Students name : Kemenangan Tiba
Course number and Name : FIN 456 - International Financial Management
Instructors Name : Brittany Holloman
Date : 24/01/2024
TRANSACTION EXPOSURE
A. Introduction:
Exchange rate risk can be broadly described as the risk that a company's performance
will be affected by changes in exchange rates. Exchange rate movements have an influence
on the cash flows of multinational companies and impact the performance and value of
multinational companies. The volatility of currency exchange rates has a major influence on
the cash flows of multinational companies. Corporate finance managers must understand
how to measure the exposure in MNC companies to exchange rate fluctuations so that they
can determine what steps to take and how to protect their operations from the impact of
these exposures.
The volatility of exchange rate movements is very high. To illustrate, an MNC company
in the US is engaged in importing goods and selling them in the US. The company pays 1
million euros at the beginning of each quarter. If the company is not hedged, the dollar value
of the debt will change in line with the value of the euro. When the value of the euro
weakens, the company's costs will be low. However, when the value of the euro strengthens,
the company's costs are high. This will affect the company importers in making import
purchases. Now, let's change the example to an MNC engaged in exporting goods that
receives 1 million euros every quarter and converts it into dollars. The company will earn
more when the value of the euro strengthens than when it weakens. As the international
business grows, the company experiences exposure as a result of exchange rate volatility.
Foreign exchange exposure will be faced by companies that conduct transactions in
foreign currencies so that exposure arises as a result of changes in foreign exchange rates.
With the relevance of exchange rate changes realized by MNC companies so that they
consider hedging. Companies generally face three (3) forms of exchange rate exposure,
namely: Transaction Exposure, Translation Exposure and Economic Exposure. In this
discussion we will discuss in detail about Transaction Exposure.
B. DEFINITION OF TRANSACTION EXPOSURE:
In the discussion of foreign exchange risk, how much a company is affected by foreign
exchange movements is generally called exposure. Transaction exposure provides the
possibility of a company experiencing profit or loss in business due to transactions that use
foreign currencies as denominations. In another sense, transaction exposure is the risk
experienced by the company's future cash flow due to fluctuations in foreign exchange rates.
Transaction exposure measures the change in value of a transaction due to the difference
between the foreign exchange rate at which the transaction is agreed and at which the
transaction is settled. The change in expected cash flow from transactions where the
agreement is made before the change in foreign exchange rates and the settlement of the
transaction is completed after the change in foreign exchange rates. Thus, transaction
exposure relates to existing transactions that have not yet matured, which will have an
impact on the company's short-term cash flow.
Transaction exposure exists when a company enters into a contractual transaction that
causes the MNC to require or receive a certain amount of foreign currency at some time in
the future. The dollar value of debt can easily increase by 10 percent or more, and the dollar
value of receivables can easily decrease by 10 percent or more, which may completely
eliminate the profit margin on product sales.
Transaction exposure focuses on unexpected changes in foreign exchange that impact
future cash flows over a shorter time horizon. Transaction exposure measures gains and
losses arising from financial obligations whose terms are denominated in foreign currencies.
It can be concluded that transaction exposure arises from contractual cash flows in foreign
currencies that affect the company's short-term cash flow as a result of fluctuations in
foreign exchange risk.
C. HOW TRANSACTION EXPOSURES ARISE:
With the value of contractual transactions carried out by the company, it can be
explained the cause of the transaction exposure experienced by the company. Theoretically,
the change in cash flow is explained as follows:
1.
The value of the company's cash inflows acquired by the company in various foreign
currency denominations is determined by the foreign exchange rate and at the time of
acquisition is converted into the desired currency.
2.
The value of the company's outflows is paid in foreign currency denominations and the
value is based on the foreign exchange rate when the payment is made.
3.
Fluctuations in the value of future cash transactions are due to fluctuations in foreign
exchange rates that provide transaction exposure for the company.
This transaction exposure arises due to:
1.
Purchase or sale of goods/services made on credit and the price is expressed in foreign
currency/value.
2.
Borrowing and lending of funds where interest and installment payments are
denominated in foreign currency
3.
Acquire assets or incur liabilities denominated in forex.
4.
Being in an unfinished forward contract.
As an illustration, when a company in Indonesia makes sales (purchases) abroad, there
will be uncertainty about the amount of rupiah that will be obtained (paid) from (to) abroad.
If the rupiah depreciates (appreciates) against a foreign currency, then rupiah receipts will be
greater (smaller). And vice versa for payments.
Other transactions in the form of lending and borrowing contracts can cause companies
to experience transaction exposure. As an illustration, when companies in Indonesia borrow
(lend) in US dollars, and the value of the rupiah depreciates, the amount of interest and
installments paid will increase (decrease) in amount, and this applies vice versa when the
rupiah appreciates.
MNC companies that are in or conducting transactions as illustrated above are subject to
transaction exposures and their settlement will impact the company's cash flow. Transaction
exposure management is done with hedging techniques.
D. Transaction Exposure Measurement:
In assessing transaction exposures, MNCs need to (1) estimate their net cash flows in
each currency and (2) measure the exposure impact of each currency. MNC companies tend
to focus on transaction exposures in the upcoming short-term period (next month or next
quarter) so as to anticipate foreign currency cash flows with reasonable accuracy. MNCs
generally have subsidiaries spread across multiple countries, requiring information systems
capable of tracking expected currency transactions. Subsidiaries should also be able to
access the network and provide information on current currency positions and future
transactions within the next month, quarter or year.
In measuring its transaction exposure, an MNC needs to project the consolidated net
value of cash inflows and outflows for all its subsidiaries, categorized by currency. One
foreign subsidiary may have an expected cash inflow from a foreign currency while another
subsidiary has an expected inflow from a foreign currency cash outflows in the same foreign
currency. Estimating consolidated net cash flows by currency is a useful step in assessing an
MNC's transaction exposure as it helps in determining the overall position of the MNC
company in each currency. The measurement of transaction exposure has 2 stages, namely:
1.
Calculate projected income and expenses in each specific currency over a specified
period of time (1,3 ,6, or 12 months).
2.
