Chapter 12

Operating
Exposure

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Operating Exposure

• Operating exposure, also called economic

exposure, competitive exposure, and even
strategic exposure on occasion

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12.1 Attributes of Operating
Exposure

• requires forecasting and

analyzing all the firm’s future
individual transaction exposures
together with the future
exposures of all the firm’s
competitors
• The analysis of longer term is
the goal of operating exposure
analysis.
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Attributes of Operating Exposure
• 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
intracompany (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 intracompany nature

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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 far more

important for the long-run health of a
business
• operating exposure is inevitably
subjective because it depends on
estimates of future cash flow changes
• Planning for operating exposure
depends on 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 included in the
definition of operating exposure
• From an investor’s perspective, if the
foreign exchange information should
be reflected in a firm’s market value.
• Only unexpected changes in
exchange rates should cause market
value to change.

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Measuring the Impact
of Operating Exposure
• The following slide presents the dilemma
facing Trident as a result of an unexpected
change in the value of the euro, the
currency of economic consequence for the
German subsidiary.
• There is concern over how the subsidiaries
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 of Operating Exposure :
Trident (P.332)

• Trident Europe:
–Case 1: 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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12.2 Strategic Management of
Operating Exposure

• The objective 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.
• A diversification strategy does not require
management to predict disequilibrium, only to
recognize it when it occurs.

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Diversifying Operations (P.327)
• If a firm’s operations are diversified
internationally, management is
prepositioned both to recognize
disequilibrium and to react competitively.
• Recognizing a temporary change in
worldwide competitive conditions permits
management to make changes in operating
strategies.
• Domestic firms may be subject to the full
impact of foreign exchange operating
exposure and do not have the option to
react in the same manner as an MNE.
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Diversifying Financing(P.329)
• If a firm’s financing sources are diversified,
it will to take advantage of temporary
deviations from the international Fisher
effect.
• However, to switch financing sources a firm
must already be well-known in the
international investment community.
• Again, this would not be an option for a
domestic firm

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12.3 Proactive Management of
Operating Exposure

• The six most commonly

employed proactive policies are:
–1. Matching currency cash
flows
–2. Risk-sharing agreements
–3. Back-to-back or parallel
loans
–4. Currency swaps
–5. Leads and lags
–6. Reinvoicing center
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1. Matching Currency Cash Flows
• In this example, a US firm has 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 endless series of transaction
exposures could be continually hedged with
forwards or other contractual agreements.

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Exhibit 12.4 Matching:
Debt Financing as a Financial Hedge

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1. Matching currency cash flows
– One way is to acquire debt denominated
in that currency (matching).
– Another alternative for the US firm to
seek out potential suppliers of raw
materials or components in Canada
– In addition, the company could engage
in currency switching, in which the
company would pay foreign suppliers
with Canadian dollars.

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2. Currency Clauses: 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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3. Back-to-Back Loans
– also referred to as a parallel loan or credit swap

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

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Proactive Management
of Operating Exposure

• Two impediments to 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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4. 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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5. Leads and Lags : Retiming the
transfer of funds

– by accelerating or decelerating the

timing of payments that must be made
or received in foreign currencies.
– Intracompany leads and lags is more
feasible
– Intercompany leads and lags requires
the time preference of one independent
firm to be imposed on another.

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6. Reinvoicing Centers

• There are three basic benefits arising from

the creation of a reinvoicing center:
– 1. Managing foreign exchange exposure

– 2. Guaranteeing the exchange rate for

future orders

– 3. Managing intrasubsidiary cash flows

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Exhibit 12.7 Use of a Reinvoicing
Center

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Proactive Management
of Operating Exposure
• Some MNEs now attempt to hedge their
operating exposure with contractual
hedges.
• Merck and Eastman Kodak have
undertaken long-term currency option
positions hedges
• 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 12-27
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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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