CHAPTER 6. FX OPERATING EXPOSURE

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1 CHAPTER 6. FX OPERATING EXPOSURE Regardless of the scope of a firm s international operations, volatile FX rates can impact profitability and growth. How a firm measures and manages its risk exposure to FX variability is a central issue in global financial management. Foreign exchange operating exposure, or FX operating exposure, is the variability of a firm s operating cash flow stream caused by changing FX rates. This chapter covers many of the basic sources of FX operating exposure and explains how it is measured. The chapter also presents the idea of operational hedging, which is having operating costs with an FX exposure that tends to match, or offset, the FX exposure of the revenues. The box FX Changes and Operating Profits is intended to bring out the real world importance of FX operating exposure. In April 2001, the FX price of the euro had unexpectedly been dropping for a year. In the first quarter, DuPont s revenues from Europe were down 10% due to a 9.5% drop in the euro. FX Changes and Operating Profits: April 2001 A weak euro cost Eastman Kodak Co. millions of dollars in the first quarter. It's not taking the same risk again. The world's largest photography company, which generates about a quarter of its revenue in Europe, this month joined a list of major U.S. firms hedging to protect themselves against the plunging currency. ``It's becoming the in thing these days,'' said Bob Brust, chief financial officer of Rochester, New York-based Kodak. ``I would have never guessed the euro would be down where it is.'' Merck & Co., Johnson & Johnson, and Minnesota Mining and Manufacturing Co. are among other companies that have hedged euro exposure, according to their most recent filings. Kodak is also not alone in reporting revenue declines caused by the sagging euro, which touched a record low today and has lost 22 percent of its value against the dollar since its debut last year. Procter & Gamble Co. said the weak euro contributed to a 2 percent sales decline in the January-March quarter, and DuPont Co. said the currency was the primary reason for a 10 percent drop in revenue from Europe in dollar terms. Gerber Scientific Inc., a South Windsor, Connecticut maker of automated manufacturing systems, will cut jobs and warned profit will drop in the quarter ending April 30, partly because of the euro. In Kodak's case, a euro worth about 95.5 cents, its level on March 31, would cut earnings 22 cents a share for the full year, the company said. The euro's 9.5 percent slide this year came after firms such as Goldman, Sachs & Co. and Deutsche Bank AG predicted in December the currency would rise to about $1.10 or $1.12 in the first quarter. Instead, the euro sank to its weakest levels yet, touching as low as U.S. cents and FNCE 5205, Global Financial Management Lecture 3 Page 1

2 yen this week. It started out last year at $1.17 per euro and 133 yen, amid optimism that even had some analysts suggesting it would supplant the dollar as the currency of choice on world financial markets. The euro has been pummeled as growth in the 11-nation single currency region failed to pick up as quickly as some investors and analysts had expected. We take a long-term view,'' said Alan Resnick, treasurer at Bausch & Lomb Inc., the Rochester, New York maker of eye care products. ``At some point the euro is going to turn around.'' While the euro's decline can reduce the company's revenue in dollar terms, that is offset to some degree by lower manufacturing costs in Europe created by the drop, Resnick said. Bloomberg, April 28, FX OPERATING EXPOSURE To study FX operating exposure, we look at a US exporter s FX operating exposure to the euro. Suppose our example company, United Pipe Fittings (UPF), produces aluminum pipe fittings in the United States. Sales are in the Eurozone, predominantly to German construction companies. 1 This year, UPF expects to sell 400 fittings at a local currency price of 1 per fitting, generating revenues in euros (R ) of 400. Excluding aluminum, the variable production cost is $0.40 per fitting, for a total variable production expense of $160 for the expected output of 400 fittings. Aluminum is priced globally in US dollars, and the price is currently $0.25 per pound of aluminum. Each fitting requires one pound of aluminum, so the cost of the aluminum is $0.25 per fitting for a total expected aluminum expense of $100 for 400 fittings. Assume fixed operating costs of $40. Assume the spot FX rate is currently 1.25 $/. In our examples, we ll base the expected revenues and expected operating cash flows on this assumed spot FX rate. To assess FX operating exposure, we ll perform a what if analysis. That is, we ll ask what happens to the operating cash flow if the spot FX rate unexpectedly turns out to be some rate other than 1.25 $/. At the current spot FX rate of 1.25 $/, UPF s expected revenues of 400 convert to $500, implying an operating cash flow in US dollars (O $ ) of $ = $200. UPF s projected operating cash flow statement, given the current spot FX rate of 1.25 $/, is shown in Exhibit 6.1a. 1 This hypothetical scenario is adapted from Stephen Godfrey and Ramon Espinosa, Value at Risk and Corporate Valuation, Journal of Applied Corporate Finance, Winter 1998, FNCE 5205, Global Financial Management Lecture 3 Page 2

3 EXHIBIT 6.1a UPF Expected Operating Cash Flow ($) X $/ = 1.25 $/ Revenues (R $ ) $500 ( 1.25 $/ ) Variable Production Expense 160 Aluminum Expense 100 Fixed Operating Costs 40 Operating Cash Flow (O $ ) $200 What happens to UPF s operating cash flow if the spot FX rate unexpectedly changes from 1.25 $/ to 1 $/? While unexpected FX changes may result in a firm changing its product price and/or output level, as we discuss shortly, for now we assume UPF makes no price or output adjustments. That is, UPF still expects to sell 400 fittings at 1 per fitting. Thus, UPF s local currency revenues (in euros) do not change when the spot FX rate unexpectedly changes. At a new spot FX rate of 1 $/, the local currency revenues of 400 would convert back to only $400. Variable production expenses, aluminum cost, and fixed operating costs would not change. UPF s projected cash flow statement, given the new spot FX rate of 1 $/, is shown in Exhibit 6.1b. EXHIBIT 6.1b UPF Operating Cash Flow ($) X $/ = 1 $/ Revenues (R $ ) $400 ( 1 $/ ) Variable Production Expense 160 Aluminum Expense 100 Fixed Operating Costs 40 Operating Cash Flow (O $ ) $100 FNCE 5205, Global Financial Management Lecture 3 Page 3