Calculate the overall exposure of each net income and expense
This adds complexity to the measurement of transaction exposures although it does not
change the measurement concept. The amount of income and expenditure, besides being
determined by projections, is also affected by estimated changes in exchange rates.
According to (Hady, 2010, p.176) the factors that determine the level of exposure are:
a.
The amount of receiveable/payable value that will be received from each foreign exchange,
b.
The potential level of fluctuation or volatility of the movement of each forex currency
c.
Correlation between the fluctuations of the forex in question
E. Hedging Techniques On Transaction Exposures:
With currency fluctuations and contractual transactions carried out by MNC companies
resulting in transaction exposures, for this reason the company certainly seriously considers
hedging contractual transactions denominated in foreign currencies.
The first step is to identify the degree of its transaction exposure as described in the table
above. Next, the company should consider hedging these exposures so that it can decide
what kind of hedging techniques are optimal and whether they can protect its transaction
exposures. By undertaking transition exposure management, financial managers can
improve cash flows and add value to their MNC companies.
Hedging techniques on transaction exposures can be done through hedging in the
forward/futures market, money market or options. The discussion on hedging techniques
through financial contracts is described below:
1.
Futures Hedge:
This technique can be used by companies with currency futures to hedge transaction
exposures. The futures contract allows the MNC company to lock in the value of a particular
currency where the company can buy a particular currency therefore the company can hedge
its foreign currency debt.
Futures contracts are negotiated between a company and a financial institution such as a
Commercial Bank to be customized to meet the company's needs. Futures contracts can be:
a.
Buying currency; A company that buys a currency futures contract gets the right to
receive a certain amount of currency at a predetermined rate on a certain date.
b.
Selling currency; A company that sells a currency futures contract gets the right to sell
a certain amount of currency at a predetermined rate on a certain date.
2.
Forward Hedge:
Forward contracts are used to fix the future rate at which an MNC company will buy or
sell a currency. These contracts are generally used in large transactions and MNCs may
request forward contracts in an amount equal to the amount used. The company may sell (or
buy) forward its foreign currency receivables (or payables) to eliminate transaction
exposure. If the revenue earned in foreign currency is not in a hedging position, the amount
of cash flow in domestic currency is viewed based on the future spot rate. If it is hedged by
forward, any future spot rate will not affect the domestic currency cash flow. In the
comparison between forward and futures contracts, forward contracts are considered more
favorable when compared to futures contracts for the reasons below:
a.
Futures contracts are instruments that are standardized in terms of contract size,
delivery date and so on. Unlike forward contracts which are made to suit the specific
needs of the company.
b.
Due to the quoted nature of market prices, there are interim cash flows before and up
to the maturity date on futures contracts invested with interest rate uncertainty.
So, in the end, futures contracts will be more difficult to execute. Normally, futures
contracts are similar to forward contracts, but the main difference is that futures contracts
are standardized while forward contracts will be negotiated between MNCs and
Commercial Banks.
3.
Money Market Hedge:
Money market hedging involves taking a position in the money market to protect future
payables or receivables. Hedge a payable or receivable position by:
a.
A money market hedge of debt is when a company has excess cash, it can short-term
deposit the excess cash in a foreign currency that will be needed in the future.
b.
A money market hedge of receivables is when a company has receivables denominated
in a foreign currency. The company can hedge this position by taking out a loan in that
currency and converting it into dollars. The receivables to be received will be used to
repay the loan.
A company can borrow (or lend) in a foreign currency to hedge its foreign currency
receivables (or payables) by linking its assets and liabilities in the same currency. In a
foreign currency receivable transaction, the key step is to determine the amount of foreign
currency to be borrowed.
4.
Currency Option Hedge:
Currency option hedging gives companies a flexible "choice" of exchange rate
exposures. Futures/forwards and money market hedging have the disadvantage of
completely eliminating exchange rate exposure. As a result, companies miss opportunities to
capitalize on potentially profitable changes in exchange rates. The ideal hedge should isolate
the company from the negative impact of exchange rate fluctuations but allow the company
to capitalize on the positive impact of exchange rate changes. Currency option hedging
techniques provide this characteristic. However, MNCs must assess whether this technique
provides a higher return than the premium paid for the option.
Companies can purchase foreign currency call (put) options to hedge their foreign
currency payables (receivables). The buyer of the option contract will be charged an option
price (premium) that gives the right to sell (against foreign currency receivables) or buy
(against foreign currency payables), without the need to consider future spot rates.
If the option contract is profitable for the company, the option will be exercised,
otherwise it will not be exercised. Hedging currency options provides an option for
companies in terms of limiting downside risks while preserving the upside potential of the
option value.
F. Hedging of Exposure On Payable:
Multinational companies may decide to hedge part or all of their payable transactions so
that they can be protected from possible currency appreciation. From the explanation of
hedging techniques above, companies usually compare the expected cash flow of each
hedging technique. The selection of the appropriate hedging technique may vary from period
to period, as the relative advantages factor changes over time. The hedging techniques will
be discussed one by one with examples given below.
Assume The Gabriel Co. an importer company receives an invoice (payable) from
Singapore amounting to SGD 1,000,000 in 1 year. The company considers hedging through
(1) Forward Contract hedging, (2) Money Market hedging and (3) Option Contract hedging.
Then, compare the three techniques with (4) without hedging strategy, then give a decision
on the strategy that is feasible to do on the payables position. Data and information related
to forex conditions in the international market are as follows:
a.
Current Spot Rate: $ 0.60
b.
SGD one-year Forward rate: $0.62
c.
Interest rate in 1 year:
d.
1 year SGD call option with exercise price $0.60 and premium $0.03 per unit
1)
Call Option Hedging:
Purchase a call option (the calculations in the table below assume that the call option
will be exercised when the debt matures or not at all). Call option exercise price $0.60 and
premium $0.03
When comparing the above hedging techniques, it is likely that the company will incur
more costs when buying a call option or money market hedge. Overall, buying a forward
contract is more profitable for the company. The optimal hedging technique varies greatly
over time depending on the prevailing forward rate, interest rate, premium value of the call
option and the forecast spot rate at the time of payment maturity. Then, we can compare the
results if the company does not hedge its payables:
2)
No Hedging:
Purchase SGD 1,000,000 at spot rate for 1 year payable payment. Based on the
estimated SGD spot rate in 1 year from the data described above, The Gabriel Co. can
estimate the cost of the payables if it is not hedged.
