Dr. P.V. Viswanath



Economics/Finance on the Web
Student Interest


Operating Exposure


Analysis of Operating Exposure based on Maurice Levi's approach

Operating Exposure requires an extremely broad perspective.  It is difficult to avoid with the exposure-reducing techniques we have met so far: forwards, futures and so on are geared to current, known payments or receipts rather than to future operating consequences of exchange rates. 

We examine what influences the extent of operating exposure.

The Exporter


  • an export-oriented company

  • facing perfectly elastic demand (it can sell as much as it wishes without affecting the market price)

Suppose before a devaluation of the US dollar, Aviva Corporation was able to sell in Britain all the jeans that it wished to produce at a pound price of p1. 

 After devaluation, Aviva will still be able to sell all the jeans it wishes at this same pound price.  This is because in a competitive market with producers operating in many countries, other firms in other countries will still be willing to supply jeans at a pound price of p1; the depreciation in the dollar/pound price should not affect them in any fashion.  (The situation would be different if US firms constituted a significantly large part of the supply of jeans.)

If the pound price is unchanged by depreciation, this means that Aviva can charge a higher US$ price; there will be more dollars to the pound after the dollar depreciation.

In fact, if the market is competitive, the new price $p2 will be related to the old dollar price $p2 by the following equation:


where S’ is the new exchange rate and S is the old, where all exchange rates are specified in direct (American) terms, i.e. number of dollars per pound.

 At the new dollar price, the pound price will remain unchanged.

We assume that none of the inputs used by Aviva are internationally tradable so that their prices are unaffected by the exchange rate.  As a result, the marginal cost curve MC does not shift. 
It is the international tradability of the inputs, not whether Aviva imports the inputs or not, that matters.

 Since we assume that demand is perfectly elastic, the demand curve (which is also the average revenue curve) is flat.  Hence Aviva’s marginal revenue curve is also flat.  (http://ingrimayne.saintjoe.edu/econ/TheFirm/DemandCurve.html) Aviva’s supply curve, which is its marginal cost curve is upward sloping, since the marginal cost of producing each additional unit is greater than that of producing the previous unit.  Hence, the amount supplied by Aviva is at the intersection of the marginal cost curve (MC) and the marginal revenue curve (which is MR1), i.e. at point A.  This is true, since Aviva will continue to produce as long as Marginal Revenue is greater than Marginal Cost, which happens at the point where the marginal cost curve cuts the marginal revenue curve from below.  In other words, the price will be p1, and the amount supplied by Aviva will be X1.

 Now, what happens after the depreciation?  Although the pound price has not changed, the dollar price has increased, and since Aviva can sell all that it wants at this new higher dollar price, it is as if the demand curve has shifted to D2 (= MR2).  Hence Aviva will be able to sell X2 units at this new dollar price of $p2. 

 What is the impact of the depreciation on Aviva’s profit?

 Profit is revenue less cost.  The old revenue is given by the rectangle O$p1AX1.  The new revenue is the rectangle O$p2BX2.  Hence the increase in revenue is the difference in the two rectangles.  The total cost is given by the area under the marginal cost curve; hence the increase in cost is the area ABX2X1. 

 Clearly, therefore, the total profit (measured in the home currency) for an exporter will increase when the home currency depreciates.  We can also see that the factors affecting the increase in profit are:

the slope of the MC curve; the more flexible the firm is in its production capabilities, the flatter will the MC curve will be, and the greater the benefit from a currency devaluation.

 Q: “Every one percent decline in the value of our currency increases profit by one percent of total revenue.”  Is this statement true?

A: It is true only if the firm is producing at capacity.  Else, if the firm can increase production, profit will increase even more; and the amount of this additional increase will depend on the slope of the marginal cost curve.

 This is valid in the short run; what happens in the long run?

 1. In the long run, the lure of additional profits in the export sector might attract more firms to enter into the jeans business and compete with Aviva until the supply of jeans increases.  This can bring the demand curve for Aviva back to the old D1.  If so, we are back to square one, and the positive impact of the devaluation will be temporary. 

 However, if the supply from the home country is small relative to the total supply of the good, then the demand curve might not drop all the way back down to D1.  If so, then there may still be some profits for firms in the home country, after the depreciation, even in the long run.  Thus, if the long-run price is at the level of pL, then long-run quantity supplied will be at the level XL, and incremental profits, relative to the old regime, will continue to be positive and equal to pLCAp1. 

2. What happens if some of the inputs are also imported?  In this case, not only will the demand curve shift, but the supply curve will shift, as well.  This is because the depreciation will cause the cost of the imports to rise.  Hence, it will cost more to produce each marginal unit of output at each output level.  This can be shown as a leftward shift of the marginal cost curve.


