Chapter 12

Operating
Exposure

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Key Focus Areas

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What is Operating
Exposure?

What are the attributes

of Operating
Exposure?

How do we measure
Operating Exposure?

What are the strategies

adopted to manage
Operating Exposure?

Operating Exposure

Types of Foreign Exchange Exposure

Chap 10: Transaction Exposure

Transaction Exposure,
measures changes in the
value of outstanding
financial obligations
incurred prior to a
change in exchange
rates but not due to be
settled until after the
exchange rates change
It deals with changes in
cash flows the result
from existing contractual
obligations
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Chap 11: Translation Exposure

Translation exposure,
also called accounting
exposure, arises because
financial statements of
foreign subsidiaries
which are stated in
foreign currency must
be restated in the
parents reporting
currency for the firm to
prepare consolidated
financial statements

Chap 12: 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

 Leading private healthcare

group in Malaysia
Under the Think Global and
act Local KPJ is focusing to
expand globally
Foreign exposure in Australia,
Indonesia and Thailand

Telecommunication

Diversified conglomerate with

75% of revenue in 2013 related
to property development and
investment
Significant exposure in China
and Southeast Asia markets

Banking

Diversified conglomerate with

investments in industrial,
plantations, automotive etc
Had highest annual revenue in
2013 among listed companies
Foreign exposure in Southeast
Asia, Americas, Europe

Construction

Malaysian Oil & Gas major

Global operations in more than
ten countries
Significant foreign exposure in
South America, Southeast Asia
and African markets

Healthcare

Plantations

Oil & Gas

Operating Exposure Malaysian Companies

Leading telecom operator in
Malaysia with Celcom brand
Indonesia is a key growth
market for Axiata and was the
second largest contributor to
revenue in 2014

Leading Malaysian bank

Focusing on positioning
themselves as the top regional
bank
Foreign operations in
Singapore, Thailand, Vietnam
and Indonesia

Companies as part of their growth strategy embrace globalization

in turn exposing them to operating exposures

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Exhibit 12.1 Ganado Corporation: Structure and Operations

Ganado Corp. is a U.S.-based multinational firm. Exhibit 12.1

shows Ganados basic structure and currencies of operation

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Ganado Corporation Cash Flows

Geography
US

Germany

China

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Operating Exposure

Ganado U.S. buys

and sells in dollars

Ganado in Germany
buys and sells in
euros
Ganado China has
sales based in dollars,
euros, and renminbi
the latter being the
dominant cash flow
for Ganado China

Operationally the functional

currencies of the individual
subsidiaries in combination
determine overall operating
exposure of the firm in total

Net operating cash flow is

the source of value created
by the firm over time

Static vs. Dynamic Operating Exposure

Measuring exchange rate
exposure required analysis of
short and intermediate term
(fixed or static) contracts, and
longer term (more dynamic)
forecasting

US

Germany

Case Study
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 renminbi is

slowly revaluing.

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China

Ganado U.S.: No change

in the shortterm, may
also be affected by
eventual higher prices
from China

Ganado Germany: All

local currency cash
inflows and outflows in
EUR. No change in the
shortterm, may also be
affected by eventual
higher prices from China
Ganado China: Sales in
USD will result in fewer
Rmb proceeds in the
short term phase.
Profitability will fall in the
short run.
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Static vs. Dynamic Operating Exposure

Net Result for Ganado

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Positive:
Fall in dollar in short term, however is
likely to have a positive impact on
translation exposure as profits and
earnings in reminbi and euros
translate into more and more dollars

Negative:
Possibly a fall in total profitability of
the firm in the short term, primarily
due to the fall in profits of the Chinese
subsidiary i.e. short term transaction/
operating exposure impact

Exhibit 12.2 Financial and Operating Cash Flows Between Parent

and Subsidiary
Exhibit 12.2 summarizes cash flow possibilities for Ganado U.S.
and China

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Operating Exposures Phases of Adjustment and Response

Company A:
How a change in exchange rates can impact expected cash flows at four levels

Phase
Short Run
Medium Run/
Equilibrium
Medium Run/
Disequilibrium
Long Run
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Time

Price
Changes

Volume
Changes

Less than one

year

Prices are fixed/

contracted

Two to five years

Complete pass
Volumes begin a
through of exchange
partial response
rate changes
to prices

Existing
competitors begin
partial responses

Two to five years

Partial pass through

of exchange rate
changes

Volumes begin a
partial response
to prices

Existing
competitors begin
partial responses

Completely
flexible

Threat of new
entrants and
changing competitor
responses

More than five

years

Completely flexible

Volumes are
contracted

Structural
Changes

No competitive
market changes

13

Exhibit 12.4 Ganado and Ganado Germany

Exhibit 12.4 presents the impact on the firm given an unexpected change in
exchange rates

Ganado derives much of the reported

profits earnings and earnings per
share (EPS) from German subsidiary

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Measuring the Impact of Operating Exposure

Strategic Options for Ganado Germany post Euro Depreciation:

Maintain its domestic sales prices constant in Euro terms (no

change in any variable)
Raise domestic prices because competing imported products
are priced higher in Europe (by increasing volume)
Choose to keep export prices constant in terms of foreign
currencies, in terms of Euros (by increasing the sales price)