4 As we see in Exhibit 6.1b, if the spot FX price of the euro is 1 $/, UPF s operating cash flow is only $100. If the euro depreciates from 1.25 $/ to 1 $/, UPF s operating cash flow in US dollars declines because 1) the revenues in euros are not worth as much in US dollars at the lower FX price of the euro, and 2) the operating costs are not affected. It will be useful to measure FX operating exposure as an elasticity: the percentage change in the operating cash flow, given the percentage change in the FX price of the foreign currency. We use the symbol ξ to denote FX exposure in general and the symbol ξ O $ to denote FX operating exposure to the euro from the US dollar perspective. The O subscript indicates that the exposure is operating exposure; other letters will be used to denote other types of FX exposure. The subscript indicates that it is changes in the FX price of the euro that causes the FX exposure. As usual, the superscript denotes the currency in which the financial results are expressed, which for UPF is the US dollar. Thus, ξ O $ symbolizes the percentage change in the firm s US dollar operating cash flow level, %ΔO$, given the percentage change in the spot FX price of the euro, x $/, where %ΔO $ = (O 1 $ O 0 $ )/O 0 $ and x $/ = %ΔX $/ = (X 1 $/ X 0 $/ )/X 0 $/. The elasticity definition of FX operating exposure, from the point of view of US dollars, is shown in equation (6.1): ξ O $ = %ΔO $ /x $/ (6.1) In the UPF example, the spot FX change represents a 20% depreciation of the euro, from 1.25 $/ to 1 $/. The operating cash flow (in US dollars) drops by 50% (from $200 to $100) when the euro drops by 20%, so UPF s FX operating exposure to the euro, ξ O $, is ( 0.50)/( 0.20) = UPF s FX operating exposure to the euro is 2.50 and indicates that operating cash flow will fall by 2.50% for a 1% drop in the spot FX price of the euro. Confirm UPF s FX operating exposure of 2.50 by showing that a 20% appreciation of the euro (to 1.50 $/ ) would result in a 50% increase in operating cash flow. Answer: At 1.50 $/, UPF s expected operating cash flow in US dollars will be $ = $300. The percentage change in operating cash flow is $300/$200 1 = 0.50, or 50%, in response to a 20% rise in the FX price of the euro. This represents FX operating exposure of FNCE 5205, Global Financial Management Lecture 3 Page 4

5 OPERATIONAL HEDGING If a firm stabilizes some or all of its operating costs in the currency to which the revenues are exposed, the firm is said to be using operational hedging. The purpose of operational hedging is to reduce the FX operating exposure. Let s look at an example where UPF relocates some latter stages of fittings production from the United States to the Eurozone. To help clarify the example, assume the company takes on the new corporate name of EPF. Assume the restructuring means that the variable production costs (excluding aluminum) are borne in the Eurozone and are 0.32 per fitting, or a total expected variable production expense of 128 for 400 fittings. Since aluminum is priced globally in US dollars, the cost of the aluminum is stable in US dollars at $0.25 per pound of aluminum and thus $0.25 per fitting. Also assume EPF s fixed operating costs are still incurred in the United States and are still $40. Continue to assume that EPF s sales volume and selling price are not affected by FX changes. EPF s expected operating cash flow statement, given a current spot FX rate of 1.25 $/, is shown in Exhibit 6.2a. EXHIBIT 6.2a EPF Expected Operating Cash Flow ($) X $/ = 1.25 $/ Revenues (R $ ) $500 ( 1.25 $/ ) Variable Production Expense 160 ( 1.25 $/ ) Aluminum 100 Fixed Operating Costs 40 Operating Cash Flow (O $ ) $200 As we see in Exhibit 6.2a, at a spot FX rate of 1.25 $/, EPF s expected revenues of 400 convert to $500, variable production expenses of 128 convert to $160, and the expected operating cash flow in US dollars is $ = $200. What happens to EPF s operating cash flow if the spot FX rate unexpectedly changes from 1.25 $/ to 1 $/? Since we assume sales volume is not affected by the FX change, EPF s revenues and variable production expenses are stable in euros and so fall in US dollars. The aluminum cost and fixed operating costs are stable in US dollars. EPF s operating cash flow statement, given a spot FX rate of 1 $/, is shown in Exhibit 6.2b. FNCE 5205, Global Financial Management Lecture 3 Page 5

6 EXHIBIT 6.2b EPF Operating Cash Flow ($) X $/ = 1 $/ Revenues (R $ ) $400 ( 1 $/ ) Variable Production Expense 128 ( 1 $/ ) Aluminum 100 Fixed Operating Costs 40 Operating Cash Flow (O $ ) $132 (down from $200) As we see in Exhibit 6.2b, when the spot FX price of the euro is 1 $/, EPF s operating cash flow is only $132. If the euro depreciates from 1.25 $/ to 1 $/, EPF s operating cash flow in US dollars declines, but not by as much as for UPF. The reason is that some of EPF s operating costs match currency with the revenues, i.e. are stable in the currency to which the revenues are exposed, whereas all of UPF s operating costs are stable in US dollars. EPF s operating cash flow (in US dollars) drops by 34% (from $200 to $132) if the euro depreciates by 20%, so the FX operating exposure to the euro, ξ O $, is 0.34/ 0.20 = EPF s FX operating exposure to the euro, 1.70, indicates that the operating cash flow in US dollars will fall by 1.70% for a 1% drop in the spot FX price of the euro. Figure 6.1 shows FX operating exposures to the euro for UPF and EPF. The slope is steeper, 2.50, for UPF, which does no operational hedging. For EPF, whose variable production costs are stable in euros, the FX operating exposure is FNCE 5205, Global Financial Management Lecture 3 Page 6

7 Figure 6.1 FX operating exposures to the euro for UPF and EPF. The slope is steeper, 2.50, for UPF (no operational hedging). For EPF, whose variable production costs are in the Eurozone, the FX operating exposure is OPERATIONAL HEDGING AT UNITED TECHNOLOGIES CORPORATION To further see the effects of operational hedging, consider a scenario based on the Carrier Company (air conditioners), a division of United Technologies Corporation (UTC). Let us focus on Carrier s European subsidiary. The price of the airconditioners in Europe is stable in euros. Carrier can choose where to source compressors, which account for about 30% of the cost of producing an air conditioner. One alternative is to produce the compressors in the United States; the other choice is Ireland, which is in the Eurozone, so the cost of making a compressor would be stable in euros. Assume that all other inputs, especially labor, in the production of air conditioners by Carrier-Europe are acquired in Europe and have unit costs that are stable in euros. If Carrier gets compressors from the United States, the cost of producing an air conditioner for the European market is 70% stable in euros and 30% stable in US dollars. From the US dollar point of view, UTC s FX operating exposure would be higher. If Carrier-Europe gets compressors from Ireland, then the entire cost of producing an air conditioner for the European market is stable in FNCE 5205, Global Financial Management Lecture 3 Page 7

