International Financial Management

P G Apte

1
 Introduction
• How to assess and manage the impact of exchange rate
changes on the firm's future cash flows from operations
which are not fixed in either the home currency or the
foreign currency
• Impact of operating exposure can be felt well beyond just
pricing and invoicing decisions. It can threaten a firm’s
competitive position and may force the firm to rethink its
entire business strategy
• A firm is subject to operating exposure even when it has
little or no direct involvement in international markets –
through its suppliers and customers
• The analysis and management of operating exposure are at
the same time more important and considerably more
difficult than contractual transactions exposure

2
 Operating Exposure
•Operating exposure depends upon
– Change in nominal exchange rate
– Change in the selling price (output price)
– Change in the quantity of output sold
– Change in operating costs i.e. quantities and prices of
inputs
Some of these effects will be captured in the Real
Exchange Rate.
If the firm can raise output price in line with foreign inflation
without reduction in sales, its costs keep pace with home
inflation and nominal exchange rate moves in line with
relative PPP, there would be no operating exposure.

3
 Operating Exposure

• Operating exposure can be looked upon as a

combination of two effects - the conversion effect
and the competitive effect
– Conversion effect refers to the changes in home
currency value of a given foreign currency cash flow
– Competitive effect refers to changes in foreign currency
cashflows.
– These reflect the impact on sales revenues and costs
arising due to changes in prices consequent upon
changes in exchange rates

4
 The Price and Quantity Effects of
Exchange Rate Changes
• The aspects of market structure which influence the
behavior of prices and the resultant quantity response
of various goods and services are
– The geographical extent of the market- Localized or
Global
– Whether the market is segmented or integrated –
Aircrafts vs.Pharmaceuticals
– Who are the dominant producers and consumers of the
good in question- In which currency are prices more
likely to be stable?
– Market power and demand elasticities – Seller’s pricing
freedom

5
 The Price and Quantity Effects of
Exchange Rate Changes
– The quantity impact of a given price change is
determined by price elasticities of demand
– Exchange rate changes affect prices of a firm's inputs
– The degree of mismatch between the currency
composition of a firm's variable costs and that of its
major competitors
• The diagram below summarises the effects of the
above factors on the severity of operating
exposure faced by a firm

6
Determinants of Operating Exposure

7
 Assessing Operating Exposure:
Scenario Approach
• Consider alternative exchange rate scenarios and
under each specify how prices, quantities and
costs will behave
• Based on considerations of competitive behaviour
and the response of the various cost components to
domestic and foreign inflation and changes in
exchange estimate operating cashflows under
different scenarios
• Assess likelihood of different scenarios

8
 Assessing Operating Exposure:
Scenario Approach
• The firm needs to know the structure of its output
markets, demand elasticities and competitive
reactions as well as detailed information about its
cost structure and the response of the various cost
components to changes in exchange rate and other
macroeconomic shocks
• Simultaneous changes in several variables
complicates the task further since precise
identification of the impact of each becomes
difficult

9
 Operating Exposure: Regression
Approach
• Use a business model to estimate at time t0 (today) the
firm's cash flows in its home currency denoted CFt1-t2 for
the period t1 to t2 for various values of the spot rate St1 at
time t1
• Regression equation

CFt1-t2(i) = αt0,t1 + βt0,t1St1(i) + ut1(i)

• The coefficient βt0,t1 measures the impact of a unit change

in exchange rate on the cash flows and has the dimension
10
of foreign currency
 Operating Exposure: Regression
Approach (contd.)
• The part of cash flow measured by (αt0,t1 + ut1) is

unexposed to exchange rate while βt0,t1 measures the

exposed cash flow or exposure

• The firm can hedge itself by selling an amount βt0,t1 of the

foreign currency forward

• If today's forward rate for contracts maturing at t1 is Ft0,t1
the gain from the forward sale is βt0,t1[Ft0,t1- St1(i)]
• For simplicity we are assuming that the entire cash flow
will be realized at time t1
11
 Operating Exposure: Regression
Approach
• The value of the hedged cashflow is given by
CFt1-t2,hedged(i) = αt0,t1+βt0,t1St1(i)+ut1(i)+βt0,t1[Ft0,t1 - St1(i)]

= αt0,t1+βt0,t1Ft0,t1+ut1(i)

which is independent of the spot rate at time t1

• The regression approach can in principle be extended to
identifying several exposures simultaneously
• The impact of each of these risk factors can be estimated
using historical data on budgeted and actual cash flows

12
 An Exporter Firm

• Real depreciation will increase the profitability -

measured in home as well as foreign currency - of
an exporter provided again that relative price
shifts are not significantly adverse
• This would be generally true unless the costs rise
faster than inflation at home.