Suppose the original marginal cost curve is at MC1 and the original marginal revenue curve is MR1.   The firm produces at X1, where the marginal revenue and cost curves intersect at A.  Suppose this is also a point of zero abnormal profits, i.e. the average cost curve (AC1) also goes through the point A.  Suppose now the marginal cost curve moves from MC1 to MCL.  Now, if because of depreciation, the price moves to pL, Aviva will produce at the level of XL (at the intersection of the marginal revenue and marginal cost curves).  At this point, though, profits need not be zero.  If the average cost curve is now ACL, which intersects the vertical line from C at B, then total profits will be pLCXLO – FBXLO or pLCBF.

 3. What happens if because of the depreciation in the value of the local currency, there is general inflation or general wage inflation, either because of the impact of internationally tradable inputs, generally, or because of the growth in the economy, which leads to wage and other inflation?

The impact would be similar to what we have seen above, viz. a shift in the marginal cost curve to the left.  This would cause the increase in profit to be less than if there were no cost impact.  However, in general, we would expect the impact to be favorable. 

The impact of a shift in the marginal cost curve due to internationally traded inputs is probably more immediate than the impact of a shift due to general wage inflation, but the ultimate results are similar. 

Imperfect Competition

Upto this point, we have seen what happens if the firm operates in a perfectly competitive market, and has no market power.  What happens if the firm has some market power, that is, it is operating in an imperfectly competitive market?



Suppose to begin with, the demand curve is at D1.  Then, if the price is at p1, the exporter can sell X1.  After the currency depreciates, if Aviva keeps its pound price constant (which means it gets to increase its dollar price to p’), it will continue to be able to sell the same amount X1.  This new price p’ will be greater than the previous price p1 by exactly the amount of the depreciation (as seen above).  We can do the same with any other export quantity level.  This will give us a new demand curve D2, which will be above the old demand curve, and each point will be above the old curve by the same proportion. 

 Now that the demand curve for Aviva’s product is no longer flat (the demand curve is no longer perfectly elastic), the marginal curve does not coincide with the demand curve (or average revenue curve).



The marginal revenue curves, corresponding to the demand curves (or average revenue curves) are given by the curves labeled MR1 and MR2. 

 To come back to our analysis, the old D1 curve represented the demand curve before the devaluation; the new demand curve is the curve D2 that is above our old demand curve by a proportion equal to the amount of the depreciation.

 In order to figure out what the production decisions of the firm will be under the new exchange rate circumstances, we need a supply curve, that is, a marginal cost curve.  In order to make things a little simpler, let us assume that the marginal cost curve is flat, that is, the supply elasticity is one. 

With the old demand curve, the firm produced at the level X1, where the MC curve met the MR1 curve.  The price was at the level p1, where the vertical from the output level X1 intersected the demand curve. 

With the new demand curve, the firm produces at the level X2, where the new marginal revenue curve, MR2, intersects the marginal cost curve, MC.  The price at this point is p2, which is discovered as before. 

Since the marginal cost curve is flat, so is the average cost curve.  Hence the total costs are equal to the common marginal cost, OC times the quantity produced.

The total revenues are equal to p1 times X1 for the pre-devaluation case, and p2 times X2 for the post-devaluation case.

 Subtracting the cost from the revenue, we see that the additional profit due to the depreciation in the value of the dollar is the shaded area.  Although we have assumed an elastic supply curve, it should be clear that if marginal costs increased with quantity, the incremental profit would be lower, because the increased output would lead to a concomitant increase in average cost per unit.

 In general, then, the extent to which profits are affected depends on

  •  the elasticity of the demand curve and

  • the slope of the marginal cost curve

 If the marginal cost curve is perfectly vertical, i.e. supply is perfectly inelastic, then it is clear that output will remain constant, and hence so will average cost.  Average revenue will rise by the same percentage as the depreciation of the currency, and hence will contribute to increased profits.

 Hence if an exporter is interested in evaluating its operating exposure to foreign exchange risk, it should look at the demand sensitivity of the firm (slope of the MR curve), and the degree of capacity utilization and other factors that will come into play in the determination of the MC curve.

Of course, as before, we need to look at whether the MC curve is affected by the international tradability of the firm’s inputs and a general wage inflation caused by the depreciation. 

Analysis in foreign-currency units:


We will see that the increase in profits also holds up if measured in foreign currency units. 

 If prices are measured in pounds, there is no reason to expect the demand curve and the marginal revenue curve to change.  However, in pounds, the MC curve will shift downwards, since the dollar is cheaper, and costs in dollars are no more expensive than before (or if they increase, they do not increase more than the decrease in the value of the dollar).

Profits in pounds, pre-depreciation would be (£p1-MC1) times X1, or alternatively, the area under the marginal revenue curve, upto the MC1 line.

