Anna C.

Vergara
BSBA-4FM

CAPITAL MARKET
Operating exposure is the degree of risk that a company is exposed to when there is some type
of change in varying currency values that are relevant to the operation of the company. The shifts
in exchange rates may affect the value of certain assets of the business and thus have an impact
on the overall profitability of the company. For this reason, the idea is to position the company
and its assets so that any change in the exchange rate is likely to exhibit either a favorable
change or very little change at all.

For most companies, it is the non-monetary assets that are usually affected
by operating exposure. This includes assets like equipment and facilities. Shifts in the exchange
rate can cause the value of these assets to increase or decrease over time, which may in turn
cause the operating cash flows of the business to be affected in some manner. If
theoperating exposure leads to higher expenses for the operation, this can lead to smaller profits
and a reduced flow of cash into the business, making it harder to remain competitive.

The same general principal of operating exposure is true with investing in the foreign exchange
market. Investors want to make sure that the trading they conduct on this market results in the
creation of a return. In order to accomplish this goal, investors must project any possible events
that are likely to lead to a negative state of operating exposure, causing their holdings to lose
value in relation to the value of other currencies. The investor who is able to accurately identify
indicators of this type stands a better chance of selling a currency while it is doing well, and
replace it with a currency that carries a lower amount of operating exposure.

It is important to remember that operating exposure is a projection of what is likely to come in the
future. For this reason, assessing the rate of exposure is a constant process. Should unforeseen
events take place that have the potential to trigger a drastic shift in the prospective rate
of exposure, the need to revise previous projections becomes real and immediate. Using this type
of assessment with prudence can help a business or an investor minimize losses and also aid in
creating a position for growth at some point in the future. Failure to do so can mean a loss of
value to key assets, and possibly hamper the productivity of a business for many years to come.
The extent to which a company is exposed to exchange risk and inflation risk. That is, operating
exposure is the exposure to the risk that a change in an exchange rate or the inflation rate will
negatively impact a company's revenue.
CHAPTER 9: OPERATING EXPOSURE

1.

Definitions. Define the following terms:

Economic exposure emphasizes that the exposure is created by the economic

consequences of an unexpected
exchange rate change. Economic consequences, in turn, suggests that the impact is due to
the response of external
forces in the economy, rather than, say, something directly under the control of
management. Competitive
exposure suggests that the consequences of an unexpected exchange rate change are due
to a shift in the
competitive position of a firm, vis-á-vis its competitors. Strategic exposure suggests that
matters of long-range
cost changes and price setting, needed to anticipate or adjust to an unexpected change in
exchange rates, are
matters of corporate strategy; i.e., how the company positions itself in anticipation of
risks caused by exchange
rate changes.

2.

Operating versus transaction exposure. Explain the difference between operating

exposure and transaction
exposure.

Both exposures deal with changes in expected cash flows. Transaction exposure deals
with changes in near-term
cash flows that have already been contracted for (such as foreign currency accounts
receivable, accounts payable,
and other debts). Operating exposure deals with changes in long-term cash flows that
have not been contracted
for but would be expected in the normal course of future business. One might view
operating exposure as
“anticipated future transactions exposure,” although the concept is broader because the
impact of the exposure
might be through sales volume or operating cost changes.

Given a known exchange rate change, the cash flow impact of transaction exposure can
be measured precisely
whereas the cash flow impact of operating exposure remains a conjecture about the
future.

3.

Unexpected exchange rate changes;

a.

Why do unexpected exchange rate changes contribute to operating exposure, but

expected exchange
rate changes do not? An expected change in foreign exchange rates is not included in the
definition of
operating exposure, because both management and investors should have factored this
information into their
evaluation of anticipated operating results and market value. From a management
perspective, budgeted
financial statements already reflect information about the effect of an expected change in
exchange rates. For
example, under equilibrium conditions the forward rate might be used as an unbiased
predictor of the future
spot rate. In such a case management would use the forward rate when preparing the
operating budgets, rather
than assume the spot rate would remain unchanged.

b.

Explain the time horizons used to analyze unexpected changes in exchange rates. An
unexpected change
in exchange rates impacts a firm's expected cash flows at four levels, depending on the
time horizon used.