8 euros. From the US dollar point of view, UTC would be making maximal use operational hedging. Clearly, UTC s FX operating exposure from Carrier-Europe depends on where the compressors are sourced. If they are sourced in Europe, UTC s FX operating exposure to the euro (from the US dollar point of view) is lower, as more operational hedging is used. Of course, there are other considerations in the decision on where to source the compressors, such as price and quality. Our focus here is only on FX exposure considerations. Assume that in addition to variable production costs of 0.32 per fitting, EPF s fixed operating costs are in the Eurozone and are 32. All other assumptions are the same as in the text. Find EPF s FX operating exposure to the euro. Answer: At 1.25 $/, the fixed operating costs of 32 convert to $40. Thus EPF s expected operating cash flow in US dollars will still be $ = $200. At 1 $/, EPF s operating cash flow in US dollars will be $ = $140. The percentage change in the operating cash flow (in US dollars) is $140/$200 1 = 0.30, or 30%, in response to a 20% drop in the FX price of the euro. This represents FX operating exposure to the euro of 1.50, which is lower than in the text example, because here EPF has more of its operating costs doing operational hedging. FX REVENUE EXPOSURE AND FX PASS-THROUGH FX revenue exposure is the elasticity of a firm s revenues to unexpected spot FX changes, viewed from the perspective of the firm s base currency. If R $ represents the level of a firm s revenues measured in US dollars, the firm s FX revenue exposure to the euro would be denoted ξ R $ and would be computed as %ΔR $ /x $/. Symbolically, ξ R $ = %ΔR $ /x $/. FX REVENUE EXPOSURE: In the examples so far, where FX changes do not affect sales price or output, foreign currency revenues are subject to pure FX conversion exposure. Pure FX conversion exposure is a special case where there are no economic effects on the foreign currency revenues. The only impact of the unexpected FX rate change is the impact of conversion of foreign currency revenue into the firm s base currency. In this case, the percentage change in revenues from the base currency point of view is equal to the percentage change in the FX price of the foreign currency. That is, the FX revenue exposure to the foreign currency is equal to 1. In this section and the next, we look beyond pure FX conversion exposure and consider some of the other factors that affect a firm s FX revenue exposure to a currency. First, a FNCE 5205, Global Financial Management Lecture 3 Page 8

9 firm might adjust a product s local currency selling price in response to FX changes, passing through some or all of FX changes to the customers. The higher the FX passthrough, the less risk faced by the exporting firm. For example, assume UPF passes through 100% of all FX changes to its customers by changing the local currency selling price without affecting sale volume. If the FX price of the euro drops from 1.25 $/ to 1 $/ [this is a 20% drop], UPF simply raises the price of pipe fittings in euros from 1 to 1.25 [this is a 25% increase], and the revenues of selling 400 pipe fittings would be 500, which would convert back to $500. In this case, UPF s FX revenue exposure to the euro would be 0, because the revenues are the same in US dollars, whether the spot FX rate is 1.25 $/ or 1 $/. Full FX pass-through is basically indexing the product s local currency price to spot FX rate changes, so that the exporter has no FX risk. Instead, the customers bear 100% of the FX risk. Note that for full (100%) pass-through, the percentage change in the local currency selling price, %ΔP, will be equal to 1/(1 + x $/ ). FULL (100%) PASS-THROUGH: %ΔP = - 1 In the example where x $/ = 0.20, the full pass-through change in the fittings price is 1/(1 0.20) 1 = 0.25, or 25%. Maybe a company cannot pass through 100% of FX rate changes without affecting volume demanded for a product. Say UPF thinks it can pass through only 20% of a given FX change without affecting sales volume. In this case, if the FX price of the euro changes 20% from 1.25 $/ to 1 $/, UPF raises the local currency price of pipe fittings from 1 to The local currency price increase of 5% is 20% of the price increase that would reflect full pass-through, 25%. With a new local currency selling price of 1.05 when the spot FX rate is 1 $/, the revenues in euros of selling 400 pipe fittings would be 420, which would convert back to $420. In this case, UPF s FX revenue exposure to the euro would be 0.80, because if 20% of a given FX change is passed through, it means that 80% is retained. You may also verify that: %ΔR $ =, and ξ R $ = = Say UPF can pass through 80% of a given FX change without affecting sales volume. What would be UPF s FX revenue exposure to the euro? If the FX price of the euro changes 20% from 1.25 $/ to 1 $/, what is the new local currency fittings price? Answers: The FX revenue exposure to the euro would be UPF would raise the local currency price of pipe fittings by 0.80(25%) = 20%, from 1 to With a new FNCE 5205, Global Financial Management Lecture 3 Page 9

10 local currency selling price of 1.20 when the spot FX rate is 1 $/, the revenues in euros of selling 400 pipe fittings would be 480, which would convert back to $480. In this case, UPF s FX revenue exposure to the euro would be 0.20, because if 80% of a given FX change is passed through, it means that 20% is retained. You may also verify that %ΔR $ = $480/$500 1 = 0.04, and ξ R $ = %ΔR $ /x $/ = 0.04/ 0.20 = Figure 6.2 shows how FX revenue exposure and FX pass-through are related, assuming the firm makes no output adjustments when the FX rate unexpectedly changes. Firm A, with the relatively low FX pass-through of 0.20, has the higher FX revenue exposure of Firm B, with a relatively high FX pass-through of 0.80, has the lower FX revenue exposure of Figure 6.2 FX revenue exposures for two firms. Firm A, with relatively low FX pass-through of 0.20 has the higher FX revenue exposure of Firm B, with the relatively high FX pass-through of 0.80 has the lower FX revenue exposure of These firms make no output adjustments when the FX rate unexpectedly changes. DOW CHEMICAL EUROPE The Dow Chemical Corporation s system assesses a rating of local currency price FNCE 5205, Global Financial Management Lecture 3 Page 10