It can be seen that the expected value of payables without hedging techniques is $10,000
greater if the company does a forward hedge. And there is an 80% probability that the cost
of payables without hedging is greater than the cost of hedging with a forward contract.
Thus, The Gabriel Co. decided to hedge payables with a forward contract.
G. Protect Value Exposure on Credit (Hedge On Receivables)
Multinational companies may decide to hedge part or all of their receivables transactions
so that they can be protected from possible currency depreciation. From the explanation of
hedging techniques above, companies usually compare the expected cash flows of each
hedging technique. Similar techniques can be applied to hedging receivables as well as the
explanation of hedging payables above. The application of hedging techniques on
receivables is explained in the case example below. Suppose Santa Monica Co.
An exporting company from the USA has receivables for orders from Singapore
amounting to SGD 500,000 in 1 year. The company is considering hedging its receivables
through (1) Forward Contract hedging, (2) Money Market hedging and (3) Option Contract
hedging. Then, compare the three techniques with (4) no hedging strategy, and decide on the
following feasible strategies to be carried out on the receivables position. Data and
information related to forex conditions in the international market are as follows:
a.
Current Spot Rate: $ 0.60
b.
SGD one-year Forward rate: $0.62
c.
Interest rate in 1 year:
d.
1 year SGD Put Option with exercise price $0.63 and premium $0.04 per unit
e.
Santa Monica Co. makes a probability and estimation of the Future Spot Rate (FSR)
for one year:
1.
Put Option Hedge:
The company purchased a put option with an exercise price of $0.63 and a premium of
$0.04. Assuming this option will be exercised when the receivable is received or not at all.
Based on the hedge calculation results of the three techniques above, it can be concluded
that the forward hedge is superior when compared to the money market hedge and has a 70%
greater chance than the Put Option Hedge. In conclusion, forward hedge is more optimal.
After concluding the forward hedge, the company wanted to compare the probability of not
hedging its receivables.
When comparing the expected value without hedging ($319,000) with the forward hedge
($310,000), the company decided not to hedge its receivables. The no hedging strategy has
an 80% chance of being superior to the forward hedge. The company's decision not to hedge
creates a trade-off, where the company expects to benefit from SGD currency appreciation
over the next 1 year, but is vulnerable to adverse effects if SGD depreciates.
H. Comparison Of Transaction Exposure Hedging Techniques:
A comparison of each hedging technique is summarized in the table above. When
companies use futures contracts, forward contracts, or instruments in the money market,
they can estimate the amount of funds denominated in domestic currency needed to pay off
foreign currency payables in the future, or the amount of funds denominated in domestic
currency that will be received from foreign currency receivables in the future. Thus,
companies can determine which hedging techniques are feasible and appropriate. However,
the hedging technique on exchange options cannot be determined with certainty because the
cost of debt repayment and revenue are not known in advance.
I. POLICY PROTECT VALUE (HEDGING) MULTINATIONAL COMPANIES
In general, hedging policies vary according to the level of risk aversion of each MNC
management. An MNC may choose to hedge most exposures, no hedging or selective
hedging.
1.
Hedge most exposures:
Some MNCs hedge their transaction exposures so that their enterprise value is less affected
by exchange rates. MNCs that hedge most of their exposures do not necessarily expect to
gain from hedging. In fact, MNC companies that hedge get slightly smaller returns when
compared to not hedging, just to avoid the possibility of exchange rate fluctuations that
could harm the company.
2.
No Hedging:
Multinational companies that are diversified across countries may consider not hedging their
exposures. This strategy may be influenced by the view that having a diversified set of
exposures will limit the impact of actual exchange rate movements on the MNC during the
period.
3.
Selective Hedging:
Some MNCs hedge only if the company believes that hedging will increase the company's
expected cash flows or the company expects the exchange rate to move in a favorable
direction.
J. HEDGING OF LONG-TERM TRANSACTIONS:
Multinational companies that have forex cash flows several years from now can engage
in long-term hedging. For companies that can accurately estimate foreign currency payables
or receivables that will arise several years from now, there are three types of hedging.
(3) techniques for hedging long-term transaction exposures, including:
1.
Long Forward:
Long forward contracts can be used for companies that have entered into long-term fixed-
rate export and import contracts and wish to protect their cash flows from exchange rate
movements. Long forwards, like short-term forward contracts, can be customized to meet a
company's specific needs. Many large banks are willing to buy or sell long forwards of up to
10 years for important currencies. Banks will choose companies that are credible in meeting
the long-term obligations agreed in the contract.
2.
Currency Swap:
This method provides an opportunity to exchange one currency for another at a certain rate
and date, where the Bank acts as an intermediary between two parties who want to do
Currency Swap.
3.
Parallel Loan:
Also known as a back to back loan, it is a loan that involves an exchange of currency
between two parties, with an agreement to exchange the currency back at a certain rate and
date in the future.
K. Hedging Alternative For Reduce Transaction Exposure
As a measure to reduce transaction exposure risk, there are times when companies are
unable to eliminate transaction exposure completely. Companies are not always able to
project cash inflows and outflows from future sales or purchases denominated in foreign
exchange with accuracy. In addition, the cost of hedging is too great compared to the
benefits obtained. When hedging facilities are not available or too expensive for the
company, there are several alternative methods that can be used, at least to reduce exposure.
These alternative methods include:
1.
Leading and Lagging:
Leading (acceleration) according to (Hady, 2010, p.195) is an accelerated payment strategy,
usually due to a reaction to the movement of the exchange rate that will be used to
appreciate. Meanwhile, lagging is a payment strategy that is postponed as a result of a
reaction to the projected exchange rate that will be used to depreciate.
2.