The first-level impact is on expected cash flows in the one-year operating budget. The
gain or loss
depends on the currency of denomination of expected cash flows. The currency of
denomination cannot be
changed for existing obligations, such as those defined by transaction exposure, or even
for implied
obligations such as purchase or sales commitments. Apart from real or implied
obligations, in the short run
it is difficult to change sales prices or renegotiate factor costs. Therefore realized cash
flows will differ from
those expected in the budget. However, as time passes, prices and costs can be changed to
reflect the new
competitive realities caused by a change in exchange rates.

The second-level impact is on expected medium-run cash flows, such as those expressed
in two- to
five-year budgets, assuming parity conditions hold among foreign exchange rates,
national inflation rates,
and national interest rates. Under equilibrium conditions the firm should be able to adjust
prices and factor

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costs over time to maintain the expected level of cash flows. In this case the currency of
denomination of
expected cash flows is not as important as the countries in which cash flows originate.
National monetary,
fiscal, and balance of payments policies determine whether equilibrium conditions will
exist and whether
firms will be allowed to adjust prices and costs.

If equilibrium exists continuously, and a firm is free to adjust its prices and costs to
maintain its expected
competitive position, its operating exposure may be zero. Its expected cash flows would
be realized and
therefore its market value unchanged since the exchange rate change was anticipated.
However, it is also
possible that equilibrium conditions exist but the firm is unwilling or unable to adjust
operations to the new
competitive environment. In such a case the firm would experience operating exposure
because its realized
cash flows would differ from expected cash flows. As a result, its market value might
also be altered.

The third-level impact is on expected medium-run cash flows assuming disequilibrium

conditions. In
this case the firm may not be able to adjust prices and costs to reflect the new competitive
realities caused
by a change in exchange rates. The firm's realized cash flows will differ from its expected
cash flows. The
firm's market value may change because of the unanticipated results.

The fourth-level impact is on expected long-run cash flows, meaning those beyond five
years. At this
strategic level a firm's cash flows will be influenced by the reactions of existing and
potential competitors
to exchange rate changes under disequilibrium conditions. In fact, all firms that are
subject to international
competition, whether they are purely domestic or multinational, are exposed to foreign
exchange operating
exposure in the long run whenever foreign exchange markets are not continuously in
equilibrium.

4.

Macroeconomic uncertainty. Explain how the concept of macroeconomic uncertainty

expands the scope
of analyzing operating exposure.

Macroeconomic uncertainty is the sensitivity of the firm’s future cash flows to

macroeconomic variables in
addition to foreign exchange, such as changes in interest rates and inflation rates.
5.

Strategic response. The objective of both operating and transaction exposure management
is to anticipate
and influence the effect of unexpected changes in exchange rates on a firm’s future cash
flows. What
strategic alternative policies exist to enable management to manage these exposures?

Diversifying operations and diversifying financing.

6.

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 in the most appropriate way. How can this task best be accomplished?

The key to effective preparations for an unexpected devaluation is anticipation. Major

changes to protect a firm
after an unexpected devaluation are minimally effective.

Diversifying operations. World-wide diversification in effect pre-positions a firm to make

a quick response to any
loss from operating exposure. The firm’s own internal cost control system and the
alertness of its foreign staff
should give the firm an edge in anticipating countries where the currency is weak.
Recognizing a weak currency
is different from being able to predict the time or amount of a devaluation, but it does
allow some defensive
planning. If the firm is already diversified, it should be able to shift sourcing, production
or sales effort from one
country/currency to another in order to benefit from the change in the post-devaluation
economic situation. Such
shifts could be marginal or major.

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Diversifying financing. Unexpected devaluations change the cost of the several

components of capital – in
particular, the cost of debt in one market relative to another. If a firm has already
diversified its sources of
financing, that is, established itself as a known and reputable factor in several capital
markets, it can quickly move
to take advantage of any temporary deviations from the international Fisher effect by
changing the country or
currency where borrowings are made.

7.

Diversifying operations.

a) How can a MNE diversity operations? 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 occur.
For example,
management might notice a change in comparative costs in the firm’s own plants located
in different
countries. It might also observe changed profit margins or sales volume in one area
compared to another,
depending on price and income elasticities of demand and competitors’ reactions.