11 stability in the face of FX changes. The lower the local currency price stability, the lower the FX revenue exposure because the higher is the FX pass-through, with no assumed impact on sales volume. Dow s Eurozone marketing managers are asked to rate the stability of the local currency prices (in euros) of each product, using a price stability rating of 0 to 100. A stability rating of 100 means a product s price in euros is 100% stable; it is expected to be unaffected by changes in the spot FX rate, and Dow cannot or does not pass through spot FX changes to the customer. Thus Dow bears 100% of the exposure to spot FX changes. Because all the FX risk is retained by the seller, not passed through to the buyer, Dow s FX revenue exposure in US dollars to the euro is 1 for products with a local-currency price stability rating of 100. A local-currency price stability rating of 0 implies that the product s price in euros has no stability when the spot FX rate changes. Spot FX changes are entirely passed through to Eurozone customers in the product s local price in euros, with no impact on sales volume. So Dow s revenues (in US dollars) are not exposed to the euro. When the spot FX price of the euro changes, the price of a product is dropped in precisely the right amount to leave Dow s revenues unaffected when viewed in US dollars. The 0 rating represents full pass-through and corresponds to an FX revenue exposure of 0. Of course, most Dow products had a stability rating between 0 and 100. A Dow stability rating of 60 means that 60% of the foreign currency price is stable and not subject to the passthrough of FX changes, while 40% of any FX change is passed through in the form of a partially offsetting change in local euro product prices. Some examples of the local currency stability ratings of Dow s products in Europe are shown below. Dow rates magnesium 0, implying that a change in the spot FX price of euro leads to immediate changes in prices quoted in euros. Caustic soda, by contrast was rated 60, implying less responsiveness of local prices to spot FX changes. And propylene glycol and agricultural products were rated 80 and 90 respectively, suggesting that FX changes have little effect on local prices. Source: John J. Pringle, Managing Foreign Exchange Exposure, Journal of Applied Corporate Finance, Winter 1991, FX pass-through is related to the concept of a product s currency of determination in a given market, which is the currency in which a product s price is (most) stable in that market. Many basic commodities have a single currency of determination throughout the world. The currency of determination of metals is generally the US dollar in all markets, which we have applied for aluminum in our examples. At one time, Swedish paper companies were so dominant that the Swedish krona was the currency of determination for paper. For consumer products, the currency of determination is often the local currency in which it is sold. For example, the currency of determination of the EPF s fittings is the local currency, the euro, if their prices are held fixed in euros. In many other cases, the currency of determination is ambiguous. If 40% of a spot FX change is passed through, we say that the fitting s price is determined by both the euro and the US dollar, but the euro is the stronger determinant. The currency (or currencies) of determination of a given product may be different in different markets. For example, if a US firm has no foreign competitor in the US, but its exports are sold into a foreign market where there is a dominant firm, the currency of FNCE 5205, Global Financial Management Lecture 3 Page 11

12 determination could be the US dollar in the US and the overseas currency in the foreign market. FX Pass-Through and FX Cost Exposure: Caterpillar and Finning A firm s FX cost exposure for an imported product is the reciprocal of the exporter s FX revenue exposure for the same product. You can see this in an illustration based on the US firm Caterpillar and the Canadian tractor distributor, Finning. Caterpillar sells tractors to Finning, and Finning then sells them in Canada. If the US dollar appreciates relative to the Canadian dollar, Caterpillar would pass through some but not all of the FX change by raising the prices of tractors sold to Finning. If Caterpillar passes through 40% of any FX change, then 40% of the FX risk is transferred to Finning, and Caterpillar s revenues from Finning would have an FX revenue exposure of 0.60 to the Canadian dollar. In terms of FX pass-through, an exporter s FX revenue exposure to the importer s currency and the importer s FX cost exposure to the exporter s currency must sum to 1. From its perspective in Canadian dollars, Finning would have an FX cost exposure of 0.40 to changes in the FX price of the US dollar relative to the Canadian dollar. From its perspective of US dollars, Caterpillar has an FX revenue exposure of = 0.60 to changes in the FX price of the Canadian dollar. FX REVENUE EXPOSURE AND PRICE ELASTICITY OF DEMAND In many cases, it will not be possible to change product price without affecting demand. Technically, the price elasticity of demand would have to be zero for a firm to be able to pass through FX changes with no impact on sales volume. In the other extreme, a firm in a perfect competition environment faces perfectly price elastic demand and cannot change the local currency price of its product. If the demand for UPF s fittings were perfectly price elastic, UPF s response to a change in the FX price of the euro would, if anything, involve a change in production output. In the initial UPF example of the chapter, UPF did not adjust output in response to an unexpected FX change. More likely, UPF would lower production when the euro drops and increase production when the euro rises. In theory, the amount of production adjustment would depend on how variable production cost per unit of output relates to the volume produced. Example, suppose that FX pass-through is 0, and UPF would slash production from 400 to 300 if the euro drops by 20% (from 1.25 $/ to 1 $/ ). UPF s revenues in US dollars would drop to 300(1 $/ ) = $300, a decrease of 40% from the expected revenues of $500. Here, the FX revenue exposure is estimated to be ξ R $ = %ΔR $ /x $/ = 40%/ 20% = 2. FNCE 5205, Global Financial Management Lecture 3 Page 12

