Module - 28 Operating Exposure Management: At Strategic Level

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1 NPTEL Module - 28 Operating Exposure Management: At Strategic Level Developed by: Dr. Prabina Rajib Associate Professor Vinod Gupta School of Management IIT Kharagpur, prabina@vgsom.iitkgp.ernet.in Joint Initiative IITs and IISc Funded by MHRD - 1 -

2 Session 28 Operating Exposure Management: At Strategic Level Highlights & Motivation: Change in the foreigner exchange risk affects firms in many other major ways. Change in foreign exchange not only affects individual transactions, it affects the firm value as a whole. Change in the exchange rate can affect the competitiveness of the firm and may have a bearing on the survival of the firm. The impact of change in foreign exchange rate on firm value is known as the operating exposure. Measuring operating exposure is quite difficult as anticipating how a company s sales, input prices will be affected due to change in the forex rate. More so quantifying how competitive scenario for the company will change due to exchange rate thus affecting future cash flow can be akin a gazing crystal ball!! Hence companies spend considerable time and effort to measure and manage the operating exposure. This session deals with how companies manage their operating exposure by undertaking certain strategic level activities. Learning Objectives: In this session, the following aspects have been dealt in greater detail: Management of operating exposure: Strategic Level Diversifying Operational cash flows Diversifying financing cash flows Yankee bonds, External Commercial Borrowings ( ECBs) and Foreign Currency Convertible bonds (FCCBs) issued by Indian companies. Operating exposure management and shortcomings of forwards, futures and options contracts in managing operating exposure. Joint Initiative IITs and IISc Funded by MHRD - 2 -

3 28.1: Introduction. Session 26 and Session 27 deal with the measurement of operating exposure and management of operating exposure at operational level. In this session, how management of operational exposure at a strategic level is discussed in detail. As this session has the reference to the example of Indian Exporter operating risk aspects given in Chapter 26, even at the cost of repetition, this example, is given again. An Indian company has agreed to supply 2000 units (within in coming 12 months) of bed linen to Wal-Mart. Wal-Mart has agreed to pay USD20 per piece. On the date of the contract, the spot rate is INR 45 per USD. It translates to INR 900 per piece. Direct cost per unit of linen is INR 700. The fixed cost is INR 300,000 per year. For every 1 unit of bed linen the Indian exporter sells, the contribution margin is Rs Hence it takes 1500 units to cover the fixed cost. With a sales figure of 200, 000 units, the Indian company is making a profit of INR 100,000 (INR 200 per unit * 500 units). Indian company is happy to receive a gross profit of INR 200 per unit. Indian exporter buys all raw materials from other Indian companies. However, if INR starts appreciating progressively, then Indian exporter is generating lesser revenue in INR. It may so happen that after some level of INR-USD rate, Indian exporter is losing money. For example, if INR-USD rate changes to INR 36 per USD, the Indian exporter is able to cover its variable cost of INR 700, but only contributing INR 20 for every linen piece it is exporting. If exchange rate appreciates to INR 34/USD, the Indian exporter receives INR 680 which is less than its variable cost. If the exporter expects this exchange rate is going to prevail, then exporting to Walmart is not a viable option. Management of foreign exchange exposure can also be done at a strategic level by Diversifying Operation Diversifying Financing Joint Initiative IITs and IISc Funded by MHRD - 3 -

4 28.2: Diversifying Operation: To thwart forex currency risk, a company can diversify its operation by diversifying sales and marketing activities, starting new production facilities and shifting the sourcing of raw material. Diversification of Sales and Marketing Activities: To minimize the impact of currency risk, companies sell in multiple market. In fact companies continuously keep searching for new markets to diversify their sales. It not only gives them economies of scale, but also reduces the impact of exchange rate on their profit. Companies may step up their brand building activities so that they are able to charge a higher price so that the higher price is able to take care of exchange rate fluctuations. New Product Strategy: Companies start introducing new products, move up in the value chain by offering high value products. High value products, differentiated products enable companies to earn higher margin and higher margin products can withstand exchange rate fluctuation better than a low margin products. Of course a company needs to undertake these strategies, even for the domestic market so as to be the market leader. For example, if Indian exporter feels that INR is going to appreciate progressively, then it should start focusing more on selling in Japanese market, or start developing its presence in domestic market or start marketing in another geographical region may be at Europe or East Asia. Similarly, if the cost of imported raw material is increasing due to progressive depreciation of home currency, then companies start scouting for new source of raw material supply. If a company is producing in more than one country and then it can shift the production from one country to another depending on where it is able produce at cheaper rate. It is clearly evident that diversifying operation by entering into new market, introducing new product, shifting the supplier base etc., can not be done at a department level. These changes can be brought in by decisions at a strategic level. On top of this, these decisions have a long term bearing on the profitability of the company as these decisions can not be undone quickly. In fact almost all cross-border M&A activities are done so that a company is able to expand its business to new market, offer new product, and acquire new resources which help a company to mitigate adverse foreign exchange risk. Joint Initiative IITs and IISc Funded by MHRD - 4 -

