># '.C to be e!uivalent to as much as ;.>> million. Moreover# according to that same Aall "treet Eournal article# Fthe more engines produced and sold under the previously negotiated contracts# the greater 3olls-3oyce9s losses will be.G Questions ,. $escribe the factors you would need to -now the assess the economic impact on 3olls-3oyce of the change in the dollar: sterling exchange rate. $oes inflation affect 3olls-3oyce9s exposureH .. 1iven these factors# how would you calculate 3olls-3oyce9s economic exposureH

/. "uppose 3olls-3oyce had hedged its dollar contracts. Aould it now be facing any economic exposureH Dow about inflation ris-H 0. Ahat alternative financial management strategies might 3olls-3oyce have flowed that would have reduced or eliminated its economic exposure on the @.". engine contractsH 2. Ahat nonfinancial tactics might 3olls-3oyce now initiate to reduce its exposure on the remaining engines to be supplied under the contractsH On future business (e.g.# diversification of export sales H C. Ahat additional information would you re!uire to ascertain the validity of the statement that Fthe more engines produced and sold under the previously negotiated contracts# the greater 3olls-3oyce9s losses will beGH

+ase: 4a-er <irways

The crash of "ir *reddie 4a-er9s "-ytrain had little to do with the failure of its navigational e!uipment or its landing gearI indeed# it can largely be attributed to misguided management decisions. 4a-er9s management erred in selecting the financing mode for the ac!uisition of the aircraft fleet that would accommodate the booming transatlantic business spearheaded by "ir *reddie9s sound concept of a Fno-frill# low-fare# stand-byG air travel pac-age. )n ,76,# 4a-er was a highly leveraged firm with a debt of more than ;0>> million. The debt resulted from the mortgage financing provided by the @.". Eximban- and the @.". aircraft manufacturer Mc$onnell $ouglas. <s most ma=or airlines do# 4a-er <irways incurred three ma=or categories of cost: (, fuel# typically paid for in @.". dollars (even though the @nited Jingdom is more than self-sufficient in oil I (. operating costs incurred in sterling (administrative expenses and salaries # but with a nonnegligible dollar cost component (advertising and boo-ing in the @nited "tates I and (/ financing costs from the purchase of @.".-made aircraft# denominated in dollars. 3evenues accruing from the sale of transatlantic airfare were about evenly divided between sterling and dollars. The dollar fares# however# were based on the assumption of a rate of ;...2 to the pound. The imbalance in the currency denomination of cash flows (dollar-denominated cash outflows far exceeding dollar-denominated cash inflows left 4a-er vulnerable to a sterling depreciation below the budgeted exchange rate of K,:;...2. indeed# the dramatic plunge of the exchange rate to K,:;,.C over the ,76,-,76. period brought 4a-er <irways to default. +ould 4a-er have hedged its FnaturalG dollar liability exposureH The first option of indexing the sale of sterling airfare to the day-to-day exchange rate was not a viable alternative. <dvertisements# based on a set sterling fare# would have had to be revised almost daily and would have discouraged the Fprice-elastic# budget-consciousG clientele of the company. <nother possibility would have been for 4a-er to direct more of its mar-eting efforts toward <merican travelers# thereby giving it a more diversified demand structure# when the pound devalued against the dollar# fewer 5ritish tourists would vacation in the @nited "tates# but more <mericans would travel to 5ritain. 4a-er could also have financed the ac!uisition of $+ ,> aircraft in sterling rather than in dollars# thereby more closely matching its pound outflows with its pound inflows. This example points out that the currency denomination of debt financing can ill afford to be determined apart from the currency ris- faced by the firm9s total business portfolio.