13 In the more realistic case where the demand for UPF s pipe fittings is neither perfectly price inelastic nor perfectly price elastic, UPF is likely to adjust both local currency price and production volume. If the FX price of the euro unexpectedly drops, UPF would want to raise the fittings price, but the price increase means that fewer fittings would be in demand, so production would be reduced. If the FX price of the euro unexpectedly rises, UPF would want to produce more fittings, but would have to drop the local currency price in order to sell the higher output. A firm s optimal price and output adjustments to an unexpected FX rate change will depend on the product s price elasticity of demand and on how the variable production cost per unit relates to the production volume. The higher the price elasticity of demand, other things equal, the more that a firm will tend to adjust output and the less that the firm will tend to adjust the local currency selling price. Example, suppose UPF would find it optimal to raise the fittings price by 8% to 1.08, and cut production by 20% from 400 to 320, if the FX price of the euro unexpectedly drops from 1.25 $/ to 1 $/. These changes correspond to a price elasticity of demand (%ΔOutput/%ΔPrice) of 20%/8% = UPF s new revenues in US dollars would be 1.08(320)(1 $/ ) = $346, a decrease of 31% from the expected revenues of $500. The percentage change in revenues is the compound result of the percentage change in product price (8%), the percentage change in output ( 20%), and the FX conversion effect of the percentage change in the FX price of the euro ( 20%): ( )(1 0.20)(1 0.20) - 1 = (1.08)(0.80)(0.80) 1 = 0.31, or 31%. The FX revenue exposure is estimated to be ξ R $ = %ΔR $ /x $/ = 31%/ 20% = Note that the FX pass-through is 32%, because the price increase of 0.08 is 32% of the full FX pass-through increase of Suppose UPF would raise the fittings price by 12% to 1.12, and cut production by 15% from 400 to 340, if the euro drops by 20% (from 1.25 $/ to 1 $/ ). Find A) the price elasticity of demand; B) the FX pass-through; and C) the FX revenue exposure. Answers: A) These changes correspond to a price elasticity of demand (%ΔOutput/%ΔPrice) of 15%/12% = 1.25; B) FX pass-through = 0.12/ 0.25 = 0.48, or 48%. C) UPF s new revenues in US dollars would be 1.12(340)(1 $/ ) = $381, a decrease of 24% from the expected revenues of $500. The percentage change in revenues is the compound result of the percentage change in product price (12%), the percentage change FNCE 5205, Global Financial Management Lecture 3 Page 13

14 in output ( 15%), and the FX conversion effect of the percentage change in the FX price of the euro ( 20%): (1.12)(0.85)(0.80) 1 = 0.238, or 23.8%. Here, the FX revenue exposure is estimated to be ξ R $ = %ΔR $ /x $/ = 23.8%/ 20% = Figure 6.3 shows how FX revenue exposure, FX pass-through, and price elasticity of demand are related, using the three UPF examples in this section, where the firm adjusts output when the FX rate unexpectedly changes. FIGURE 6.3 SUMMARY of UPF FX REVENUE EXPOSURE SCENARIOS UPF Adjusts Output when FX Rate Unexpectedly Changes Price Elasticity of Demand FX Pass-Through FX Revenue Exposure % % 1.55 Infinity 0 2 FX OPERATING EXPOSURE AND FX REVENUE EXPOSURE In the chapter s initial example where UPF makes no price or output adjustments in response to unexpected FX rate changes, the FX revenue exposure to the euro is 1 and the FX operating exposure is In the examples of operational hedging, EPF s FX revenue exposure to the euro is also 1. We showed that EPF s FX operating exposure to the euro is 1.70 when the fixed operating costs are incurred in the United States and are stable in US dollars. An example showed that EPF s FX operating exposure to the euro would be 1.50 if the fixed operating costs are incurred in the Eurozone and are stable in euros. Is there a formula that connects FX operating exposure and FX revenue exposure? The answer is yes, and the formula is given in equation (6.2). ξ O $ = ξ R $ (R $ /O $ ) i ξ Ci $ (C i $ /O $ ) (6.2) In equation (6.2), C i $ represents the ith category of the firm s expected exposed operating costs, expressed in US dollars. UPF has three operating cost categories: variable production expense, aluminum expense, and fixed operating costs. ξ Ci $ is the FX cost exposure to the euro of ith category of the exposed operating costs: ξ Ci $ = %ΔC i $ /x $/. The symbol i indicates a summation over all of the operating cost FNCE 5205, Global Financial Management Lecture 3 Page 14

15 categories. i Consider the initial scenario where UPF adjusts neither fittings price nor output when the FX rate unexpectedly changes, and thus the FX revenue exposure is 1. See Figures 6.1a and 6.1b. For UPF, none of the operating costs change when the FX rate unexpectedly changes, so the FX cost exposure of all three categories is 0. Equation (6.2) says that the firm s FX operating exposure should be 1($500/$200) 0($160/$200) 0($100/$200) 0($40/$200) = 2.50, consistent with what we found earlier. Next consider the EPF firm in Figures 6.2a and 6.2b. Like the initial scenario for UPF, EPF adjusts neither fittings price nor output when the FX rate unexpectedly changes, and thus the FX revenue exposure to the euro is 1. In US dollars, the variable production expense has a pure FX conversion exposure to the euro. Thus the variable production expense category has an FX cost exposure of 1. EPF s two other operating cost categories (aluminum cost and fixed operating costs) do not change when the FX rate unexpectedly changes, so the FX cost exposure of each of those two categories is 0. Thus equation (6.2) says that the FX operating exposure to the euro should be 1($500/$200) 1($160/$200) 0($100/$200) 0($40/$200) = 1.70, consistent with what we found earlier. Consider the EPF scenario where the fixed operating costs are incurred in the Eurozone and are stable in euros. Use equation (6.2) to find the FX operating exposure. Answer: The fixed operating costs have an FX cost exposure to the euro of 1, so equation (6.2) says that the FX operating exposure to the euro should be 1($500/$200) 1($160/$200) 0($100/$200) 1($40/$200) = 1.50, consistent with what we found earlier. Let s look at equation (6.2) in the UPF FX pass-through scenarios, where UPF makes no output adjustments when the FX rate unexpectedly changes. In these cases, the FX cost exposure to the euro of all operating cost categories is 0. We already found that if UPF is able to do full FX pass-through with no change in demand, the FX revenue exposure to the euro is 0. The revenues in US dollars are $500 after an unexpected FX rate change. So the firm s operating cash flow does not change when the FX rate unexpectedly changes, and the firm s FX operating exposure to the euro is also 0, which would be the answer if we apply equation (6.2): ξ O $ = 0($500/$200) 0($160/$200) 0($100/$200) 0($40/$200) = 0. If UPF s FX pass-through is 0.20 with no change in demand, we already found that the FX revenue exposure to the euro is The revenues in US dollars are $420 after an unexpected drop of 20% in the spot FX price of the euro. So the firm s new operating cash flow is $ = $120, a drop of 40%. The FX operating exposure to the euro is 0.40/ 0.20 = 2, which would be the answer if we apply equation (6.2): ξ O $ = 0.80($500/$200) 0($160/$200) 0($100/$200) 0($40/$200) = 2. If UPF s FX pass-through is 0.80 with no change in demand, we already found that the FX revenue exposure to the euro is What is the FX operating exposure? FNCE 5205, Global Financial Management Lecture 3 Page 15