5 It makes sense for companies to diversify financing even without a foreign exchange risk. If a firm has diversified its financing, with the change in exchange rate, the company would be able to shift its financing from one country to another easily. It is well known fact that foreign companies pay higher cost when they enter into the foreign market to raise funds due to information asymmetry. Diversifying financing base helps a company to reduce the time-to-market as well as reduce cost of funding. To diversify their financing needs many Indian companies have issued Yankee bonds or rasied money through External Commercial Borrowings (ECBs) and Foreign Currency Convertible Bonds (FCCBs). Yankee bonds: These are foreign bonds denominated in US$ and issued in the United States by foreign corporations. A foreign bond is a bond issued in a country by foreign issuer and denominated in the currency of the country of issue. Yankee bonds are principally marketed in the USA to insurance companies, pension funds, mutual funds, financial institutions, and international funds. A company issuing a Yankee bond has to get the bond registered in SEC(Stock Exchange Commission) of US and has to list in any American stock exchanges. Reliance Industries Ltd. (RIL) is the first company to issue a Yankee bond in RIL s second Yankee Bond issue in 1997 made news by being the first company from India with successful flotation of $100 million 100-year Yankee bond followed by a second issue of $214 mn for a period of 30 year. Table 28.1 lists some of the major Yankee bond issues by Indian companies and the issue details. Table 28.1: Yankee Bonds Issued Indian Companies Name Issue Maturity Year Amount Coupon Rate Year Reliance Industries $150 mn 8.15% US$ Reliance Industries $214mn NA ICICI Ltd $150mn 7.55% US$ PFC Ltd $100mn 7.5% US$ Telco 1997 N.A $200 mn Libor +200 BP Reliance Industries $100mn NA Tata Electric Co $150mn 7.875% Tata Electric Co $150 mn 8.5% 1 Reliance Industries also raised the first-ever Pound sterling bond in UK market in It raised 100- million, 10-year maturity having coupon rate linked to 10-year UK gilts. 2 ICICI Ltd. also floated two bonds in Switzerland similar to the Yankee bond.. These bonds are known as Alpine Bonds Joint Initiative IITs and IISc Funded by MHRD - 5 -

6 Eurobonds: Eurobonds differ from foreign bonds in one important dimension. For Eurobonds, there is a mismatch between the country (and region) of issue and the currency denomination of the bond. Thus, when a Indian company issues a USD denominated bond in Europe and Japan or any other region not having US$ as its home currency, then the issue is termed as Eurobond. Eurobonds can have fixed/floating coupon rate with/without convertible option of converting it into specific number of shares at a predetermined price. Both the kinds are listed and traded on various foreign stock exchanges. In India, companies have issued Eurobonds in the international market even before the liberalization. But all these bonds were issued by public sector organizations and are of fixed coupon, fixed maturity and without having the convertibility option. Table 28.2 lists the Eurobonds issued by Indian companies during 1986 to 1990 in different currencies. Table 28.2 :Eurobonds Issued during Name Date of Issue Amount Date of Maturity Coupon rate in respective currencies. IDBI June-89 $100mn June-96 10% ONGC Dec-88 $125mn Nov % SBI June-88 Yen 15 bn June % IDBI March-87 DM 200mn Dec % IDBI Sep-88 DM 250mn Sep % IDBI Feb -86 DM 100mn Feb-93 7% ONGC 2/1987 DM 150mn Feb % These bonds were issued by quasi-government organizations with sovereign guarantee. After 1992, many private Indian companies have tapped the Eurobond market. Baring few fixed coupon fixed maturity issues majority of companies issued foreign currency convertible Eurobonds (FCCBs). These FCCBs are either to be converted to domestic shares or to GDRs/ADRs 3.The following table, Table 28.3 lists the details of FCCBs issued by Indian Companies since GDRs/ADRs are equity issues by Indian companies listed and traded in foreign stock exchanges. More details on both GDRs/ADRs are given in later sessions.. Joint Initiative IITs and IISc Funded by MHRD - 6 -