The new profit would be indicated by the area under the marginal revenue curve, upto the MC2 line.  It is clear that the incremental profit in pounds is given by the area bounded by the marginal revenue curve, the MC2 curve and the vertical line at X1, which is positive.

Examples of operating exposure (and other) hedging

from Gregory J. Millman, The Floating Battlefield: Corporate Strategies in the Currency Wars (New York, AMACOM, 1990).

 ·  Caterpillar

As a consequence of the high value of the dollar in the early 1980's, Caterpillar, historically a world leader in construction equipment, found itself at a distinct disadvantage in competition with Komatsu, a Japanese manufacturer of hydraulic excavators.  Later in the 1980's U.S. monetary policy eased after the decline in inflation and U.S. interest rates fell. The value of the dollar also fell as foreign investors were no longer so interested in trading their currencies for dollars to invest in U.S. financial markets.

In 1986 Caterpillar had a $100 million profit on foreign exchange that turned its $24 million operating loss into a $76 million profit for the year. As a result of its experiences Caterpillar established a special company group to manage currency risk.

Other companies did not fare so well.

  •  What could it have done?  What did it do?

 ·  Lufthansa

Lufthansa, the German airline, contracted with Boeing to purchase aircraft in the mid-1980's when the value of the dollar was increasing. The price was set in dollars and Lufthansa was afraid that the dollar would strengthen, increasing the Deutsche mark cost of the planes. In 1986 Lufthansa entered into forward contracts for the dollars required to pay for the planes. Although Lufthansa feared a strengthening of the dollar what actually happened is that the dollar weakened. The forward contracts cost Lufthansa $140 to $160 million more for the planes than if it had simply waited and purchased the dollars on the spot market.

  •  Is this operating exposure hedging?

 ·  FMC

FMC in 1988 had 88 facilities in 15 different countries and derived one third of its $3.3 billion sales revenue in international markets. Its Irish subsidiary produced an ingredient for aspirin tablets that it sold to European aspirin manufacturers. A strengthening dollar would make it difficult to maintain its market share. FMC used forward contracts and currency options to hedge against a strengthening dollar and used the profits to enable the Irish subsidiary to cut prices and maintain its competitive position even in face of an strengthening dollar. FMC's hedging extended out three years and this made the forward contracts a risky strategy, particularly since it anticipated sales revenue that might not materialize.

 FMC's strategy was an example of a financial hedge. There are also operating adjustments and natural hedges. For example, if the dollar weakens then Japanese car companies may supply more of their American market sales from U.S. sources, either manufacturing cars in the U.S. or buying components from dollar sources (or from sources such as Korea or Taiwan whose currencies are tied to the dollar). If the dollar strengthens compared to the yen then their U.S. sales will be more heavily supplied from Japanese sources. This strategy is basically a matter of matching the currency of costs with the currency of revenues. 

There are various considerations in quantifying the foreign exchange risks of a company. One approach is to tabulate the costs and revenues versus currencies. This assumes that prices in the countries of the origins of transactions will remain fixed in the face of foreign exchange shifts. In other words, this ignores the adjustments that might occur as a result of the new currency values.

The adjustments described above are legitimate actions on the part of multinational businesses. There are other adjustments of questionable validity. For example, a study by Richard Marston of the Wharton School of Business of the University of Pennsylvania concluded that "Japanese firms vary their export prices relative to their domestic prices in response to changes in real exchange rates." As Millman puts it, "when the yen becomes strong (expensive), Japanese manufacturers raise their domestic prices while keeping their export prices constant." This can happen only if the Japanese domestic market is shielded from effective foreign competition.

 ·  Union Special

Union Special - A small, Chicago-based manufacturer of sewing machines. Its sales were in the $100 million per year range and until the late 1980's it had no explicit foreign exchange rate risk strategy. But, as Millman points out, by doing nothing it actually did have a strategy; i.e., it bet the entire company on the changes in the floating exchange rate.

Fifty percent of Union Special's sales were outside of the U.S. but it did 80 percent of its manufacturing domestically. In the 1970's it had about 25 percent of its manufacturing capacity in Germany but it reacted to its declining profits in the early 1980's by consolidating its production in the U.S. Instead of matching currencies of costs and revenue it chose to mismatch them. It then tried to maintain market share by cutting prices in the face of the strengthening dollar. The result was major losses and in 1988 the company was taken over by Japanese buyers.

  •  Analyze this, using economic analysis.

 ·  Laker Airlines

Sir Freddy Laker - Laker pioneered low cost trans-Atlantic travel. He primarily sold American vacations to British travelers. He started out at a time when the pound was strong and the dollar weak. Business was good and he contracted to buy American aircraft at a price set in dollars. When the dollar strengthened not only was his pound revenue worth less in terms of dollars so more pounds had to be devoted to paying for the new planes but the weaker pound resulted in less travel.  Laker had fewer pounds but a bigger bill for the planes. The result was bankruptcy.