16 Answer: The revenues in US dollars are $480 after an unexpected drop of 20% in the spot FX price of the euro. So the firm s new operating cash flow is $ = $180, a drop of 10% from the expected operating cash flow of $200. The FX operating exposure to $ the euro is 0.10/ 0.20 = 0.50, which would be the answer if we apply equation (6.2): ξ O = 0.20($500/$200) 0($160/$200) 0($100/$200) 0($40/$200) = Now let s look at equation (6.2) in the three UPF scenarios we covered in the previous section, where output adjustments are made when the FX rate unexpectedly changes. Figure 6.4 summarizes the FX operating exposures of the scenarios. FIGURE 6.4 SUMMARY of UPF FX OPERATING EXPOSURE SCENARIOS UPF Adjusts Output when FX Rate Unexpectedly Changes Price Elasticity of Demand FX Revenue Exposure FX Operating Exposure Infinity When a firm adjusts output in response to unexpected FX rate changes, the operating costs that depend on production volume also change. These operating cost changes are a source of FX cost exposure, because the costs change in response to unexpected FX rate changes. When the FX price of the euro unexpectedly drops, UPF reduces output. This response is like a built-in operational hedging effect, even when none of the operating costs are stable in euros. Consider the perfect competition scenario where the price elasticity of demand is infinite, and recall that UPF s FX revenue exposure to the euro is 2. In that scenario, the firm slashes production from 400 fittings to 300 fittings if the FX price of the euro unexpectedly drops by 20% (from 1.25 $/ to 1 $/ ). The firm s revenues in US dollars would drop to 300(1 $/ ) = $300. The new operating costs would be $0.40(300) (300) + 40 = $235. The new operating cash flow is $ = $65. So the operating cash flow changes by $65/$200 1 = 0.675, or 67.5%. Since the euro s drop is 20%, the FX operating exposure to the euro is 67.5%/ 20% = FNCE 5205, Global Financial Management Lecture 3 Page 16

17 To apply equation (6.2) in this scenario, we need to know the FX cost exposure to the euro of each of the operating cost categories. The first two operating cost categories (variable production expense and aluminum costs) have an FX cost exposure to the euro because the firm adjusts production volume when the FX rate unexpectedly changes. The operating costs in the first two categories fall by 25% when the firm s output drops by 25%. Since these changes are a response to an unexpected 20% drop in the euro, both operating cost categories have an FX cost exposure to the euro of 25%/20% = The other cost category, fixed operating costs, has an FX cost exposure to the euro of 0, because the firm s fixed operating costs do not change when the FX rate unexpectedly changes. Thus, equation (6.2) says that the FX operating exposure to the euro should be 2($500/$200) 1.25($160/$200) 1.25($100/$200) 0($40/$200) = 3.375, consistent with what we found above. Let s next find the FX operating exposure to the euro in the scenario where the price elasticity of demand is 2.50 and the FX revenue exposure to the euro is In that scenario, the firm raises the price to 1.08 and cuts production from 400 to 320 if the euro drops by 20% (from 1.25 $/ to 1 $/ ). The new revenues in US dollars would be 1.08(320)(1 $/ ) = $346. The new operating costs would be $0.40(320) (320) + 40 = $248. The new operating cash flow would be $ = $98. So the operating cash flow changes by $98/$200 1 = 0.51, or 51%. Given that the euro s drop is 20%, the FX operating exposure to the euro is 51%/ 20% = To apply equation (6.2), note that the variable production expense and aluminum expense categories have an FX cost exposure to the euro of 1, because the output drops by 20% (from 400 fittings to 320 fittings) when the euro drops by 20%. The fixed operating cost category has no FX cost exposure to the euro. Equation (6.2) says that the FX operating exposure to the euro should be 1.55($500/$200) 1($160/$200) 1($100/$200) 0($40/$200) = 2.58, consistent with the answer above (except for rounding). Consider the UPF scenario where the price elasticity of demand is 1.25 and the FX revenue exposure is In that scenario, the firm raises the fitting price to 1.12 and cuts production from 400 fittings to 340 fittings if the euro drops by 20% (from 1.25 $/ to 1 $/ ). Find the FX operating exposure and double check the answer using equation (6.2). Answers: The new revenues in US dollars would be 1.12(340)(1 $/ ) = $381. The new operating costs would be $0.40(340) (340) + 40 = $261. The new operating cash flow would be $ = $120. So the operating cash flow changes by $120/$200 1 = 0.40, or 40%. Given that the euro s drop is 20%, the FX operating exposure is 40%/ 20% = 2. Each of the first two operating cost categories (variable production expense and FNCE 5205, Global Financial Management Lecture 3 Page 17