7 Table 28.3: EURO-CONVERTIBLE BONDS issued as FCCBs Since 1992 Company Name Issue month Amt ($m) Coupon Rate (US$) Shares per ECB Essar Gujrat Jul Jul-98 Reliance Industries Oct Oct-99 Jindal Strips Oct Feb-99 SCICI Oct Apr-04 Sterlite inds.(india) Dec Jun-99 Bharat Forge Jan NA NA TISCO Feb Feb-00 ICICI Feb Feb-00 Ispat Industries Feb Mar-01 Ballarpur Ind. May Aug-99 SPIC Jul Jul-99 Mah& Mah Aug Aug-01 Reliance Petro. Aug Converted to Aug-01 GDRs GlobaTele-systems Oct Aug-03 IPCL Mar N.A At a price of Rs. 466 per share. Mar 02 GACL Jan mn 1 4 At a price 28% above GACL s share price at BSE. Suzlon Energy April To be converted at a price of INR54.01 Conversion Date Jan-06 April : Operating exposure management and forwards, futures and options contracts. 4 Though the stated coupon rate is 1%, but as these bonds were issued at a discount to the face value with Y-T-M around 4.9% Joint Initiative IITs and IISc Funded by MHRD - 7 -

8 Though transaction exposures can be managed by forwards/futures/options contracts, these contracts loose relevance for managing operating exposure. Derivative contracts like forwards/futures/options can manage only known and certain exposure. However operating exposures are basically uncertain in nature. No way can a company find out how much of business it will loose if currency appreciates/deprecates and affects its competitive position. Operating exposures are also long term in nature. Hedging uncertainty of such cash flows requires availability of long term derivatives contracts. Long tenure contracts are not available and if available, these are very illiquid. Hence operating exposures are managed by diversifying operation and diversifying financing activities. Multiple choice questions: 1. Which of the following is an example of diversifying financing activities? a) diversifying sales b) diversifying location of operations c) raising funds in more than one country d) sourcing raw materials in more than one country 2. If a company wants to hedge the foreign currency sales proceed ( it is going to receive the sale proceed year after year) by a) lending money denominated in foreign currency sale b) increasing sales to that country c) increasing sales in this country d) borrowing money in the foreign currency sale 3. An Indian company has entered into a long term supply contract to a firm in USA. To manage the foreign currency receivables risk, the Indian firm is sourcing its raw material supplier from USA. This strategy is known as a) currency-switching b) matching c) diversification d) Natural Hedge Joint Initiative IITs and IISc Funded by MHRD - 8 -

9 4. A Chinese firm with a U.S. subsidiary and a U.S. firm with a Chinese subsidiary agree to a parallel loan agreement. In such an agreement, the Chinese firm is making a/an loan to the subsidiary while effectively financing the subsidiary. a) indirect; U.S.; Chinese b) indirect; Chinese; U.S. c) direct; U.S.; Chinese d) direct; Chinese; U.S. 5. Re-invoicing centers are set up in tax haven countries for. a) charge higher prices b) meet different accounting standards c) bypass government restrictions and/or avoid taxes d) A and B e) A, B, and C Short Questions: 1. What roles reinvoicing centers play in management of operating exposure? 2. What are Yankee Bonds? 3. Why foreign currency derivative contracts are of less use to manage operating risk? 4. Auto Spare parts Ltd. of India exports AC units to be fitted in cars manufactured in USA. The current FX rate is INR 46.40/$. Auto Spare parts Ltd. of India exports 3000 units a year at price of $ 650 each. Auto Spare parts Ltd. economist submitted a report to the CEO expressing that spot INR is going to appreciate by 10 % by the next year and would remain unchanged for coming 3 years. It per annum fixed cost is INR 19mn and incurred in INR terms. Auto Spare parts Ltd. does not generate sales from any other source. Accepting this forecast as given, Auto Spare parts Ltd. faces a pricing decision to be made for the coming year: It may either (1) maintain the same USD price and in effect sell for fewer INR, without changing the volume sales. or (2) Increase the USD price so that its INR receipt remain unchanged as of current level and experience 15% drop in volume. (a) What would be the short-run (one-year) implication of pricing strategy (1)? (b) What would be the short-run (one-year) implication of pricing strategy (2)? (c) Which strategy do you recommend? Joint Initiative IITs and IISc Funded by MHRD - 9 -

10 Answers to Multiple Choice Questions: 1. c 2. d 3. d 4. c 5. c References: 1. Operating Exposure, Multinational Business Finance, Eiteman, Moffett, Stonehill and Pandey, 10 th Edition, Pearson Education, ISBN, Techniques for managing economic exposure, class note by Prof. Gordon Bodnar, 3. Rupee impact: Infosys cuts earnings guidance Nestle s global operation, Source: 5. Currency Swap deals by Maruti Udyog Limited,Source: Annual report Greece facing Goldman Sachs debt deal scrutiny 7. Japan, India agree on $6 bn currency swap deal Joint Initiative IITs and IISc Funded by MHRD