International Financial Management: Exposure Types

International Financial Management: Managing Operating & Translation Exposures

• The presentation covers managing operating and translation exposures for multinational corporations (MNCs).
• Operating Exposure: The impact of exchange rate fluctuations on a firm's future expected cash flows. It is also known as competitive/strategic exposure, and economic exposure. Any change affecting the present value of a firm due to changes in future operating cash flows is a result of unexpected exchange rate fluctuations.
• Operating exposure can affect corporate cash flows in ways not directly connected to foreign transactions.
• MNCs should evaluate operating exposure for each currency, focusing on cash inflows and outflows.
• Pro forma income statements for each subsidiary help estimate operating exposure.
• Exchange rate changes often relate to variations in real growth, inflation, interest rates, and government actions. Such changes can cause firms to adjust their financing and operating strategies.
• The significance of managing operating exposure is evident in the 1997-98 Asian crisis, and in recent events involving CHF and RUB currencies.
• Companies can determine their operating exposure by analyzing how sensitive their expenses and revenues are to various exchange rate scenarios.
• Firms can reduce operating exposure by restructuring operations (e.g., changing sales and expenses) to balance exchange rate-sensitive cash flows.
• Restructuring may involve adjusting sales in new/existing foreign markets, modifying dependencies on foreign suppliers, establishing/eliminating foreign production facilities, and changing liabilities denominated in foreign currencies.
• MNCs should understand long-term potential benefits before restructuring due to reversal costs.

Operating Exposure - Hedging Strategies

• Pricing policy: Adjustment of prices based on foreign currency fluctuations.
• Purchasing foreign supplies: Adjust purchasing to lower costs during periods of strong foreign currencies.
• Financing with foreign funds: Using foreign currency loans for some business operations.
• Revising operations: Modifying operations in subsidiaries to optimize use of foreign currencies, especially with forward contracts.
• Forward contracts: Use of contracts with predetermined exchange rates for a set period. While useful, they are temporary.

Operating Exposure - Example

• Toyota's case study illustrates how currency fluctuations impact operations.
• Euro's decline against the Japanese Yen and British Pound impacted Toyota sales in Europe.

Translation Exposure

• MNCs translate subsidiary financial data into the home currency for consolidation in financial reports.
• Also known as accounting exposure.
• Foreign subsidiaries' financial statements, expressed in foreign currencies, must be restated in the parent's reporting currency.
• Translation exposure itself doesn't directly affect a firm's cash flows, but it influences reported consolidated earnings.

Translation Exposure - Further Considerations

• Translation exposure is the possibility of an increase or decrease in the parent's net worth and reported profits due to exchange rate changes since the last translation.
• Remeasuring items in financial statements is usually simple and straightforward.
• Using different exchange rates for different items on an individual statement will create an imbalance.
• Many countries have complex rules and principles, balancing historical and current market value when translating the items.
• Historical exchange rates are used for some items (e.g., equities, fixed assets). Current exchange rates are often used for current items (e.g., inventory, current liabilities, income, and expenses).
• A key concept is functional currency, which is the currency of the primary economic environment in which a subsidiary operates and in which it generates cash flows.
• Subsidiaries can be classified as either integrated (operation is an extension of the parent) or self-sustaining (operating independently in the local market).

Translation Exposure - Hedging

• MNCs may match foreign liabilities with foreign assets to reduce translation exposure (Natural Hedging).
• 100% matching is seldom practical.
• Traditional methods like forward and futures contracts can be used for hedging.
• Selling currency proactively can offset gains from future subsidiary earnings.

Translation Exposure - Limitations of Hedging

• Hedging translation exposure is limited by factors, including inaccurate forecasts, inadequate contracts for certain currencies, and accounting distortions linked to the choice of translation exchange rates.
• Increased transaction exposure, related to hedging activities.

ER Forecasting

• Companies use historical data and technical analysis to forecast exchange rates.
• Limited use compared to fundamental analysis, focusing mostly on short-term future predictions.
• Fundamental analysis combines economic factors with exchange rates.
• Regression analysis, equations, sensitivity analysis, and PPP (Purchasing Power Parity) are key considerations.

Final Remarks

• Clear identification of the impact of exchange rate movements on consolidated earnings is crucial for MNCs. This presentation covers these aspects.