18 aluminum costs) has an FX cost exposure of 0.75, because the output drops by 15% when the euro drops by 20%. The other cost category, fixed operating costs, has an FX cost exposure of 0. Equation (6.2) says that the FX operating exposure should be 1.19($500/$200) 0.75($160/$200) 0.75($100/$200) 0($40/$200) = 2. Let s look at the operational hedger EPF and assume that EPF would make the same volume adjustments as UPF when the FX price of the euro changes unexpectedly. Consider the perfect competition scenario where the price elasticity of demand is infinite. EPF cannot change the fittings price but slashes production from 400 fittings to 300 fittings if the FX price of the euro unexpectedly drops by 20% (from 1.25 $/ to 1 $/ ). The firm s revenues in US dollars would drop to 300(1 $/ ) = $300, a decline of 40%. As with UPF in the corresponding scenario, the FX revenue exposure is 2. The new operating costs (in US dollars) would be 0.32(300)(1 $/ ) + $0.25(300) + $40 = $211. The new operating cash flow is $ = $89. So the operating cash flow changes by $89/$200 1 = 0.55, or 55%. Since the euro s drop is 20%, the FX operating exposure to the euro is 55%/ 20% = 2.775, which is lower than in the corresponding scenario for UPF, which does not do operational hedging, The percentage change in EPF s variable production expense is $96/$160 1 = 0.40, or 40%, if the euro drops by 20%. We can find this as a compound result of the percentage change in output ( 25%) and the FX conversion effect of the percentage change in the FX price of the euro ( 20%): (1 0.25)(1 0.20) - 1= (0.75)(0.80) 1 = So the variable production expense have an FX cost exposure to the euro of 0.40/ 0.20 = 2. Recall that the aluminum cost category has an FX cost exposure of 1.25 because output drops by 25% when the euro drops by 20%. Equation (6.2) says that the FX operating exposure to the euro should be 2($500/$200) 2($160/$200) 1.25($100/$200) 0($40/$200) = 2.775, consistent with what we found above (except for rounding). Consider the UPF scenario where the price elasticity of demand is 1.25 and the FX revenue exposure is In that scenario, the firm raises the fitting price to 1.12 and cuts production from 400 fittings to 340 fittings if the euro drops by 20% (from 1.25 $/ to 1 $/ ). Instead of UPF, say the firm is the operational hedger, EPF. Find the FX operating exposure and double check the answer using equation (6.2). Answer: The new revenues in US dollars would be 1.12(340)(1 $/ ) = $381. The new operating costs would be 0.32(340)(1 $/ ) (340) + 40 = $234. The new operating cash flow would be $ = $147. So the operating cash flow changes by $147/$200 1 = 0.265, or 26.5%. Given that the euro s drop is 20%, the FX operating exposure is 26.5%/ 20% = The percentage change in EPF s variable production costs is $109/$160 1 = 0.32, or 32%, if the euro drops by 20%. We can find this as a FNCE 5205, Global Financial Management Lecture 3 Page 18

19 compound result of the percentage change in output ( 15%) and the FX conversion effect of the percentage change in the FX price of the euro ( 20%): (1 0.15)(1 0.20)- 1 = (0.85)(0.80) 1 = So the variable production expense category has an FX cost exposure to the euro of 0.32/ 0.20 = Recall that the aluminum cost category has an FX cost exposure of 0.75 because output drops by 15% when the euro drops by 20%. Equation (6.2) says that the FX operating exposure to the euro should be 1.19($500/$200) 1.60($160/$200) 0.75($100/$200) 0($40/$200) = 1.32, consistent with what we found above (except for rounding). OPERATING LEVERAGE AND FX OPERATING EXPOSURE Operating leverage refers to the breakdown between fixed operating costs and variable operating costs. A firm with a higher degree of operating leverage has more fixed operating costs relative to expected operating cash flow. It is well known that, other things equal, a firm with a higher degree of operating leverage has more volatility in operating cash flow. Does the degree of operating leverage affect the FX operating exposure? The answer depends on whether a firm adjusts its output in response to FX changes. If FX changes do not affect output, as in our initial UPF and EPF examples, there is no distinction between fixed and variable operating costs from the perspective of FX changes, since variable operating costs are only variable the sense that they vary with output. Thus if unexpected FX changes do not affect output, a firm s degree of operating leverage does not affect its FX operating exposure. As an example, go back to the initial UPF scenario and assume that variable production costs are $0.45 per fitting instead of $0.40 per fitting, and fixed operating costs are $20 instead of $40. So we are saying that UPF has a different production technology with a lower degree of operating leverage. All other assumptions of the scenario are the same. The expected variable production expense for 400 fittings is now $180. At 1.25 $/, UPF s expected operating cash flow in US dollars will be $ = $200. At 1 $/, UPF s operating cash flow in US dollars will be $ = $100. The percentage change in operating cash flow is still $100/$200 1 = 0.50, or 50%, in response to a 20% drop in the FX price of the euro. This represents FX operating exposure of 2.50, the same as UPF s FX operating exposure in the initial UPF scenario where the degree of operating leverage is higher. But the same change in production technology would reduce the FX operating exposure if the firm adjusts output when the FX rate unexpectedly changes. Consider the scenario where the price elasticity of demand is infinite. In the scenario, the firm slashes production from 400 fittings to 300 fittings if the euro unexpectedly drops by 20% (from 1.25 $/ to 1 $/ ). The firm s new revenues in US dollars would be 300(1 $/ ) = $300. With the new degree of operating leverage, the new operating costs would be $0.45(300) (300) + FNCE 5205, Global Financial Management Lecture 3 Page 19

20 20 = $230. The new operating cash flow would be $ = $70. So the operating cash flow changes by $70/$200 1 = 0.65, or 65%. Since operating cash flow drops by 65% when the euro s unexpected drop is 20%, the FX operating exposure to the euro with the lower degree of operating leverage would be 65%/ 20% = 3.25, which is lower than the FX operating exposure of with the higher degree of operating leverage. Of course, it is very possible that the firm with the new production technology would find it optimal to make different output adjustments when FX rates unexpectedly change than the firm with the initial production technology. But we ignore this possibility to focus on the impact of the degree of operating leverage on the FX operating exposure. We have seen that, other things equal, the higher the price elasticity of demand, the more a firm will be inclined to make output adjustments in response to unexpected FX rate changes. Thus operating leverage will have a larger impact on FX operating exposure when price of elasticity of demand is higher. Put another way, the point here is that two firms with the same degree of operating leverage do not necessarily have the same FX operating exposure, even if both firms have the same FX revenue exposure and even if all the operating costs of both firms are incurred in the same country. The reason is that the firms might respond to unexpected FX changes with different output adjustments. REGRESSION ESTIMATION OF FX EXPOSURE Probably not on Exams. This chapter shows that many factors affect a firm s FX operating exposure to a foreign currency. It should be obvious that analyzing a firm s FX operating exposure would be far more difficult in the real world than in the simple scenarios of the chapter. Because of the complexities, FX exposures are often estimated with actual data. Regression analysis is one way a firm might estimate its overall FX operating exposure. Although a firm s FX exposures are likely to fluctuate over time, regression analysis may still be useful in estimating FX exposures. Regression analysis assumes that FX exposure is linear and symmetric. Table 6.1 shows some empirically estimated FX operating exposures to the yen, the pound, and the euro. The data used is from the 1990s. For example, Merck s estimated FX operating exposure to the yen of means that a 1% increase in the FX price of the yen on average coincided with a 2.711% increase in operating profits. TABLE 6.1 REGRESSION ESTIMATES: FX OPERATING EXPOSURES GILLETTE MERCK GE ξ O $ Std Err ξ O $ Std Err ξ O $ Std Err Yen FNCE 5205, Global Financial Management Lecture 3 Page 20