Change the export prices to somewhere in between (partial

pass through, i.e. changing sales price, volume and direct costs)

The strategic response a company would undertake would depend on how

much price can be changed without impacting the demand (price elasticity),
which would also include competitors response!
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Measuring the Impact of Operating Exposure

VARIABLES
Sales Volume

Sales Price Per Unit

Direct Cost Per Unit

Exchange Rate: Euro Depreciation from $1.2000/ to $1.0000/

Exchange Rate

Sales Volume

Sales Price

Direct Cost

Case 1
Case 2
Case 3

Case 4
Decrease
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+ 10%
Constant

+ 10%

+ 5%

Increase
16

Exhibit 12.5 Ganado Germanys Baseline Valuation

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Measuring the Impact of Operating Exposure (Case 4)

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Before

After

Sales Volume

1,000,000

1,100,000

Sales Price

12.80

14.08

Direct Cost

9.60

10.00

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Exhibit 12.6 Ganado Germanys Valuation (Case 4)

Assumptions

Sales volume (units)

Sales price per unit

Direct cost per unit

German corporate tax rate

Exchange rate ($/)
Income Statement
Sales revenue

Direct cost of goods sold

Cash operating expenses (fixed)

Depreciation

2015

2016

2017

2018

1,100,000

1,100,000

1,100,000

1,100,000

1,100,000

10.00

10.00

10.00

10.00

10.00

14.08

29.5%

14.08
29.5%

14.08
29.5%

14.08
29.5%

14.08
29.5%

1.0000

1.0000

1.0000

1.0000

1.0000

2014

2015

2016

2017

2018

-11,000,000

-11,000,000

-11,000,000

-11,000,000

-11,000,000

-600,000

-600,000

-600,000

-600,000

-600,000

15,488,000 15,488,000 15,488,000 15,488,000 15,488,000

-890,000

-890,000

-890,000

-890,000

-890,000

Pretax profit

2,998,000

2,998,000

2,998,000

2,998,000

2,998,000

Net income

2,113,590

2,113,590

2,113,590

2,113,590

2,113,590

2,113,590

2,113,590

2,113,590

2,113,590

2,113,590

-89,907

Income tax expense

Operating Cash Flows

Net income

Add back depreciation

Changes in net working capital

-884,410

600,000

-884,410

600,000

-884,410

600,000

-884,410

600,000

-884,410

600,000

Cash flow from operations

2,623,683

2,713,590

2,713,590

2,713,590

2,713,590

Cash flow from operations, in dollars

$2,623,683

$2,713,590

$2,713,590

$2,713,590

$2,713,590

Present Value @ 15%

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2014

$9,018,195

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Ganado Germanys Valuation (Compare Baseline and Case 4)

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 Germanys present
value is now $9,018,195
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Exhibit 12.7 Summary of Ganado Germany Value Changes to

Depreciation of the Euro

Ganados German subsidiarys value falls by the percent change in the

exchange rate, -16.7%

Volume increased by 40% as a result of increasing price competitiveness,

the German subsidiarys value increased 22.5%
Case

Summary of Trident Germany Value Changes to Depreciation of the Euro

Exchange RatePrice

Volume

1: No variable changes

$1.20/

1,000,000 9.60

3: Sales price increases

$1.00/

Baseline

2: Volume increases

4: Price, cost, volume increases

$1.20/

12.80

$1.00/

12.80

$1.00/

12.80

15.36
14.08

Cost

1,000,000 9.60
1,400,000 9.60
1,000,000 9.60

1,100,000 10.00

Valuation

Percent change
Change in value in value

$6,052,484

($1,210,497)

$7,262,981
$8,900,601

__

$1,637,621

22.5%

$1,755,214

24.2%

$12,059,761 $4,796,780
$9,018,195

-16.7%

66.0%

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
The resulting change in subsidiary valuation of +24.2% may be creeping
toward a realistic outcome
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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 four most commonly employed proactive policies are:
Matching currency cash flows
Risk-sharing agreements
Back-to-back or parallel loans
Currency swaps
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Proactive Management of Operating Exposure

Matching currency cash flows

Exhibit 12.8 depicts the exposure of a U.S. firm with continuing export
sales to Canada
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

Matching currency cash flows

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Proactive Management of Operating Exposure

Currency Clauses: Risk-Sharing

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

For e.g. the exchange rate between Ford and Mazda is Yen115/$ - Yen125/$
then Ford will accept all the exposure risks between this range. However, if it
above Yen125/$ then Mazda and Ford shares the risks equally.
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Proactive Management of Operating Exposure

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

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

Back-to-Back Loans

Exhibit 12.9 illustrates a back-to-back loan

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Proactive Management of Operating Exposure

Back-to-Back Loans

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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Contractual Approaches: Hedging the Unhedgeable

Cross-Currency Swaps

A currency swap resembles a back-to-back loan except that it does not

appear on a firms 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

Cross-Currency Swaps:

Exhibit 12-10 illustrates the use of a cross-currency swap

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Thank You

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