  •  Can we analyze this situation using the economic analysis apparatus developed above?

 ·  Finning Tractor & Equipment

Finning Tractor & Equipment Company of British Columbia, Canada- Finning was a dealership for Caterpillar. Even before the high value dollar period of the early 1980's Caterpillar equipment cost about 15 percent more than Komatsu equipment, but the service provided by Finning overcame the price disadvantage. The strong dollar of the early 1980's turned Komatsu's 15 percent price advantage into a 40 percent price advantage. Finning knew that once Komatsu built up its business it would establish a service network that would offset the service advantage of Caterpillar.  Finning tried very hard to keep Komatsu from establishing itself in British Columbia. It lost.  But Komatsu hoped to make up for the low price on the equipment by charging high prices for replacement parts. The cost of replacement parts in three years equals the initial price. The Komatsu equipment buyers were shocked at the price of Komatsu replacement parts. But the Komatsu equipment was so close to Caterpillar models that Finning was able to sell Caterpillar parts to Komatsu customers at a lower cost. The experience of being "held up" by Komatsu on replacement parts resulted in those customers returning to Caterpillar the next time they bought equipment.

  •  What is happening in this case?

 ·  Caterpillar

Caterpillar -- After sustaining a $953 million loss over the 1982-84 Caterpillar was acutely conscious of its exposure to foreign exchange fluctuations, particularly the yen, and foreign currency risk management a major focus of its corporate strategy. As a consequence in 1985 about 45 percent of its $198 million profit ($89 million) was from foreign exchange gains. And as mentioned before, in 1985 the $100 million foreign exchange gains more than offset its $24 million operating profit loss.

 ·  Chrysler

Chrysler - At one time Chrysler had extensive overseas operations, but its restructuring in the late 1970's involved selling off its European, Latin American and Australian subsidiaries. Chrysler then became a company with negligible foreign manufacturing and marketing. Its foreign exchange exposure was then almost entirely as a result of the value of the yen on its market share in the U.S. automobile market. Japanese car makers had a cost advantage of about $2000 per car in the early 1980's. Chrysler management decided that Chrysler simply could not compete in the low end of the market and should rely upon offshore sources for that segment of the market. Chrysler entered into a contract with Mitsubishi Motors Corporation for V6 engines. This contract became the major element of Chrysler's foreign currency exposure.

The contract, negotiated in 1983 and 1984, stipulated that for exchange rates from 240 to 220 yen to the dollar Mitsubishi would absorb the entire cost of an exchange rate change. Within the range 220 to 190 yen to the dollar, Chrysler and Mitsubishi split the cost of exchange rate shifts evenly. In the range 190 to 130 Chrysler bore 75 percent of the costs of exchange rate shifts and below 130 Chrysler had to absorb the entire cost. When the value of the yen dropped Chrysler began hedging in a big way. Chrysler tried to predict yen exchange rates out to ten years. In the auto industry it takes about five years to go from a decision to produce a product to putting it on the market. Because of the increasing prospective costs associated with the Mitsubishi contract, Chrysler management decided to produce the V6 engine within the company.

In about 1990 Chrysler was buying about $14 billion annually in North America. This did not include about $3 billion of spare parts. Chrysler had about $1.3 billion in exchange rate exposure from purchases out of North America (about two thirds from the Mitsubishi contract). Once a month, a committee prepares a report on Chrysler's exchange rate exposure. After a hedging committee decides on strategy, a trading group implements the hedging committee's plan. Historically Chrysler used forward contracts to hedge, but since 1988 currency options have become an important element for hedging. The trading is relatively conservative. Only the net exposure is hedged. The traders are kept in their jobs for eighteen months whereas elsewhere in the company people are moved on to new positions after twelve months.

Chrysler generally has been satisfied with their foreign exchange operations and is considering systematically hedging other risks such as interest rate fluctuations. 

  • Is this operating exposure?

 ·  Union Carbide

Union Carbide, one of the world's major chemical companies, views foreign currency risks as a money making opportunity. That is to say, it does not just hedge its exposure but aggressive trades in an attempt to make a profit. The operating units sell their foreign currency exposures to a company currency risk management unit. A task force of thirty people manage Union Carbide's currency operations. The task force is broken down into working groups of four or five who deal with special issues such as managing currency risk in hyperinflationary countries. The task force focuses on managing short term (one year) currency risks but it is recognized that it is long term (five year) risk management that is important for the financial health of the company.