Recognizing a temporary change in worldwide competitive conditions permits

management to make
changes in operating strategies. Management might make marginal shifts in sourcing raw
materials,
components, or finished products. If spare capacity exists, production runs can be
lengthened in one country
and reduced in another. The marketing effort can be strengthened in export markets
where the firm’s products
have become more price competitive because of the disequilibrium condition.

b) How can a MNE diversify financing? If a firm diversifies its financing sources, it will
be pre-positioned
to take advantage of temporary deviations from the international Fisher effect. If interest
rate differentials
do not equal expected changes in exchange rates, opportunities to lower a firm’s cost of
capital will exist.
However, to be able to switch financing sources, a firm must already be well known in
the international
investment community, with banking contacts firmly established. Once again, this is not
an option for a
domestic firm that has limited its financing to one capital market.
Diversifying sources of financing, regardless of the currency of denomination, can lower
a firm’s cost
of capital and increase its availability of capital. It could also diversify such risks as
restrictive capital market
policies, and other constraints if the firm is located in a segmented capital market. This is
especially important
for firms resident in emerging markets.

8.

Proactive management of operating exposure. Operating and transaction exposures can

be partially
managed by adopting operating or financing policies that offset anticipate foreign
exchange exposures.
What are four of the most commonly employed proactive policies?

The four most common proactive policies and a brief explanation are:

1) Matching currency cash flows. The essence of this approach is to create operating or
financial foreign
currency cash outflows to match equivalent foreign currency inflows. Often debt is
incurred in the same
foreign currency in which operating cash flows are received.

2) Risk-sharing agreements. Contracts, including sales and purchasing contracts, between

parties operating in
different currency areas can be written such that any gain or loss caused by a change in
the exchange rate will
be shared by the two parties.

3) Back-to-back loans. Two firms in different countries lend their home currency to each
other and agree to
repay each other the same amount at a latter date. This can be viewed as a loan between
two companies
(independent entities or subsidiaries in the same corporate family) with each participant
both making a loan

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and receiving 100% collateral in the other’s currency. A back-to-back loan appears as
both a debt (liability
side of the balance sheet) and an amount to be received (asset side of the balance sheet)
on the financial
statements of each firm.

4) Currency swap. In terms of financial flows, the currency swap is almost identical to
the back-to-back loan.
However in a currency swap, each participant gives some of its currency to the other
participant and receives
in return an equivalent amount of the other participant’s currency. No debt or receivable
shows on the
financial statements as this is in essence a foreign exchange transaction. The swap allows
the participants to
use foreign currency operating inflows to unwind the swap at a later date.

9.

Matching currency exposure.

a) Explain how matching currency cash flows can offset operating exposure. One way to
offset an
anticipated continuous long exposure to a particular currency is to acquire debt
denominated in that currency.

b) Give an example of matching currency cash flows. Exhibit 9.4 depicts the exposure of
a U.S. firm with
continuing export sales to Canada. In order to compete effectively in Canadian markets,
the firm invoices
all export sales in Canadian dollars. This policy results in a continuing receipt of
Canadian dollars month
after month. If the export sales are part of a continuing supplier relationship, the long
Canadian dollar
position is relatively predictable and constant.

Exhibit 9.4 Matching: Debt Financing as a Financial Hedge

Canadian
Corporation

(buyer of goods)

Canadian
Bank

(loans funds)

Exports
goods to
Canada
US Corp borrows
Canadian dollar debt
from Canadian Bank

U.S.
Corporation

Payment for goods

in Canadian dollars

Exposure: The sale of goods to Canada creates a foreign

currency exposure from the inflow of Canadian dollars

Hedge:

Principal and interest

payments on debt
in Canadian dollars

The Canadian dollar debt payments act as a financial

hedge by requiring debt service, an outflow of Canadian dollars

10.

Risk sharing. An alternative arrangement for managing operating exposure between firms
with a
continuing buyer-supplier relationship is risk sharing. Explain how risk sharing works.

Risk-sharing is a contractual arrangement in which the buyer and seller agree to “share”
or split currency
movement impacts on payments between them. If the two firms are interested in a long-
term relationship based

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on product quality and supplier reliability and not on the whims of the currency markets,
a cooperative agreement
to share the burden of currency risk management may be in order.

