CHAPTER 12
OPERATING EXPOSURE
1. Measurement of Operating Exposure.
a. What is the difference between operating exposure and transaction
exposure?
b. How is operating exposure measured?
c. Why is it difficult to measure operating exposure?
a. Both operating exposure and transaction exposure measure any change in
the present value of a firm resulting from changes in future operating cash
flows caused by any unexpected change in exchange rate. Both exposures
deal with changes in expected cash flows. While transaction exposure
b. To mitigate its impact, the management of the firm must attempt to
measure operating exposure. To perform this measurement, the
management must investigate several aspects of its operation, such as the
method by which the company is generating revenue in the specific
country; the degree of responsiveness of the company’s sales volume to
price changes; the degree by which competitors are likely to be affected by
the currency risk; the currency in which the company’s expenses are
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2. Operating Exposure versus Transaction Exposure. What are the main
differences and similarities between operating exposure and transaction
exposure? Which of the two exposures is more relevant for long-term
planning?
While transaction exposure deals with changes in short-term cash flows that
have already been contracted, operating exposure deals with changes in long–
3. Unexpected Exchange Rate Changes. Explain why the management of
MNEs finds that quantifying and hedging operational exposure are
challenging tasks.
Exchange rate and currency volatility expose companies to transaction
exposure, translation exposure and operational exposure. Unanticipated
exchange rate changes can immensely affect the competitive position of a
4. Unexpected Exchange Rate Changes. Explain when exchange rate
uncertainty does not expose firms to exchange risk.
Exchange rate uncertainty does not necessarily imply that a firm faces
exchange risk exposure, especially if it is already hedged by operating in
multiple markets, accessing diversified sources of finance, and having flexible
5. Static versus Dynamic. Why is static risk insurable while dynamic risk is not
insurable?
Static or current exposures are short-term risks due to interest rate changes,
exchange rate volatility that would lead to changes in short-term sales revenue
and profitability. In contrast, dynamic exposure is long-term risk due to long-
term changes in economic conditions, the business environment, managerial
6. Operating Versus Financing Cash Flows. According to financial theory,
which is more important to the value of the firm, financing or operating cash
flows?
The cash flows of the MNE can be divided into operating cash flows and
financing cash flows. Operating cash flows arise from intercompany (between
unrelated companies) and intracompany (between units of the same company)
receivables and payables, rent and lease payments for the use of facilities and
7. Economic Exposure. Economic exposure is highest for MNEs with multiple
foreign currency operations. Is economic exposure confined to MNEs or does
it involve local firms as well?
Sometimes operating exposure is given different names to emphasize whether
the exposure is due to external uncontrollable forces or internal forces under
the control of the management. Economic exposure refers to the risk and
degree of sensitivity of the firm’s future cash flows created by
macroeconomic uncertainty and ambiguity. Macroeconomic variables that can
affect a firm’s future cash flows include fluctuations in the foreign exchange
8. Strategic Exposure. Operating or strategic exposure has become a concern of
long-term corporate strategy. Which level of management is responsible for
mitigating and managing strategic exposure? Explain the various policy
options that management uses to manage strategic exposure.
Operating exposure is the risk that fluctuations in the foreign exchange rate
will adversely affect the present value of a firm’s future cash flow. Operating
9. Managing Operating Exposure. The key to managing operating exposure at
the strategic level is for management to recognize a disequilibrium in parity
conditions when it occurs and to be pre-positioned to react most appropriately.
How can this task best be accomplished?
If a firm’s operations are diversified internationally, management is pre–
positioned both to recognize disequilibrium when it occurs and to react
competitively. Consider the case where purchasing power parity is
temporarily in disequilibrium. Although the disequilibrium may have been
unpredictable, management can often recognize its symptoms as soon as they
10. Managerial Strategic Roles. What are the diversification strategies and
financing policies that the management of the firm adopts to mitigate
transaction and operating exposure?
It is primarily the management of the firm that is responsible for planning for
operating exposure because it necessitates an integration of multiple strategies
in sales, finance, marketing, purchasing and production. The management can
develop strategies to change the firm’s operating and financing policies and to
diversifying operations. If the firm’s operations are diversified internationally,
its management team can recognize disequilibrium when it occurs and make
11. Proactive Management. Operating exposures can be partially managed by
adopting operating or financing policies that offset anticipated foreign
exchange exposures. What are four of the most commonly employed
proactive policies?
The four most common proactive policies and a brief explanation are:
12. Currency Switching. Explain how currency switching can offset long-term
exposure to a foreign currency.
When the firm is exposed to a foreign currency in the long-run due to
continuous currency receipts, it must seek an equally continuous method to
hedge against this risk. For example, suppose that a British firm receives
constant cash flows in Danish kroner from its trade partner. The firm can use
13. Currency Risk Sharing. Explain why suppliers are ready to get into currency
risk sharing deals with MNEs. How do such deals impact the financial
position of both parties?
If MNEs operate in a country that witnesses excessive exchange rate
fluctuations, they may add a clause or an agreement in their contracts that
adjusts the price in case the exchange rate fluctuates beyond a specified band.
This risk-management tool aims to distribute risks among both the MNE and
its customers (buyers or sellers) such that both parties split the profit/loss. If
the MNE has a long-term buyer–supplier relationship, then the supplier would
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14. Back-to-Back Loans. Back-to-back loans have caused many of the banking
crises in emerging economies in the 1990s. What guarantees can firms obtain
in order to use this type of foreign exchange hedge?
Back-to-back or parallel loans are used to hedge against foreign exchange
risks. Each of the two trading partners borrows funds in its partner’s currency
for a specified period of time, after which they repay them to their lenders.
This is considered a hedge as each of the counterparties is supposed to repay
15. Currency Swaps. Do currency swaps always hedge against foreign exchange
exposure? What other precautions are needed for effective hedging?
A currency swap is an exchange of future cash flows denominated in different
currencies. Because the exchange rate is fixed at inception, firms believe that
they are protected against future exchange rate movements. But in some
instances the currency swaps may be insufficient to help protect banks. For
example, in countries where foreign exchange rates are volatile, banks tend to
16. Hedging the Unhedgeable. How do some firms attempt to hedge their long-
term operation exposure with contractual hedges? What assumptions do they
make in order to justify contractual hedging of their operating exposure? How
effective is such contractual hedging in your opinion?
The ability of firms to hedge the “unhedgeable” is dependent upon
predictability: 1) the predictability of the firm’s future cash flows, and 2) the
predictability of the firm’s competitor’s responses to exchange rate changes.
Although the management of many firms may believe they are capable of