21 Pound Euro FNCE 5205, Global Financial Management Lecture 3 Page 21

22 REGRESSION ESTIMATION OF FX EXPOSURE BY VULCAN MATERIALS Depending on the FX revenue exposure and FX cost exposure, a foreign subsidiary does not necessarily pose a positive FX operating exposure to its parent. An example of a real company is the US firm Vulcan Materials. Vulcan used regression to estimate the FX operating exposure of its UK subsidiary to the British pound, from the parent s US dollar point of view. To the surprise of the managers, the estimated FX operating exposure was practically 0. In analyzing the regression result, Vulcan managers realized that the UK subsidiary s sales pose no FX revenue exposure to the pound from the US dollar perspective. Vulcan UK sells metals like aluminum whose prices in British pounds are indexed to the $/ FX rate so that the price is essentially stable when viewed from the perspective of US dollars. That is, Vulcan UK keeps the prices of its products stable in US dollars; it fully alters the prices in pounds to offset changes in the $/ FX rate, with no impact on sales volume. Thus from the US dollar point of view, the sales of Vulcan UK have no FX revenue exposure to the pound, even though the subsidiary s revenues in pounds are volatile. Moreover, the market price for the raw materials (scrap metal) is also relatively stable in US dollars. Since the scrap metal accounts for about 80% of operating costs, Vulcan UK s operating costs in pounds also largely adjust with changes in the $/ spot FX rate. Since both the revenues and costs of Vulcan UK are relatively stable when viewed in US dollars, the approximate FX operating exposure to the pound is 0, even though the subsidiary sources sales and production totally in the United Kingdom.* The standard error is an estimate of the standard deviation of the FX operating exposure estimate. The relatively low standard error of suggests that we can have some confidence in Merck s yen exposure estimate of The FX operating exposures in the Table 6.1 show high estimated FX exposures for GE; estimates are relatively unreliable, however, judging from the high standard errors. For example, GE s estimated FX operating exposure to the yen is with a standard error of Because of the relatively high standard error, GE s estimated FX operating exposure to the yen is not significant in a statistical sense. (More sophisticated statistical methods are possible than the simple ordinary least squares regression used here, which was just to convey the basic idea.) Table 6.2 shows some estimated FX revenue exposures for Gillette, Merck, and GE to the yen, the pound, and the euro. GE s estimated FX revenue exposure to the yen, for example, is with a standard error of The relatively low standard error suggests that the estimate of is significant in a statistical sense. The FX revenue exposure estimates are mixed for Gillette, but are relatively unreliable, judging from the FNCE 5205, Global Financial Management Lecture 3 Page 22

23 standard errors. TABLE 6.2 REGRESSION ESTIMATES: FX REVENUE EXPOSURES GILLETTE MERCK GE ξr$ Std. Error ξr$ Std. Error ξr$ Std. Error Yen Pound Euro FX OPERATING EXPOSURE AND CURRENCY PERSPECTIVE EXAM!!! Now let s go back and consider the EPF firm again. What if EPF is actually a Eurozone company whose base currency is euros? When we think about this idea, we think that EPF is still the same company as before in terms of operations, but the headquarters is in the Eurozone instead of the United States. The production process still begins in the United States where $40 in fixed operating cost is incurred. The rest of the production is still in the Eurozone with variable production costs of 0.32 per fitting. And the aluminum still costs $0.25 per fitting. Being headquartered in the Eurozone, EPF s managers would care about financial results in euros and FX exposure to the US dollar. Let s examine how EPF s financial results in euros change for the same unexpected spot FX rate change as earlier, but we ll look at it as a change in the spot FX price of the US dollar (in euros). The spot FX price of the euro changes from 1.25 $/ to 1 $/, so the spot FX price of the US dollar changes from 0.80 /$ to 1 /$, a spot appreciation of 25% in the US dollar. At the initial spot FX rate 0.80 /$ (1.25 $/ ), EPF expects to sell 400 fittings for 1, so the expected revenue is 400. The expected variable production costs are 0.32(400) = 128. The aluminum cost in euros is (0.80 /$)($0.25)(400) = 80. The fixed operating cost of $40 converts to (0.80 /$)($40) = 32. EPF s expected operating cash flow in euros is equal to = 160. When the FX rate is 1 /$, (1 $/ ), EPF s operating cash flow is 132, as shown in Exhibit 6.3. Thus the operating cash flow in euros changes by 132/160 1 = 0.175, or 17.5%. Since operating cash flow (in euros) drops by 17.5% when the spot US dollar rises by 25%, EPF has a short FX operating exposure to the US dollar, of ξ O$ = EXHIBIT EPF Operating Cash Flow ( ), X $/ = 1 $/ Revenues (R ) 400 Variable Production Expense 128 Aluminum 100 Fixed Operating Costs 40 Operating Cash Flow (O ) 132 FNCE 5205, Global Financial Management Lecture 3 Page 23

24 We have looked at the same company (EPF) from two currency perspectives, the US dollar and the euro. From the US dollar perspective, EPF is an exporter with a natural long (positive) FX operating exposure to the euro of From the euro perspective, EPF is an importer with a natural short (negative) FX operating exposure to the US dollar of The fact that these two exposure measures sum to 1 is not a coincidence. Equation (6.3) states the relationship: ξ O $ + ξ O$ = 1 (6.3) Figure 6.5 FX operating exposure to the US dollar for EPF. X-axis, potential percentage changes in the spot FX price of the US dollar, both positive and negative. Y-axis, percentage changes in EPF s operating cash flow in euros. The slope of the line, 0.70, is the firm s FX operating exposure to the US dollar. Suppose a Eurozone multinational acquires UPF, with operating cash flows represented in Exhibits 6.1a and 6.1b. From the acquirer s euro perspective, what would be the FX operating exposure to the US dollar? We can use equation (6.3) to tell us the answer is 1.50, since we found above that the firm s FX operating exposure to the euro is 2.50 from the US dollar perspective. UPF s fittings are entirely made in the United States with operating costs entirely stable in US dollars, while some of EPF s variable operating costs are stable in euros. So from the euro perspective, UPF is more of an importer than EPF, with a correspondingly more FNCE 5205, Global Financial Management Lecture 3 Page 24