Proactive Management of Operating Exposure

Erica D. Holgado

 Operating exposure (as well as transaction exposure) can be partially managed by adopting operating or financing policies that offset anticipated foreign exchange exposures 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 The above policies are also called the operating hedge methods
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Proactive Management of Operating Exposure

1. Matching currency cash flows
First and the most common way is the use of the financial hedge to offset an anticipated continuous operating exposure by acquiring part of the firms debt-capital in that currency Another alternative would be for the U.S. firm to seek out potential suppliers of raw materials or components in Canada as a substitute for U.S. or other foreign firms A third alternative for the company is to engage in currency switching, in which the U.S. firm would pay foreign suppliers (e.g., Mexican) with Canadian dollars
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Exhibit 12.4 Matching: Debt Financing as a Financial Hedge

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2. Risk-sharing agreements
An alternate method for managing a long-term cash flow exposure between firms is via risk sharing agreement This is a contractual arrangement in which the buyer and seller agree to share or split currency movement impacts on payments between them

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The example for Ford and Mazda

Ford imports automotive parts form Mazda, so swings in exchange rates can benefit one party at the expense of the other One risk-sharing solution is that if the EX rate on the payment date is between 115/$ and 125/$, Ford pays at that EX rate, but if the EX rate falls outside this range on the payment date, Ford and Mazda will share the difference equally That is, for 110/$ (130/$), the effective exchange rate for Ford will be 112.5/$ (127.5/$)

3. 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 each others currency for a specific period of time The default risk is minimized, because each loan can be viewed as the cash collateral in the event of default for the other loa

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

At an agreed terminal date, both subsidiaries return the borrowed currencies Thus, the back-to-back loan provides a method for parent-subsidiary crossborder financing without incurring direct currency exposure
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4. Currency Swaps (or Cross Currency Swap, CCS):

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 time period Swap dealer arrange most swap on a blind basis, meaning that the initiating firm does not know its counterparty A currency swap is similar to a back-to-back loan except that it does not affect the capital structure in the balance sheet

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Exhibit 12.6 Using a Cross Currency Swap to Hedge Currency Exposure

Initially, Japanese corporation (U.S. corporation) pays yen principal (dollar principal) and receives dollar principal (yen principal) During the contract period, Japanese firm can pay dollars and receive yen At the end of the cross currency swap, they return the dollar and yen principal to each other
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5. Leads and Lags: Retiming 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 For receivables, on the contrary, firms tend to collect soft foreign currency receivables early and collect hard foreign currency receivables later Leading or lagging payments will change the cash position of one firm, with the reverse effect on the other firm

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Leads and Lags: Retiming the transfer of funds

Intercompany leads and lags is difficult to be achieved, because the time preference of one firm imposes the detriment of the other firm Intracompany leads and lags is more feasible as related companies presumably embrace a common set of goals for the consolidated group

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6. Reinvoicing centers:
A recivoicing center is a separate corporate subsidiary that serves as a type of middleman among the parent company and all foreign subsidiaries Manufacturing subsidiaries sell goods to distribution subsidiaries by selling first to a reinvoicing center, which in turn resells to the distribution subsidiary, and all subsidiaries trade with the reinvoicing center with their domestic currencies

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Exhibit 12.7 Use of a Reinvoicing Center

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 Benefits from the creation of a reinvoicing center:

Managing foreign exchange exposure centrally Guaranteeing the exchange rate for future orders Managing intrasubsidiary cash flows, e.g., leads and lags of payment

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 Disadvantages of a reinvoicing center:

Additional expense for a firm and high initial setup cost To bring increased scrutiny by tax authorities A variety of professional costs will be incurred for tax and legal advice

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