If Ford’s North American operations import automotive parts from Mazda (Japan) every
month, year after
year, major swings in exchange rates can benefit one party at the expense of the other.
(Ford is a major
stockholder of Mazda, but it does not exert control over its operations. Therefore, the
risk-sharing agreement is
particularly appropriate; transactions between the two are both intercompany and
intracompany. A risk-sharing
agreement solidifies the partnership.) One potential solution would be for Ford and
Mazda to agree that all
purchases by Ford will be made in Japanese yen at the current exchange rate, as long as
the spot rate on the date
of invoice is between, say, ¥115/$ and ¥125/$. If the exchange rate is between these
values on the payment dates,
Ford agrees to accept whatever transaction exposure exists (because it is paying in a
foreign currency). If,
however, the exchange rate falls outside this range on the payment date, Ford and Mazda
will share the difference
equally.

11.

Back-to-back loans. Explain how back-to-back loans can hedge foreign exchange
operating exposure.

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 other’s currency for a specific period of time. At an
agreed terminal date they
return the borrowed currencies. The operation is conducted outside the foreign exchange
markets, although spot
quotations may be used as the reference point for determining the amount of funds to be
swapped. Such a swap
creates a covered hedge against exchange loss, since each company, on its own books,
borrows the same currency
it repays. Back-to-back loans are also used at a time of actual or anticipated legal
limitations on the transfer of
investment funds to or from either country.

12.

Currency swaps. Explain how currency swaps can hedge foreign exchange operating
exposure. What are
the accounting advantages of currency swaps?

A currency swap resembles a back-to-back loan except that it does not appear on a firm’s
balance sheet. The term
swap is widely used to describe a foreign exchange agreement between two parties to
exchange a given amount
of one currency for another and, after a period of time, to give back the original amounts
swapped. Care should
be taken to clarify which of the many different swaps is being referred to in a specific
case.

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 period of time. Currency swaps can be negotiated for a
wide range of
maturities up to at least ten years. If funds are more expensive in one country than
another, a fee may be required
to compensate for the interest differential. The swap dealer or swap bank acts as a
middleman in setting up the
swap agreement.

A typical currency swap first requires two firms to borrow funds in the markets and
currencies in which they
are best known. For example, a Japanese firm would typically borrow yen on a regular
basis in its home market.
If, however, the Japanese firm were exporting to the United States and earning U.S.
dollars, it might wish to
construct a matching cash flow hedge which would allow it to use the U.S. dollars earned
to make regular debt-
service payments on U.S. dollar debt. If, however, the Japanese firm is not well known in
the U.S. financial
markets, it may have no ready access to U.S. dollar debt.

One way in which it could, in effect, borrow dollars, is to participate in a cross-currency

swap. The Japanese
firm could swap its yen-denominated debt service payments with another firm which has
U.S. dollar-debt service
payments. This swap would have the Japanese firm “paying dollars” and “receiving yen.”
The Japanese firm
would then have dollar-debt service without actually borrowing U.S. dollars.
Simultaneously, a U.S. corporation
could actually be entering into a cross-currency swap in the opposite direction—“paying
yen” and “receiving
dollars.” The swap dealer is taking the role of a middle man.

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Accountants in the United States treat the currency swap as a foreign exchange
transaction rather than as debt
and treat the obligation to reverse the swap at some later date as a forward exchange
contract. Forward exchange
contracts can be matched against assets, but they are entered in a firm’s footnotes rather
than as balance sheet
items. The result is that both translation and operating exposures are avoided, and neither
a long-term receivable
nor a long-term debt is created on the balance sheet. The risk of changes in currency rates
to the implied collateral
in a long-term currency swap can be treated with a clause similar to the maintenance-of-
principal clause in a back-
to-back loan. If exchange rates change by more than some specified amount, say 10%, an
additional amount of
the weaker currency might have to be advanced.

13.

Contractual hedging. Eastman Kodak is a MNE that has undertaken contractual hedging
of its operating
exposure.

a) How do they accomplish this task? Eastman Kodak is another MNE that has in the past
undertaken
contractual hedging of its operating exposure. Kodak management believes its markets
are largely price-
driven and is aware that its major competitor, Fuji, has a Japanese cost base. If the U.S.
dollar were to
strengthen in the medium to long term, Kodak’s market share in the United States and in
foreign markets
would decline. Kodak leadership also believes that whatever sales Kodak loses, its
competitors will gain.
Kodak has therefore also purchased long-term put options on foreign currencies, which
would replace long-
term earnings if the value of the U.S. dollar rose unexpectedly.