Cross Hedging:
Cross hedging is a common way for companies to reduce transaction exposure when an
exchange cannot be hedged. It is hedging an open position in one currency using another
currency that has a high correlation with the first currency. For example, a company in the
US has a 90-day A-denominated debt. Fearing an appreciation of the US dollar, the
company wants to hedge this position. If no hedging technique is available in this situation,
the company can do Cross Hedging, by finding a currency that can be hedged and has a
strong and positive correlation with the currency A. An example of a strong and positive
correlation is between USD and Euro.
3.
Currency Diversification:
The third method for alternative hedging is to diversify the forex used in export and import
transactions. If a company in Indonesia has a large cash inflow in USD and a large cash
outflow in JPY, when the company has a large cash inflow in USD, the company will be
able to hedge its cash flow in JPY. When the USD depreciates against the JPY, the company
will incur a large loss. Under these conditions, cash flows in forex will be relatively stable if
they do not have a strong and positive correlation to the domestic currency. In other words,
low positive correlation or negative correlation can be an alternative to reduce the risk of
exposure transactions. (Hady, 2010, p.196).
L. MATERIAL SUMMARY:
1.
Transaction exposure exists when future cash transactions of an MNC are affected by
exchange rate fluctuations. When transaction exposures arise, companies have three
important obligations. First, it identifies the amount of transaction exposure. Second, the
company decides whether or not to hedge its exposure. Finally, the company performs
calculations and analysis in deciding to hedge the entire exposure or part of it with
various hedging techniques available.
2.
MNCs can use hedging techniques with instruments in (a) futures contracts, (b) forward
contracts, (c) money market transactions and (d) currency options.
3.
In debt hedging techniques, companies can purchase futures or forward contracts that
represent the currency amount of the debt. Alternatively, consider making transactions
in the money market, where MNCs borrow local/home currency and exchange it into
the foreign currency that will be needed in the future. Then, the company can also
purchase call options to hedge its debt.
4.
In hedging receivables, companies can sell futures or forward contracts representing the
currency amount of the receivables. Alternatively, consider entering into money market
transactions, where MNCs borrow foreign currency to be received in the future,
exchange it into the local/home currency, and repay the loan with cash inflows from the
receivables. Then, the company can purchase put options to hedge the receivables.
5.
Futures contracts and forward contracts generally provide the same outcome. However,
forward contracts are considered more flexible as they are not standardized. When
interest rate parity occurs, money market hedging yields the same results as forward
contracts. Hedging on exchange options has an advantage over other hedging
techniques, in that exchange options do not obligate the company to be exercised if the
MNC company decides it is more profitable not to hedge. Purchasing currency options
comes at a premium cost so the advantages of currency options also have a price.
6.
Hedging techniques in long-term transactions can be done using long forwards,
currency swaps, and parallel loans.
7.
When hedging techniques are not available, MNCs can employ several techniques to
reduce transaction exposure risk such as leading and lagging, cross-hedging, and
currency diversification.
TASKS AND EVALUATION:
1.
Explain why an MNC should identify its net exposure before hedging.
2.
List some of the factors that determine the level of transaction exposure.
3.
The Jackman Co. a US company plans to hedge its debt of AUD 3,000,000 in 1 year
by entering into a money market transaction. The US interest rate is 7% while the
Australian interest rate is 12%. The current AUD spot rate is $0.85 and the 1-year
forward rate is $0.81. Specify:
a.
The dollar amount needed in 1 year if using a money market hedge.
b.
If the company buys a forward contract to hedge, which hedging technique is better
for the company to choose?
OPERATIONAL EXPOSURES
Operational exposures are more complex than transaction exposures, therefore
measuring operational exposures is not easy. The effect of operating exposures on firm value
is quite significant. Companies that cannot anticipate these exposures will result in a
decrease in competitiveness, and a decrease in company value. Many companies try to
overcome operating exposures in several ways.
A. Exposure And Exchange Rate Changes:
Measuring operational exposure is not easy to do for several reasons, it is difficult to
estimate the cash flow that will change due to changes in currency exchange rates, the effect
of inflation on cash flow, and it is difficult to estimate the exact time horizon.
A company starts to expect operational exposure the moment it decides to make an
investment, and invests the funds for the investment, and then the exposure will continue to
exist as long as the company carries out its operations.
1.
Real Rate and Expected Change:
The exchange rate that needs to be considered, and which affects the company's
exposure, is the real exchange rate, i.e. the rate that already takes inflation into account.
Nominal exchange rates do not affect a company's relative competitiveness. If a country's
currency depreciates nominally, but is then followed by inflation, then no real depreciation
has occurred. Companies in the country where the depreciation occurred will not benefit
from it. If inflation between countries is the same, then there is no change in real exchange
rates between countries. The PPP (Purchasing Power Parity) condition is met. Prices will
rise at the same rate as inflation. If there are no transaction costs, then the cost of goods
between countries will be the same. Otherwise, there will be an arbitrage process that
eventually equalizes prices goods between countries. The same prices mean that the
exchange rates between countries' currencies do not change. In this situation, multinational
companies do not face the risk of changes in currency exchange rates. The following
illustration illustrates that if the real exchange rate does not change, the cash flow will not
change.
2.
Illustration: Real Rate Effect:
Suppose that in year 0 the exchange rate Rp/$ is Rp. 2,500.00/$ the consumer price
index in the US and Indonesia is 100. In year 1 the nominal exchange rate Rp/$ is Rp.
2,750.00 the price index in the US is 100, while in Indonesia it is 110. A US multinational
company has a branch in Indonesia. The price in year 0 in Indonesia is Rp. 25,000.00, the
cost is Rp. 10,000.00. What is the profit rate in year 1 in US dollars?
In such a situation, the foreign currency denominated cash flow will change with
inflation. As long as there is no fixed contract, there is no inflation risk, and no risk of
currency exchange rate changes. But if the cash inflow is fixed (cannot adjust for inflation),
then in the above situation, the risk of currency exchange rate changes is absent but the risk
of inflation is still present. Even in the above situation, inflation will be favorable if the
company has fixed obligations, e.g. fixed debt payments. But if inflation is expected by the
bank (lender). Then the interest rate and debt repayments already incorporate the inflation.
Thus there is no gain or loss from expected inflation. Inflation risk occurs if the expected
exchange rate or inflation does not occur. It is the unexpected exchange rate or inflation that
creates the risk.