The actual currency transactions are carried out by a small number of traders, known as currency risk managers. The staffing of these positions raises some problems. Here is what Union Carbide's treasurer and CFO had to say on these matters:

[...]I have decided that I don't want to have career foreign currency risk managers at Union Carbide. On the one hand, I don't want to compete with all of the commercial banks and investment banks around the world for career foreign exchange people.[...]That's one element. Another element is that I put only my brightest high-potential people in that group, and their careers at Union Carbide are not deteremined on the basis of how much money they make for Union Carbide in the currency risk area.

  • Is this operating exposure?

 ·  Monsanto

Monsanto is another American chemical company that is a world suppler of chemicals. In 1988 40 percent of Monsanto's income came from sales in Europe, Asia, Latin America and Canada. In the 1970's Monsanto established a committee of senior financial and operating managers to evaluate the effects of currency exchange rate shifts on company profits. By the 1980's a unit within the corporate treasury was given responsibility for managing currency risk. This treasury unit however works closely with operating managers in handling Monsanto's currency risk.

Operating divisions within Monsanto hedge their annual operating plans to lock in reported income results. For example, in 1988 Monsanto Agricultural Company intended to cut the sterling price of its products in the United Kingdom, but it was worried that a weakening of the pound would turn a possible mild decrease in dollar profits from the UK into a disastrous decrease. Monsanto chose to hedge against a decline in the pound by buying currency put options. If the market price of sterling declined the profit on the options would offset the decreased dollar-value of the sterling revenues. The put options cost Monsanto $700 thousand but it gave protection with a limited risk and allowed it to benefit from any possible increase in the value of the pound.

In the middle of the 1980's there occurred an episode that illustrates the difficulties of managing properly in the face of rapidly shifting exchange rates. Monsanto Agricultural found in both the dollar price of its products and the physical volume of its sales decreasing. It reacted by carrying out a heavy advertising campaign which did not work. After pursuing other erroneous theories it finally concluded that the problem was that in the local markets its product prices were increasing relative to other prices. Monsanto had tried to maintain a constant dollar price by translating changes in the exchange rates directly into local currencies. But in areas of high inflation the exchange rates are harder hit by inflation than the domestic market so in local terms Monsanto's prices were increasing about twice the rate of inflation. Understandably Monsanto was losing market share to competiting products. Monsanto found it essential to look at local prices in pricing its products.

  •  Evaluate what’s happening here, using economic analysis.

 ·  Digital Equipment Corporation

Digital Equipment Corporation (DEC) is an American manufacturer of computers. The computer industry was once described as being Snow White and the Seven Dwarves, with IBM being Snow White. DEC is one of the dwarves. It was quite successful in the era of the minicomputer and in the 1980's its business grew and became increasingly international. The proportion of its sales which were outside of the U.S. rose from 39 percent in 1980 to 56 percent in 1988. Of its 130,000 employees, 50 to 60 thousand were based outside of the U.S.

DEC wants to appear to be a local company in its foreign markets. For this reason it does not want to adjust its foreign currency price with each shift in the exchange rate. This eliminates one type of natural hedge adjustment for DEC.

In the late 1970's DEC hedged part of its foreign currency revenues. During the era of the weakening of the dollar the unhedged portion of its revenues produced gains for the company. But in the era of the strengthening of the dollar in the early 1980's that unhedged portion produced losses. In 1982 top management decided that selective hedging was sheer speculation and the decision was made to hedge all foreign currency revenues. In 1984 DEC decided to change its accounting system so that hedge gains and losses would reported in the results of operating managers. The operating managers objected to being evaluated on the basis of results that reflected hedging gain or losses which they had no control over. At one point in 1988 a senior manager recommended that all hedging be done away with. But that would result in swings of 20 to 25 percent in quarterly earnings. That was considered unacceptable. DEC had abandoned selective hedging in 1982 and if zero hedging was unacceptable the only alternative was 100 percent hedging. And that is what they did.

As soon as a future foreign currency flow becomes certain it is converted into dollars through a forward market transaction. This eliminates the variability of the reported accounting results.

This policy of complete hedging using the forward markets is justified on the basis that the currency markets are informationally efficient so that trying to outguess the market is fruitless and merely gambling. DEC generally does not use options either. It justifies this with the argument that options are expensive hedges where as the forward contract costs nothing.

DEC considers its foreign currency risk to have two parts, a short term component and a long term component. The short term component it handles through complete hedging in the forward market. The long term component it tries to handle through shifts in sourcing, manufacturing operations and other such natural hedges.

 ·  SmithKline

SmithKline merged with Allergan and with Beckman in the early 1980's to become a major multinational pharmaceutical firm, SmithKline Beckman. It continues to pursue growth through mergers.