b) What assumptions do they make in order to justify contractual hedging of their

operating exposure?
The magnitude of the option position depends on the nature of desired replacement. For
example, if Kodak
wished to insure only the lost net earnings from exchange rate–induced losses, the option
position would be
considerably smaller than a position attempting to replace gross sales revenues. Given the
premium expenses
associated with long-term put option positions of this type, replacing earnings is preferred
to replacing sales.
c)

How effective is such contractual hedging in your opinion? Explain your reasoning. A
significant
question remains as to the true effectiveness of hedging operating exposure with
contractual hedges. The fact
remains that even after feared exchange rate movements and put option position payoffs
have occurred, the
firm is competitively disadvantaged. The capital outlay required for the purchase of such
sizeable put option
positions is capital not used for the potential diversification of operations, which in the
long run might have
more effectively maintained the firm’s global market share and international
competitiveness.

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MINI-CASE: TOYOTA’S EUROPEAN OPERATING EXPOSURE

1.

Why do you think Toyota had waited so long to move much of its manufacturing for
European sales to
Europe?

Automobile manufacturing is a very complex and capital intensive industry. Toyota, like
most manufacturers,
wished to continue to enjoy the benefits of scale and scope economies in manufacturing
as long as possible, and
had resisted the movement of more and more of its manufacturing into the local and
regional markets. Time,
however, was now running out.

2.

If the British pound were to join the European Monetary Union would the problem be
resolved? How likely
do you think this is?

The British joining the EMU would eliminate the currency risk between the UK and
Europe, but not between
Japan and Europe. The UK joining the EMU would eliminate the deviations in currency
value between the British
pound and the euro only.

Although there has been continuing and heated debate over the possibility of Britain
joining the EMU, there
is at present no specific plan to do so. In many ways the UK believes itself to be
somewhat the beneficiary of
being the single large “European” country which is not euro-based.

3.

If you were Mr. Shuhei, how would you categorize your problems and solutions? What
was a short-term
and what was a long-term problem?

The problems, at least on the basis of the data presented, appear to be primarily exchange
rate-induced pricing
problems. The fall in the value of the euro against the yen throughout 1999 and early
2000 was significant (for
example calculate the percentage change in the value of the euro between January 1999
and July 2000). For some
unknown reason most of Toyota’s North American operations had moved to
manufacturing bases in North
America, while Toyota had continued to try and service European sales via exports from
Japan. The recent
decision to manufacture a new European-targeted product, the Yaris, from production in
Japan was in the
continuing strategy. It did not appear to be a good strategy given the recent direction of
exchange rate movements.

The primary short-term solution was to continue to absorb yen-based cost increases in
lower margins on
European sales – assuming that the market would not bear passing-through the exchange
rate changes. In the
medium-to-long-term, Toyota must inevitably move more of the automobile’s content
into manufacturing
operations within the EMU (and not the United Kingdom).

4.

What measures would you recommend Toyota Europe take to resolve the continuing
operating losses?

If Toyota was willing to continue incurring the operating losses in Europe, and put
market share goals above profit
goals, then continuing the current operating and pricing policy would be in order. The
euro had regained some
of its weakness against the yen in the recent year.

The fact that significant Toyota operations existed in the United Kingdom would be a
continuing dilemma
as long as the UK stayed out of the EMU. The strength of the pound against the euro –
and the new-found stability
in that rate seen in 2000 and 2001 – did not bode well for UK-based operations for
European sales. In the longer-
term, Toyota, like many other multinationals, would have to consider moving more of its
manufacturing and cost
structure to within the EMU, not in Japan and not in the UK.