A currency is said to be risky if changes in the value of the currency cannot be predicted.
A currency that devalues or depreciates is not automatically a risky currency. If the amount
of depreciation/devaluation can be estimated. The currency has little risk, even less than a
currency that has appreciated/revalued. Expected changes are key in this regard. If the
change can be expected, then the risk of changes in the value of the currency becomes
smaller.
B. OPERATING EXPOSURE:
To clarify the exposure, the following example will be used suppose an Indonesian
company has a branch in the United States. The branch produces goods that are sold in the
US domestic market. A significant proportion of inputs come from Indonesia. Then the
dollar currency depreciates against the Rupiah significantly. Note that the following example
shows a depreciation. Usually a depreciated currency causes problems, because the cash
flow denominated in that currency, when converted to the currency of the head office
country, will be smaller than before the depreciation. Changes in cash flow due to changes
in exchange rates are caused by two things:
1.
Changes in competitiveness. Changes in exchange rates result in changes in
competitiveness. In the example above, since some of the inputs are imported from
Indonesia. The price of inputs in rupiah will become more expensive. This will affect the
competitiveness of the product.
2.
Changes due to currency conversion. Changes in exchange rates also result in changes in
cash flow. In the example above, with the depreciation of the dollar, one US dollar will
generate less Rupiah in the event of dollar depreciation.
a.
Price changes. Costs change, and sales quantity remains fixed. For example, variable
costs change following depreciation, i.e. they increase by about 10%. Such an increase
is justified because depreciation makes imported goods more expensive. Since costs
go up, the price is increased by about 100%. Fixed costs do not change because the
contract is fixed upfront and covers one year. The contract is assumed to end a few
months after the depreciation of the US dollar.
b.
As the price rises, the sales quantity will decrease further. Suppose the quantity is
expected to drop by about 1,000 units.
From the table above, the cash flow before the exchange rate change is $6,800 or Rp.
20,400,000.00 after being converted into rupiah at an exchange rate of Rp. 3,000.00 / $ in
column (2), after the exchange rate change, without changes in quantity and price / cost, the
cash flow has decreased by Rp. 2,040,000.00 in column (3), the price has been adjusted, and
also the cost, quantity has not changed. The additional cash flow shows a positive number of
Rp.390,000.00 in the last column, after changes in price, cost and quantity, the additional
cash inflow shows a negative number of Rp. 2,283,000.00.
Suppose the effect of depreciation will last for three years, we can calculate the present
value of the loss or gain due to the depreciation of the dollar. The following table shows the
results of this calculation with a 15% discount rate.
The above scenarios can be expanded into multiple scenarios, but too many scenarios
will complicate calculations and analysis, for example, if the company uses dollar-
denominated debt, dollar depreciation will be favorable. If the company also exports
products overseas (outside the US), a scenario that includes foreign markets can be included.
Different assumptions will lead to different calculation results. For example, the price is
a management decision, but the quantity sold will be more difficult to estimate, for example,
if the competition is imported goods, the depreciation of the dollar is good because it makes
the company's products more competitive relative to imported products. Conversely, if the
expected competition is domestic products the competition will be tougher. The calculation
example above shows that calculations using scenarios are very difficult to do. Mechanical
calculations can be done easily, for example by using a spread-sheet such as Lotus 123 or
Quattro Pro. But identifying the right scenario and using appropriate and realistic
assumptions is not easy to do. In addition, measuring the right time horizon is also not easy
to do. In the example above, a three-year horizon was used to simplify the analysis.
C. Measuring Operational Exposures:
The risk of changes in currency values can be identified with existing statistical
techniques. The risk is the extent to which the probability of future cash inflows differs from
the expected value. Exposure, on the other hand, indicates how much currency is at risk (due
to changes in currency values). How to measure exposure will be further explained in the
following section.
Suppose a US multinational company deals with two currencies, the French Fanc and the
US Dollar, it expects a cash inflow from its French branch of FF1,000, three months from
now. Suppose there are three future situations with different exchange rates, table 3 below
enhances these situations.
There are three possible future situations with different exchange rates: $0.250/FF.
$0.225/FF, and $0.200/FF. The dollar value of the cash inflow is written in the third line for
each situation. Suppose a multinational company enters a forward contract by selling FF
1.00 forwards, the next row (4) shows the cash flow from the foward contract for each
situation. The last table shows the net cash inflow value after combining the spot cash
inflow (row 3) with the cash flow from the foward (row 4). The hedged dollar value shows a
constant cash flow of $1,000 x F. In this example, the risk of currency exchange rate
changes is perfectly eliminated through forwards.
What is the exposure experienced by the company? In the example above the company
has an exposure of FF1,000. Exposure can thus be defined as "The amount of foreign
currency denominated currency that could change in value due to future changes in real
exchange rates, as of a specific date". The addition of a specific date reflects a specific
period. Hedging can then be defined as the foreign currency amount of the transaction
required so that the value of future cash flows, at a specific date, is not affected by future
changes in real exchange rates", Square is quite high. If the R-Square is small, or the
regression coefficient is small or insignificant, then changes in exchange rates have little
effect on changes in cash flow. Managers would be better off focusing on other factors that
are more likely to affect cash flow changes. The regression model can be modified to
include more than one currency. Multiple regression is used in this case. Interpretation can
be done in the same way as a single regression. In this case each regression coefficient
reflects the exposure a company faces for each currency. The use of regression to measure
cash flow exposure is advantageous as regression techniques are well known and easy to
perform. The use of regression models that use past data has the disadvantage of implicitly
assuming a stable pattern. Past patterns do not necessarily repeat themselves in the future.
For example, if the company decides to no longer borrow in Japan, but instead borrow in
Europe, the exposure to changes in the exchange rate Rp/Yen in the future will be reduced.
significantly. Past data can no longer be used in this regard.
