Operating exposure Flashcards
Define operating exposure
Operating exposure measures change in the present value of a firm from changes in future operating cash flows caused by unexpected changes in exchange rates
OE is equal to net cash inflows and outflows by currency and how that compares to competitors
It can both lead to loss or prift, depending on:
- The structure and operations of a MNE (e.g., effect on revenues vs. cost)
- MNE’s ability to react to changes in exchange rates
- How prices change as a result of exchange rate changes
- How sensitive consumers are to price changes
Operating exposure analysis assesses the impact of changing exchange rates on a firm’s own operations over subsequent months and years and on its competitive position vis-à-vis other firms. The goal is to identify strategic moves or operating techniques the firm might wish to adopt to enhance its value in the face of unexpected exchange rate changes.
What is the effect of time on measuring EO? and specify what can happen in the short, medium, and long run.
Depending on the time horizon chosen to analyze operating exposure the effect of a change in exchange rate will be different in its magnitude and driven by different factors (price, volume, etc.)
In the short run it is difficult to adjust price and renegotiate input costs, hence, profit will be affected but competitive position will remain.
In the medium run there are price and volume effects. It is possible to adjust prices and factor costs, the sales volume start adjusting to prices (extent depends on price elasticity of consumers), and existing competitors will start to respond.
In the long run there is a price, volume, and structural effect. Cash flows influenced by the reactions of existing competitors and new entrants.
What are the commonly used proactive policies for managing OE?
- Matching currency cash flows
- Risk-sharing agreements
- Back-to-back loans
- Cross-currency swaps
- Passive diversification
- Strategic management tools: MNC’s inbuild options to switch
Explain the startegy matching currency cash flows. Explain the figure on p.103
Offsetting anticipated continuous long-term exposure to a particular currency (constant long-term transaction exposure, due to continuous deliveries) by acquiring debt denominated in that currency.
see p. 103
Name some different types of currency matching strategies
Financial hedging - i.e., debt financing to match a receivable
Operational cash flow to hedge operational cash flow (natural hedge) -> Switch to suppliers of materials or components in Canada. Use sales proceeds (account receivables) to pay suppliers (account payables)
Currency switching: Pay foreign suppliers with another foreign currency (i.e., Paying mexican suppliers using canadian dollars, partnering with another MNC who faces similar problem on the other spectrum (you are receivng CAD and they have to pay in CAD for receiving products from Canada), or you are all in direct business relation- different from currency swapping.
Explain the strategy risk sharing agreements.
Contractual agreement between a buyer and a seller to share the impacts of currency movements between them.
Explain the strategy back to back loan.
When two companies from different countries agree to borrow each other’s currency for a specified period of time.
- ”transaction” takes place outside of the foreign exchange market
- No FX exposure because each company borrows own domestic currency in which it will repay as well
- However, the maintenance of the loan can change in real value- need to have agreement to keep principal parity
Difficult to find partner that needs the exact same amount of currency for the exact same period of time.
The collateral in case of default is in foreign currency.
Explain the strategy currency swaps.
A firm and a swap dealer (e.g., a bank) agree to exchange equivalent amount of two different currencies for a specified period of time.
Ultimately, one firm pays for the debt of the other firm and vice-versa (e.g. USD debt payment without incurring USD debt)
Swap dealer works as the intermediary –> Easier to match amount, time period and currency compared to back-to-back loan
Explain REAL OPTIONS THEORY
Theory for understanding MNC’ strategy under uncertainty
- Considering the challenges but also the opportunities coming with uncertainty
- Managers are averse to downside risk – and not risk in general.
- Main claim: MNEs can strategically benefit from uncertainty by creating real options allowing them to maintain flexibility (i.e. adjusting decisions in response to new opportunities or challenges)
ROT in the field of international strategy
- International network of subsidiaries and operating flexibility of MNEs
- Choice of entry mode (value of using international joint ventures)
- Choice of market exit or downsizing
- Choice of market entry timing
What are real options?
A real option refers to a right to take a future action at a cost without any obligation, pertaining to a tangible or intangible asset.
Examples of such actions include expanding/divesting an existing production facility, acquiring a partner’s ownership share, or switching production across subsidiaries in a multinational network.
managers in MNEs obtain the right but not the obligation to take a future action (e.g. deferring, expanding, contracting, or abandoning)”
When the value of an asset is uncertain, a real option allows the decision maker to gather new information and act only if it is beneficial.
ROs are based on real assets – e.g. production facilities and joint assets
What are the requirements two create a real option?
Two requirements for an investment to create real options:
- There should be volatility regarding future payoffs of a project: No volatility –> no uncertainty –> option value is low
- There is managerial flexibility in increasing commitment or controlling losses according to the resolution of uncertainty in the business environment
–> Managerial flexibility = managers’ active management activities
–> No managerial flexibility –> no ability to exercise the real options –> option value is low
What are some obstacles for back-to-back loan?
There are two fundamental obstacles to widespread use of the back-to-back loan.
- First, it is difficult for a firm to find a partner for the currency, amount, and timing desired.
- Second, a risk exists that one of the parties will fail to return the borrowed funds at the designated maturity—although this risk is minimized because each party to the loan has, in effect, 100% collateral, albeit in a different currency.
What are the antecedent of real options?
uncertainty, irreversibility, and RISK OF EARLY EXPIRATION OR COMPETITIVE PREEMPTION.
What is mean by exogenous and endogenous uncertainty ?
Uncertainty can be divided into exogenous and endogenous uncertainty
Exogenous uncertainty refers to passive learning where the firm can gain useful information without investment in time, effort, or money
Exogenous uncertainty is not affected by firm actions, but can only be revealed over time. It is related to uncertainty of the macro-environment (i.e., political and economic conditions)
Antecedent of real options
Endogenous uncertainty requires costly active learning.
Endogenous uncertainty can be decreased through investments by on individual firm. It concerns uncertainty about the micro environment (i.e., consumer needs and taste, and competitive conditions). It also concerns uncertainty at the firm level (i.e., relationships with partners)
Explain irreversibility
The value of managerial flexibility depends on irreversibility, which is the cost of reversing a decision.
The fraction of the investment that cannot be recovered once committed, the aggregate amount of the investment, and the divisibility of the investment determine the irreversibility of an investment.
Irreversible Investments limit flexibility
- Increase the relevance of considering uncertainty when making investment decisions.
- Some choices will increase the flexibility of firms and might be optimal when uncertainty is high.