CHAPTER 9
OPERATING EXPOSURE
STUDY OUTLINE
Operating exposure is related to transaction exposure in that both exposures
concem the
potential changes in the value of a finn's foreign-currency
denominated future cash flows.
The difference between the two is that while transaction exposure covers the cash
flows
that are obligations under contracts, operating exposure relates to the expected
future
cash flows.
l. Attributes of Operating Exposure
Since the expected cash flows that constitute operating exposure are not
contractual and often span over long time periods, the measurement and
management of operating exposure is significantly more complicated than that of
transaction exposure. The present value of expected foreign currency
denominated cash flows can change in various ways. Most importantly,
unexpected changes in values of foreign currencies will affect not only the home
currency value of those cash flows but also the demand for exported goods in
foreign countries.
— Example: If the €i'$ exchange rate is 1.0 and a Washington state apple costs $1
in the U.S. and GI in France, a euro depreciation to El .20/$ will increase the
apple cost to €l .20 if the U.S. exporter does not adjust the dollar prices.
Frenchmen may find the Washington apple too expensive after the 20% price
hike, which will affect the demand of U.S. apples in France. Alternatively, if
the euro price is kept unchanged at €l , the balance between the French supply
and demand is not affected, but the exporter now only receives 1/ 1 .20 = $0.83
for the apple. In practice, we ofien end up somewhere between these two
extremes (In terms of Chapter 4, we have less than complete exchange rate
pass-through). Exhibit 9.3 in the text illustrates a more elaborate example of
the different ways that operating exposure can affect a company with expected
foreign currency cash flows.
Note that under the assumption that expected changes in exchange rates are
already discounted in current cash flow valuation, operating exposure concerns
oniy unexpected changes in exchange rates.
ll. Strategic Management of Operating Exposure
Recall that while most of the international parity conditions have a poor track
record in short term, they are valuable tools in forecasting longer-term currency
trends. Management of a MNE with diversified operations can react to imbalances
in parity conditions by shifting the company's operations to take advantage of
product market disequilibrium conditions. A MNE with diverse operations is
better equipped to take advantage of such strategic opportunities than domestic
III.
corporations in part because they have a direct data source in different countries
where they can follow their own sales on day-to-day basis. Recall that once the
disequilibrium is public knowledge, we should expect it to be already discounted
in prices and exchange rates. Therefore, companies relying on public data are ill
equipped to take advantage of such imbalances. For a domestic company,
switching raw material sources or manufacturing locations across borders also
requires investments into new territories with expected "learning curve effects".
Conceivably, deviations from the international Fisher effect open up opportunities
for a MNE to benefit by also shifting its financing activities across currencies.
However, while product markets may be slow to adjust to disequilibritun
conditions, the financial markets should be more efficient and therefor; more
completely reflect all available information at any time.
Proactive Management of Operating Exposure
The hedging instruments discussed in Chapter 8 for transaction exposure
management work poorly in operating exposure management since they are
geared towards hedging short-term exposures of less than one year. A company
hedging its year-to-year cash flows with short-term hedging tools will be able to
lock in the exchange rate in short temi, but it will suffer from long-term exchange
rate trends. In operating exposure management, the foreign currency cash flows
are uncertain and typically stretch over years. However, this does not mean that
operating exposure is unmanageable:
A. Matching currency cash flows can be used to offset long-term operating
exposures. For example, a U.S. company receiving yen cash inflows from its
Japanese operations could finance its operations in yen. If the yen inflows can
be perfectly matched with yen outflows both iii time and volume, the firm
value will be unaffected by yen fluctuation.
B. Contractual risk-sharing comes in play with long-term supplier relationships.
For example, as part of a ten-year supply contract with an across-border
supplier, a contract that sets boundaries for the exchange rate to be used
between the two parties will reduce the exchange rate risk for both parties.
C. Back~ro-Back Loans can be used. by a MNE wanting to finance its foreign
operations in local currencies. If the parent company can find another firm
with similar but opposite situation where they want to borrow in the home
currency of the parent company, a deal can be struck where both companies to
take out a loan in their home currencies and then swap their loans. Back—to-
back loans were a predecessor of modern currency swaps, and were originally
invented to circumvent British taxes on foreign exchange transactions.
D. With Currency Swaps, companies can nowadays easily switch the
denomination of their outstanding loans. A firm that is well received by the
U.S. credit markets may want to have a yen-denominated loan in order to
manage its operating exposure. The firm can use its comparative advantage to
borrow dollars and set up a swap with another company that is capable of
borrowing in yen at a lower cost. Typically, currency swapsiare arranged by
60
swap dealers on "blind basis", where the two end borrowers do not know the
identity of their counterparty. ' -
Contractual approaches, such as long-term currency options, are a recent
addition to operating exposure management. Use of the contractual approach
is, in many companies, hampered by uncertainty over the volume of future
cash flows. Also, such long-term options may be prohibitively expensive
(recall that options are more expensive the longer their time to expiration is).
Furthermore, it can be questioned whether contractual operating exposure
hedges affect uncertainty about changes in competitiveness caused by
exchange rate movements. A company may be able to hedge the expected
cash flows, but the potential lack of long-term competitiveness is harder to
hedge against.