D. Operational Exposure Management:
Operating exposures result in changes in cash inflows, which means changes in the value
of the company. In the short term, the change in cash flow is due to changes in exchange
rates. In the longer term, changes in exchange rates will cause more fundamental changes,
namely changes in the competitiveness of the company. Changes in competitiveness will
cause changes in cash inflows in the long run. Depending on how managers react or respond
to changes in exchange rates, changes in exchange rates can be both a threat and an
opportunity. It is important to note that changes in real exchange rates will lead to changes
in competitiveness. Changes in nominal exchange rates do not automatically result in
changes in competitiveness, as inflationary factors still have to be taken into account. If after
competitiveness, because the inflation factor still has to be taken into account. If after taking
inflation into account there is no change. Which means there is no change in the real
exchange rate, then the competitiveness of the company will not change. How a company
performs operating exposure management, can be seen in the following illustration.
Illustration: Exposure Management at Toyota:
Toyota, which is the largest automaker in Japan and the world's fourth-largest company
outside the United States, had problems with the appreciation of the Japanese Yen. From
1985 to 1988, its appreciation almost doubled. In 1985, the yen/$ exchange rate was Y240/$,
while in 1988 it was around Y130/$. The US market is a significant market for Toyota. If
the production and delivery costs were at least Y3,600,000, then the selling price of the car
in the United States would have to be set at a minimum of about $15,00
(Y3,600,000/(240Y/$) in 1985, while in 1988 the price had to be about $27,692 in order to
break-even.
The price almost doubled, even though prices in the United States did not show such a
sharp increase. Toyota could have set the dollar price at the same level as in previous years.
But that would result in a decrease in Toyota's revenue, as oil and other production inputs
are imported from overseas. This will result in decreased competitiveness as US automakers
will not raise their prices significantly. Toyota could lose market share which could be bad
in the long run. If Toyota shifts its attention to the domestic market, it will not help much
either. The share of the export market is quite significant. Other Japanese automakers also
have the same problem, which could result in increased competition in the domestic market.
Such competition will further depress Toyota's revenue. To solve the problem, Toyota plans
to relocate its factory to the United States. Toyota planned to increase production capacity
by 50% from 1993 to 1996. With the relocation, car exports from Japan are expected to drop
by 30%. The pick-up truck plant will be moved from Japan to Fremont, California. US
Employment is expected to increase by 23% to 6,000 jobs at the Georgetown, Kentucky
plant.
While research on production inputs by US plants will increase 40% to $6.45 billion,
from $4.65 billion in 1993. Toyota also uses a marketing technique, which is to use
attractive lease agreements. The rent does not always change to adjust to appreciation of the
yen, although companies face the risk of reselling cars that are completed on lease. Thus the
leases are still attractive to US consumers. Although the relocation may solve the problem of
yen appreciation, the problem of overcapacity in Japanese factories may arise and may lead
to a rise in the unemployment rate. It is feared that the appreciation of the yen could cause
problems for the Japanese economy.
1.
Marketing:
Market Selection Strategy. Market selection determines which markets to enter with
which strategy. Countries with strengthening currencies are quite attractive targets to enter
because prices become relatively more expensive compared to the price of imported
products, for example if the yen currency strengthens against the Rupiah currency, then
Indonesian products have a good opportunity to penetrate the Japanese market When the US
dollar strengthened against the yen and the German Mark in the early 1980s, Japanese and
German car companies had a good opportunity to penetrate the market in the United States.
Managers can segment the market to reduce sensitivity to price changes. Changes in
exchange rates will mainly cause price competitiveness to change. When the dollar
strengthens against the Japanese yen, Japanese cars can be priced cheaper because the car
inputs are denominated in yen, which weakens against the US dollar. If US car companies
use price competition, they will not be able to compete with the lower prices offered by
Japanese car companies. US car companies can focus on segments that are less sensitive to
price changes, which are usually high-income market segments (e.g. executives or
managers). The products offered are not standard cars, but luxury cars for the upper middle
class.
a.
Products:
To avoid market sensitivity to price, companies can develop a more diverse product line,
not just depending on products that use price as a competitive tool. A growing product line
usually follows a growing target market. Thus the company must first determine the market
to be targeted, then design products to meet the needs of the market. The target market is
expected to be a target that is not so sensitive to price changes. If a country's currency
weakens, this is a good opportunity to penetrate the export market, and at the same time
strengthen product lines that have high price sensitivity at home. Product lines aimed at the
lower middle class are candidates to be developed in such a situation. A more complete
product line will also be beneficial as the company will be able to protect itself from
competitors. If there is an unfilled product line, competitors can enter the vacancy and then
use it as a base to take on other product lines in the future. Japanese car companies
capitalized on the vacancy of the small car product line, which was not offered by US car
companies. Later on, Japanese car companies even entered the luxury car segment,
challenging US car companies directly.
To develop products, research and development activities are an important part.
Continuous product innovation can promote the emergence of new products, thereby
strengthening the competitiveness of the company, and reducing price sensitivity in the
market that the company expects. Product launches can also take advantage of changes in
exchange rates to achieve better results. If a country's currency is expected to strengthen,
then the product launch into that country can be accelerated. Conversely, if a country's
currency is expected to weaken, the product launch should be delayed or slowed down. In
the first situation, the company benefits as price competitiveness increases, while in the
second situation price competitiveness will decrease.
b.
Price.
If the exchange rate changes, there are two objectives that are not always consistent:
market share and profit margin. If a country's currency devalues/depreciates, products
produced by companies in that country will become relatively cheap. The company has two
choices:
1)
Price changes. If a country's currency depreciates, the cost of imported goods will rise,
and it is likely that the price of imported goods will rise with it. Suppose imported
goods must increase by 10% to match the increase in input costs. The company can
increase the price by less than 10%, e.g. 5%. With such an increase, the company can
increase its profit margin while maintaining its competitiveness. In 1978, the US dollar
depreciated. Imported car prices were forced to increase. US car companies (General
Motors and Ford) took advantage of the situation by raising prices (while maintaining
competitiveness) to improve profit margins. Previously, the price of small cars ) ) were
set low to face competition from imported cars, the depreciation of the US dollar
allowed US car companies to breathe a little easier.
2)
Fixed price, if the price does not change, the company has the opportunity to increase
market share. But the strategy will not increase profit margins.