The economics of the pharmaceutical industry is dominated by research costs. Production costs are a much less significant factor than in other industries. Therefore shifts in exchange rates play a lesser role in operations for this industry because the gains from adjustments in sourcing and manufacturing are less important. Demand is also thought to be insensitive to price and in many countries the prices of pharmaceuticals are regulated. Despite this supposed price insensitivity SmithKline Beckman felt it benefited from the weakening dollar in the late 1980's.

Operating Exposure and Hedging It (other examples)

Examples from "Tested by the mighty euro," The Economist of March 18, 2004 , (Go to http://webpage.pace.edu/pviswanath/articles/index.html (you'll need the password), click on International Finance and then on the name of the article.)

This article talks of the fact that the euro was strong and getting stronger in 2004, and how various european companies adjusted to this fact.

In addition to using financial derivatives for currency hedging, many firms have built “natural hedges” by moving some production abroad, at the expense of euro-zone output. DaimlerChrysler, for instance, produces all of its M-class Mercedes in Alabama, and so the weaker dollar has meant windfall profits on exports back to Europe. But, as the euro has risen, for most of its exported models Mercedes, like its rival BMW, has had to increase its prices in America.

Volkswagen, Europe's biggest carmaker, says that the strong euro shaved €1 billion ($1.25 billion) from profits last year, even though it makes some models in Mexico, which limits the damage. It recently reported a 62% fall in pre-tax profits to €1.5 billion in 2003. It is using the currency crunch as an excuse to cut 5,000 jobs that it needed to slash anyway from its over-manned German plants. Even Renault, PSA Peugeot Citroën and Opel (the German arm of General Motors), though they do not sell in America, are hit indirectly, says GM's boss, Rick Wagoner, as more cars intended for export are instead diverted to European markets, adding to over-supply there. (My comment: note that a firm doesn't have to be selling abroad to have exchange rate exposure!)

Passenger aircraft are priced in dollars, so Airbus has to grit its teeth and can take only slight consolation from the $4 billion of parts it buys from America each year. Airbus's boss, Noël Forgeard, says, somewhat bombastically, that he will rely on the high margins from Airbus's new super-jumbo, on sale from 2006, as his ultimate hedge against the weak dollar.

Louis Vuitton Moët Hennessy (LVMH), a French luxury-goods firm, announced a 9% rise in operating profits earlier this month. If the euro had remained at its 2002 levels, the rise would have been 20%, says Patrick Houel, the group's finance director. All LVMH's production costs are in euros, while revenue splits three ways between euros, dollars and other currencies.

For DSM, a Dutch specialty-chemicals group, a one percentage-point move in the dollar exchange-rate has a €7m-11m impact on profits. About four-fifths of its sales are in dollars, but two-thirds of production is in the euro zone. For the moment, says the chairman, Peter Elverding, DSM's only hedge is to borrow in cheap dollars. The company may also move more of its production outside the euro zone. In 2000 it bought Catalytica, an American pharmaceuticals firm, partly in order to reduce its currency risk.

US firms like McDonald's and Merck, Pfizer, Bristol-Myers Squibb and Eli Lilly
Last week McDonald's reported its 10th consecutive monthly sales gain, a shift attributed partly to the weaker dollar. Its European sales were up by 27% in February, but by only 9% in “constant currency” terms. The same is true for drugs firms, such as Merck, Pfizer, Bristol-Myers Squibb and Eli Lilly; all have big overseas sales, but incur manufacturing costs in euros.

Chinese firms
Chinese firms are reaping the currency bonanza too, with the weakness of the dollar-pegged yuan spurring growing exports of Chinese goods (clothes, toys and cheap knick-knacks) into Europe. Euro-China trade used to balance, but last year, according to Allan Jianjun Zhang, director of the China Business Centre at PricewaterhouseCoopers, China enjoyed a surplus of more than $16 billion.

Foreign Currency Speculation by Major Corporations

Surveys of foreign currency trading by major U.S. corporations indicate that while only a very small proportion (perhaps 5 percent) engage in such trading solely as speculation (for trading profits) a much larger share (perhaps 75 percent) speculate some times. Millman reports that Intel in recent years as made as much as 15 percent of its earnings from speculation in foreign currency and interest derivative securities. In 1992 there were rumors that Dell Computers was speculating in the foreign currency market. The company refused to verify this rumor and financial analysis tried to to establish its truth or falsehood by analyzing published financial statements. The analysis indicated that there were revenues that could not be accounted for in Dell's computer business and when the results were made public the price of Dell stock plummeted. Later it was found that the resume of the trader responsible for Dell's foreign exchange operation indicated that he traded $1 billion dollars in currency contracts.