13
An Exporter Firm: In Competitive
Markets

14
An Exporter Firm: Competitive
Market Post-Depreciation

15
An Exporter Firm: Oligopolistic

16
An Exporter Firm: Oligopoly, Post-
Depreciation

17
 An Importer Firm
• A real depreciation of the home currency will
reduce importer's profits measured in either
currency
• The case of a firm which imports raw materials
and components for further processing at home
and sells the output in the home market is more
difficult since the effect of a real depreciation on
profit depends upon the share of imported inputs
in total costs, the elasticity of demand and the
behavior of other costs

18
An Importer Firm: Effect of Real Appreciation

19
A Producer with Imported Raw Materials

20
Currency of Invoicing, Quantity Criteria and
Operating Exposure

• In practice, a substantial amount of trade involves

contractual arrangements between the exporter and
the importer wherein both the quantities supplied
and prices - in either party's currency - are fixed
for sometime
• While prices respond to exchange rate changes
rather quickly, quantity response to price changes
is likely to be considerably slower

21
Currency of Invoicing, Quantity Criteria and
Operating Exposure
• If the importer does not have easy access to forward
markets or if bid-ask spreads in forward markets are very
large, an exporter insisting on invoicing in his own
currency will face a competitive disadvantage if other
exporters who are willing to accommodate the importer by
invoicing in the latter's currency
• Invoicing preferences would depend upon the strength of
the currency of invoicing, competitive factors, invoicing
practices of competitors etc. Exporters in weak currency
countries would prefer to invoice in FC; their importers
might prefer to be invoiced in exporter’s currency. Trading
off operating and transactions exposure

22
 Coping with Operating Exposure
• None of the financial instruments used to reduce
transactions exposure are of much use in reducing
operating exposure
• To the extent the firm can correctly identify and
estimate its operating exposure to exchange rates,
it can in principle use forward contracts to hedge
• The difficulty is in identifying and estimating the
exposure coefficients
• Operating exposure covers a much longer horizon
that contractual transactions exposures
• Too many uncertainties

23
 Coping with Operating Exposure
• Operating exposure must be managed by altering
the firm's operations - pricing, choice of markets,
sourcing, location of production etc.
– The firm can reduce the adverse effects of exchange
rate changes on its revenue by moving into product
lines which are less price sensitive and by countering
the effect of higher prices by means of other
competitive weapons such as local advertising and
promotion
– If inputs are purchased in markets where the local
content in their costs is high, exchange rate changes
will significantly alter the relative costs of sourcing
from alternative sources
24
 Coping with Operating Exposure

– Shifting the location of production to countries whose

currencies have depreciated in real terms can reduce the
adverse impact of exchange rate changes provided
production costs in different locations have a large
local content
• Reasons for the globalization of production and sourcing
may in fact be the desire on the part of MNCs to match the
currencies of revenues and costs
• When output markets are not perfectly competitive, the
strategy of currency matching of costs and revenues might
result in smaller expected profits though it will reduce the
variance of profits

25
The Practice of Exposure Management
• The key findings of investigations of corporate
currency exposure management practices
– Very few corporations undertake an accurate,
quantitative assessment of how unanticipated
exchange rate changes impact on the value of
their firm
– Most firms find it very difficult to gauge the
long-term exposure of their businesses to
currency fluctuations

26
The Practice of Exposure Management
– Relatively more but still a minority of the firms have
some reliable quantitative understanding of the
exposure of their operating cash flows to currency
fluctuations
– A surprisingly large number of firms appear to think
that they are not exposed to currency risk or that the
risk is trivial
– Even among firms which engage in systematic
assessment of their currency risk profile and conscious
currency risk management, the focus is almost
exclusively on short-term transactions exposures
extending up to a year

27
The Practice of Exposure Management
– Long-term operating exposures are dealt with by "on-
balance sheet" operating mechanisms
• Firms also react to exchange rate changes after-
the-fact by revising pricing policies, wage
contracts etc.
• Thus the practice of currency risk management,
particularly long term exposure, is much less
precise and sophisticated than what the
development of the theory would suggest

28
 Conclusion
• Unlike transactions and translation exposure, operating
exposure is more difficult to measure and manage but has
much deeper and long-term impact on the fortunes of a
firm
• A firm needs to know a great deal about its product and
input markets, competitive response, its customers and its
cost structure
• A cash flow at risk kind of framework needs to be
constructed which incorporates the firm's business model
which can help simulate alternative scenarios of the key
risk factors
• Operating exposure needs to be managed by changing the
structure of operations including product-market
combinations, sources of inputs and even location of
production facilities
29