The opposite strategy will be employed if a country's currency appreciates. Foreign
companies, in such a situation, can lower prices to maintain market share. But the expected
cost is according to the profit margin, which can even be a loss, especially in the short term.
On the other hand, the foreign company can raise prices to compensate for the increase in
the price of inputs imported from outside. This kind of strategy can maintain profit margins.
Once a customer moves to another product, and is satisfied with that product, it is unlikely
that the customer will return to the company's product. Decision on whether to change
prices or not Changing the price will depend on several factors, such as the elasticity of
demand, economies of scale, and whether the exchange rate change is permanent or not. If
the price elasticity of demand is high, then a price increase will result in a significant loss of
market share. Such a situation is unfavorable, so companies tend to hold prices or lower
prices. Companies will think several times about raising prices. Companies will think
several times about raising prices. Such a situation will be faced by the company if the
currency in the country appreciates or revalues.
If the price elasticity is not too high, the company can raise prices to maintain its profit
margin. Market share will not decrease significantly in such a situation. Decreasing the price
is also not very profitable, as the market share will not change much. Thus, in a situation of
low price elasticity of demand, firms have a tendency to either not change prices or raise
prices. If there are economies of scale, firms would be better off lowering prices to induce
more demand. The larger the output, the lower the cost per unit. Low prices will be offset by
low costs, which means that profit margins will be maintained. But the key in such a
situation is greater demand, if economies of scale do not exist, then the opposite strategy is
possible.
If the company makes price changes following changes in exchange rates, the problem
that needs to be considered is how often the company will make price changes. Changes that
are too frequent will mess up the profit/loss calculations made by distributors. Too frequent
changes may also be inconsistent with the company's strategy, which is not easily changed.
On the other hand, not making any changes after a change in the exchange rate does not
seem to be the best option either. Thus there is a trade-off between making frequent changes
and making infrequent changes.
c.
Promotion:
To deal with exchange rate changes, promotions are conducted consistent with product
or pricing strategies. For example, if the Yen strengthens against the Rupiah, Indonesian
companies have the opportunity to penetrate the Japanese market or attract Japanese
consumers to buy Indonesian products. Indonesian companies can present promotions that
emphasize competitive prices. Companies in Indonesia can display promotions with the aim
of attracting Japanese tourists to visit Indonesia. Promotions are packaged by displaying low
prices to visit Indonesia, because Japanese consumers have more money with the
strengthening of the yen. Conversely, if the domestic currency strengthens, competitiveness
against imported goods decreases, companies can display promotions with the aim of
reducing price sensitivity. The company tries to differentiate by showcasing other qualities
or attributes, so that price is no longer the focus of consumers' attention. Such promotions
may mitigate the negative effects of a stronger currency, but they cannot completely
eliminate them. More fundamental changes, such as product or strategy changes are required
in the event of a currency devaluation/depreciation situation.
d.
Distribution:
Distribution strategy follows the market and product strategy discussed earlier.
2.
Production:
Input composition. One of the minor changes as a result of exchange rate changes is to
change the composition of inputs. Multinational companies have great flexibility in this
regard. It can use more inputs from countries with depreciating currencies, and less inputs
from countries with strengthening currencies. If the domestic currency strengthens relative
to the foreign currency, the composition of inputs from abroad will be increased. Flexibility
in input sourcing reduces foreign exchange exposure. Relocation of Production Facilities. If
the company If a multinational has several factories in several countries, the production level
will be increased at the factory in the country with the weaker currency. Conversely, if a
country's currency strengthens, production levels at factories in that country will be
minimized. Such flexibility of multinational companies allows them to reduce foreign
exchange exposure, something that exportive or domestic companies that produce goods
domestically only do not have.
Of course, in practice such strategies have associated constraints or costs. A factory with
reduced production capacity will result in unemployment in the local area which may cause
political or social problems. If the local government has strong worker protection. The
flexibility of multinational companies in terms of relocating factories is reduced. Another
problem with relocating factories is the reduction of economies of scale in production. If a
multinational uses several factories, each factory will consequently produce smaller units
than if it were concentrated in a single factory. Unachieved economies of scale will result in
higher production costs per unit, each plant will thus produce with less efficiency.
Obviously, managers of multinational companies will consider the trade-off between the
benefits (diversification of plant locations which reduces foreign exchange exposure) and
costs (political-social costs and reduced economies of scale).
Factory Location. In the short term, production policies such as changing the
composition of inputs or moving production facilities can be carried out in the short term. If
these two policies are not enough to reduce the risk of changes in foreign exchange rates.
Multinational companies can go a step further by setting up factories in countries where the
currency is depreciating or devaluing. Japanese car companies moved manufacturing sites to
the United States because the yen appreciated against the dollar, while Japanese car sales in
the US were significant. Multinational companies can also move their factories to third
countries, usually countries with cheaper labor. In this way, production costs can be reduced,
Production cost savings can be used to compensate for the appreciation of the domestic
currency. Of course, managers need to consider how long the depreciation or appreciation of
a currency will take. If the period is too short, then relocating the factory will not be
profitable as the cost of relocation will outweigh the benefits. Note that the depreciation or
appreciation to look at is the real depreciation or appreciation. If the depreciation of a
currency is followed by inflation, then the benefits of relocating the factory will be lost.
Moving a factory overseas has disadvantages because the situation abroad will be
different from the domestic situation. For example, labor productivity or the situation of
infrastructure and facilities will be different. If a multinational company moves its factory to
a developing country, productivity will be lower. Infrastructure and facilities are less
developed, which can increase production costs. Managers need to consider this kind of
trade-off between benefits and costs. Improving Productivity. One way to address the
fundamental problem of economic exposure is to increase productivity. Inefficient factories
are closed, automation can be increased, management's relationship with workers is
strengthened, relationships with suppliers and other related parties are strengthened, and
quality is improved. By increasing productivity, the need to relocate factories is reduced as
multinational companies can compensate for foreign currency exposure with increased
productivity.
3.
Financial Policy:
Several techniques in finance can be used to manage operating exposures, including:
a.
Natural hedging by matching cash inflows with cash outflows.
b.
Back to back loan
c.
Swep
d.