 ·  Dow Chemicals

At its corporate headquarters in Midland, Michigan, Dow Chemicals runs an extensive, sophisticated currency trading operation. Dow relies upon currency traders trained in the company instead of competing for trading professionals. Pedro Reinhard, a Brazilian employee of Dow who rose to become corporate treasurer at Midland, undertook an extensive study in 1987 to determine which international currency was the determining factor in the price and profitability of each product line. Dow then tried to formulate appropriate hedging strategies for fluctuations in the values of major currencies. These strategies could involve changes in operations to adjust for changes in exchange rates, but they also included financial hedges using long term options and swaps.

A complicating factor in the use of options and swaps for hedging is that the tax codes require the computation of short term capital gains on these contracts, what is called marking to the market. The fluctuation of such short term gains and losses distort the financial picture of a corporation because no such actual gains or losses actually occur; i.e., they are paper gains and losses. 

·  Monsanto

Monsanto, headquartered in St. Louis, is a multinational chemical company with extensive international sales. When the value of the dollar increased Monsanto tended to maintain dollar prices and pass the effect of the higher dollar value on to their foreign customers in terms of higher prices in their currency. This hurt sales and the company used advertising and other promotions to try to offset the effect of the higher price of Monsanto products to foreign buyers. The company found that this strategy was no longer effective in the 1980's and it began to maintain prices in foreign currency constant in the face of the strengthening of the dollar. It also began to utilize foreign currency options to reduce the impact of adverse changes in the exchange rates. 

·  Merck Pharmaceuticals

Merck is a pharmaceuticals company located in New Jersey. A pharmaceutical company makes large investments in research and development (R&D) to produce a marketable product. The manufacturing costs are relatively small. As a result of the declining value of foreign currencies in Europe in the 1980's Merck was finding that the dollar value of its sales were also declining. It could not hold the dollar price constant by increasing the foreign prices of its products because of the competition from foreign competitors. It had to cut costs to compensate for falls in dollar revenue from foreign sales and due to the nature of its business these cost reductions came in R&D. Thus Merck was finding that its long term investment program was being driven by short term fluctuations in exchange rates. Merck was forced into a program of hedging to divorce its long term investment decisions from the short term currency markets.

 ·  Kodak

As any camera buff knows Kodak has a major competitor in in the photographic film market, Fuji of Japan. In the 1980's the strong dollar, weak yen gave Fuji a major price advantage over Kodak and Kodak lost a substantial share of the photographic film market to Fuji. This variation in the fortune of a company with an exchange rate is called operating risk. It is a more fundamental problem than the problem of transactions risk involved in foreign currency receipts and payments. Kodak dealt with the transaction risk in its business by utilizing the forward markets, but this strategy provided no security against the operating risks.

Kodak began to speculate in the currency market in the hopes that profits from adverse moves in the market would compensate for operating profits declines. In 1988 Kodak found that it was necessary to modify its hedging strategy. It pursued some hegges against operating risk such as purchasing some supplies from Japan which would reduce its costs at the same time that its compeitor Fuji had reduced costs with respect to the American market. Kodak also utilized options. As a result of Kodak's hedging operations it broke the inverse relationship that had developed between its stock price and the value of the dollar.

 ·  Magma Copper

Magma Copper, a mining company whose earnings are closely tied to the price of copper, issued a bond in 1988 that tied the payment to bondholders to the price of copper. This transferred some of the risk normally born by stockholders to the bondholders. But the risk associated with the price of copper is a unique risk as opposed to the market risk. Unique risks can be diversified away by including the security in a well-diversified portfolio.

After Magma Copper issued the copper-price based bond the beta on Magma Copper's common stock fell. Thus by reducing a business risk for the equity holders of the corporation the risk-premium fell.

 ·  Allied-Lyons

Allied-Lyons is a multinational corporation headquartered in the United Kingdom and dealing in food and beverages. The treasurer of Allied-Lyons progressed from hedging to outright speculation in the foreign currency markets. For a while his activities were generating substantial profits for the corporation and the top management unaware of the magnitude of the risks allowed him to continue his operations. After a series of losses the treasurer unwilling to admit the losses began to increase the size of his bets on the currency market. When the losses could no longer be hidden the company had to confess in 1991 to the loss of $270 million. The chairman of Allied-Lyons took responsibility for allowing the treasurer to engage in such speculation and resigned.




Operating Exposure Analysis based on Flood and Lessard

This note is based, partially, on Eugene Flood and Donald R. Lessard, “On the Measurement of Operating Exposure to Exchange Rates: A Conceptual Approach,” Financial Management, Spring 1986.

As far as operating exposure is concerned, only real exchange rate changes are relevant.
Competitive effect: sensitivity of the local currency cashflows to exchange rate changes
Conversion effect: one-for-one mapping of local currency flows to dollar flows.
A real exchange rate can affect

  • Competitive position on the revenue side
  • Cost of the firms’ inputs relative to competitors.

Information re contractual exposure can be found in the firm’s financial statements – not so, operating exposure. The exposed items are future revenues, costs, and profits.
Assessing these exposures requires an analysis of the firm’s competitive environment.

The impact of the firm’s competitive position on its operating exposure:
Operating exposure is determined by:
The structure of the markets in which the company sells its products
The structure of the markets in which the company (and its competitors) purchases its inputs.

Market structure will determine:

  • The currency habitat of the price of goods; currency habitat is that currency in which the price of the good tends to be the most stable.
  • Quantity impacts (unit sales or purchases)

Currency Habitat:

Assume Perfect Competition and Law of one price.
Assume Canadian and US setup.

Assume the lumber industry.
Suppose the marginal producers and consumers are in Canada.
Then, the C$ will be the habitat currency, the natural currency. If the Canadian currency depreciates 10%, the Canadian price will not change; hence the US prices will decrease by 10%. A firm in the US in this industry, even if all its customers are in the US will experience operating exposure. This is because the US $ price will fluctuate when the exchange rate changes.

Suppose the marginal producers and consumers are in the US; then the US$ will be the natural currency. If the Canadian currency depreciates 10%, the US$ price will remain constant; the Canadian price will have to increase 10% because the dollar revenue from any sale will have to remain the same; the dollar price must remain the same. Hence the Canadian price times the exchange rate must remain the same. If the C$ depreciates, for this to happen, the Canadian price must rise. Thus, even if you had a company that invoiced in C$ and sold to Canadian customers, it would have no exchange rate exposure.

In the above two cases, the natural currency price is not affected by the exchange rate change. Both marginal producers and consumers are in the same country and the exchange rate is extraneous to the determination of the natural currency price. Now, however, let us consider a case where supply/demand elasticities are relevant.

Suppose coal is only produced in the US, and all consumers are Canadian. Furthermore, let the market be characterized by perfect competition. When the Canadian dollar depreciates, at every C$ price, the US$ price is lower, hence the supply of coal is lower.

Note that in this case, the depreciation in the C$ causes the Canadian $ price to rise, but it will not rise by the same amount as the depreciation. The quantity sold will drop, as well. Whether the revenue will rise or drop will depend on the price elasticity of demand.

In the figure above, the supply curve remains constant because it is presented in US$. However, the demand curve will change. At each US$ price, the C$ price is higher, hence the amount demanded by Canadians will be lower. In this case, the price in US$ will drop; however, the price drop will be less than the percentage depreciation in the Canadian $.

In the above graph, note that the supply elasticity is zero. Hence the quantity sold does not change. Price absorbs the entire effect of the exchange rate change.

The net result, therefore, depends on two factors: one, the extent to which the law of one price holds, and two, the relevant demand/supply elasticities.
The Law of One Price will hold for easily transportable goods that are widely traded; to the extent that this does not hold for a good, the law of one price will not hold.
Other factors are the extent of product differentiation across countries – if there is a lot of product differentiation, then consumers will perceive the goods in different countries to be different, and hence, a drop in the price of one good will not necessarily lead to a drop in the price of a similar good in another country.
Also, the ability of the seller to bundle different goods together and thus obtain a degree of monopoly power affects the operation of the law of one price. Finally, other relevant factors are – the absence of barriers to trade, such as tariffs, quotas, etc.

This can be seen in the following table. The y-axis indicates the extent of application of the law of one price. The upper half indicates contexts where the law of one price holds to a lesser extent, and hence firms face local-currency denominated marginal revenue curves.

The x-axis indicates the marginal pricing factor. This reflects the relative importance of producer cost and consumer demand considerations that depend on, inter alia, the competitive structure of the industry, the price elasticity of demand, the range of complements and substitutes and the relevant cross-elasticities, and the structure of costs. This last refers to operating leverage. If operating leverage is high, marginal considerations are less important and pricing is dictated primarily by demand considerations. Alternatively, we can think of the marginal pricing factor as indicating situations where supply elasticities are more important that demand elasticities, while at the right end of the axis, the reverse is true.

From Flood and Lessard, “On the Measurement of Operating Exposure to Exchange Rates: A Conceptual Approach,” Financial Management, Spring 1986.

Suppose we have a US firm selling luxury cars in France. If we accept the assumption that luxury car pricing is likely to be local and does not respond to international effects, exchange rate fluctuations are not likely to affect local pricing to any great extent. This may be, for example, because local firms will not respond to exchange rate driven changes in operating costs. Furthermore, because of the cost structure of the car industry, local demand considerations will be paramount in pricing. Hence, even if the local currency depreciates, the US firm is likely to have to keep the local price constant. As a result, the currency depreciation will flow through, pretty much, to the revenues of the US firm.

On the other hand, the local price of oil is likely to adjust to worldwide impacts in oil prices.