Lead and Lag
Natural Hedging. Through natural hedging, multinational companies try to balance the
denomination of cash inflows with the denomination of cash outflows. For example, an
Indonesian multinational company exports goods to the Philippines. The company thus
obtains a significant cash inflow denominated in Philippine pesos, so the cash inflow will
become less if the cash is converted to Rupiah, while the cash outflow in Rupiah does not
change. Thus the company experiences less net cash inflow.
To avoid such a situation, a multinational company can increase its cash outflows
denominated in Philippine pesos to balance its cash inflows. The multinational company can
increase inputs from the Philippines so that the cash outflows are paid in Philippine pesos,
while the inputs are paid in Rupiah. Suppose there is a significant depreciation of the
Philippine peso, then the cash inflow will be less if the cash converted into Rupiah
decreases, but the company is compensated by paying less input after the peso is converted
into Rupiah.
To set up a natural hedge, several scenarios can be used in addition to increasing the
inputs as discussed above. The company can use peso-denominated debt. If there is a
depreciation of the peso against the Rupiah, the debt repayment in Rupiah will decrease. The
company can pay for inputs in pesos. Suppose there is a multinational company from the
Philippines operating in Indonesia, a way to balance cash inflows with outflows. Such a
method is not only limited to companies from the Philippines. Suppose there is another
multinational company that has the same interests as the Philippine company. Then the
company can be invited to exchange currencies as in the previous example. Back To Back
Loan. This method, besides being used for operating exposure management, is also often
used to overcome capital flow restrictions. Therefore, this method will be discussed more in
the chapter on Multinational Financial System. The method can be described as follows.
Suppose there are two multinational companies: (1) Racis with a branch in the United States.
If the branch France needs funds (in Francs), and the AC branch needs funds (in US dollars),
each center does not need to supply funds directly. If supplying funds directly, there will be
foreign exchange exposure. The US center provides funds in dollars, which are then
converted to francs and given to the French branch.
Through a back to back loan, a French company provides a loan in francs to the French
branch of a US multinational while a US company provides a loan in US dollars to the US
branch of a French multinational. In such a way the loan will be denominated in the local
currency, which is more in line with the denomination of the cash inflow. The French branch
has debt in francs, which corresponds to the denomination of its cash inflow. The same goes
for the US branch (in this case denominated in US dollars). Foreign Currency Swaps. A
currency swap is done by exchanging cash flows in different denominations. Suppose an
Indonesian multinational company exports goods to the United States and borrows funds in
Rupiah from a bank in Indonesia.
To balance cash inflows with cash outflows or reduce foreign exchange exposure. It
would be better for the multinational company to exchange the cash inflow into Rupiah.
Suppose the company finds a US multinational company that exports goods to Indonesia.
The company's inflows are denominated in Rupiah and the company would be better off if it
had outflows denominated in US dollars. The Indonesian multinational company can swap
its dollar cash flow into Rupiah cash flow with the US multinational company The US
multinational company has a dollar cash inflow after the swap agreement. To facilitate the
swap exchange, a dealer can be used in this case. Swap dealers (swap banks) help bring
interested parties together indirectly. The company entering into the swap transaction does
not need to know its counterparties directly. In other words, the counterparties faced by
multinational companies are swap dealers, which are usually large banks. In this way, the
risk of default becomes smaller because large banks have a good reputation. Bank then look
for partners. Directly or indirectly to balance the bank's exposure. Leading and Lagging.
Leading and lagging will be discussed in more detail in the chapter on multinational
financial systems. Leading means accelerating the flow of payments, while lagging means
slowing down payments. If a country's currency is expected to depreciate significantly, then
cash inflows denominated in that currency should be accelerated; if the cash inflow is paid
when the currency has depreciated, the value of the cash flow will be reduced. Meanwhile,
cash outflows denominated in the currency will be better if slowed down (lagging), for
example, debt payments when the currency is depreciating will be profitable because the
value of the payment will be reduced.
Leading and lagging can be done by branches or subsidiaries of a multinational company
(intra-firm), or between firms (inter-firm). Inter-firm leading and lagging is not easy to do or
can be done at an additional cost. For example, a company wants to accelerate the collection
of receivables denominated in Mexican pesi, as the pesi is expected to depreciate. If the
buyer expects the same, he will naturally try to slow down payment, waiting for the peso to
depreciate. Unless the multinational offers cash rebates or other incentives. Leading and
lagging can be done within a company (between branches) quickly. The overall value of the
company will increase, although not just for the subsidiary or branch in question. The
company can use some incentive techniques (to branch or subsidiary managers) to make
leading and lagging possible. For example, a branch manager should not be penalized if
he/she accelerates the payment of debts to the center if the currency of the country where
he/she is located will depreciate. If the branch is an independent company, of course, the
manager will choose to slow down the payment of the debt because it will be more
profitable for him profitable the company.
If the branch is also owned by another party (e.g. selling its shares in the local country),
leading and lagging techniques can hurt local shareholders. Therefore, some countries
impose restrictions on capital flows from leading and lagging. An example of such
restrictions is that the lag of exports is limited to a maximum period of 180 days, while the
lag of imports is limited to a maximum of five years. Leading and lagging thus cannot be
done perfectly as it has to take into account some of the restrictions that apply.
E. MATERIAL SUMMARY:
This chapter describes operating exposures. Operating exposure will determine
economic exposure, and will have a direct effect on the value of the company. To measure
operating exposure, we can use the regression statistical method. The regression coefficient
is an indicator of economic exposure. Hedging actions are expected to reduce the risk of
cash flow changes due to changes in exchange rates. the variance of the hedged cash flow is
smaller than the variance of the unhedged cash flow. Historical data can be used to measure
economic exposure. Management of operating exposure can be done through several areas
of marketing. Production and finance. Through marketing, operating exposure management
seeks to minimize the sensitivity of cash flow to changes in exchange rates. to reduce this
sensitivity. The company can do market selection (e.g. high-end market) or change the
product mix.
Through production, operations exposure management can be done through changing the
product mix, idling production facilities, relocating factories, or increasing productivity.
Through finance, operations exposure management can be done by natural hedging, using
back to back loans, swaps, or lead and lag.
