Measuring and managing economic exposure

Economic Exposure: based on the extent to which the value of the firm --- as measured by the present value of its expected future cash flows --- will change when exchange rates change.

Two components: Transaction Exposure and Operating Exposure.

Transaction exposure: exchange gains or losses on foreign currency-denominated contractual obligations (short term).

Transaction exposure arises out of the various types of transactions that require settlement in a foreign currency. Such as borrowing and lending in foreign currencies, the local purchasing and sales activities of foreign subsidiaries, lease payment, forward contracts, loan repayment and other contractual or anticipated foreign currency receipts and disbursements.

Operating exposure: the future gains or losses on revenues and costs because of real exchange rate changes (long term).

Operating exposure (long term)

Demand Side Supply Side

[revenue] [cost]

Price Volume Domestic Input Foreign Input

[Price elasticity of Demand] [Substitution of Costs]

Managing operating exposure:

  1. Market selection
  2. Payoff between price and volume
  3. Product innovation.
  4. Global purchasing and production.
  5. Financial management: hedging.

Case: Rolls-Royce Limited

Rolls-Royce Limited, the British aeroengine manufacturer, suffered a loss of £58 million in 1979 on worldwide sales of £848 million. The company’s annual report for 1979 blamed the loss on the dramatic revaluation of the pound sterling against the dollar, from £1=$1.71 in early 1977 to £1= $2.12 by the end of 1979.

The most important reason for the loss was the effect of the continued weakness of the U.S. dollar against sterling. The large civil engines that Rolls-Royce produces are supplied to American air frames. Because of U.S. dominance in civil aviation, both as producer and customer, these engines are usually priced in U.S. dollars and escalated accordingly to U.S. indices….

A closer look at Rolls-Royce’s competitive position in the global market for jet engines reveals the position in the global market for jet engines reveals the sources of its dollar exposure. For the previous several years Rolls-Royce’s export sales had accounted for a stable 40% of total sales and had been directed at the U.S. market. This market is dominated by two U.S. competitors, Pratt and Whitney Aircraft Group (United Technologies) and General Electric’s aerospace division. As the clients of its mainstay engine, the RB 211, were U.S. aircraft manufacturers (Boeing’s 747 SP and 747,00 and lock-heed’s L1011), Rolls-Royce had little choice in the currency denomination of its export sales but to use the dollar.

Indeed, Rolls –Royce won some huge engine contracts in 1978 and 1979 that were fixed in dollar terms. Rolls-Royce’s operating costs, on the other hand, were almost exclusively incurred in sterling (wages, components, and debt servicing). There contracts were mostly pegged to an exchange rate of about $1.80 for the pound, and Rolls-Royce officials, in fact, expected the pound to fall further to $1.65. Hence, they didn’t cover their dollar exposures. If the officials were correct, and the dollar strengthened, Rolls-Royce would enjoy windfall profits. When the dollar weakened instead, the combined effect of fixed dollar revenues and sterling costs resulted in foreign exchange losses in 1979 on its U.S. engine contracts that were estimated by The Wall Street Journal (March 11, 1980, P.6) to be equivalent to as much as $200 million.

Moreover, according to that same Wall Street Journal article, “the more engines produced and sold under the previously negotiated contracts, the greater Rolls-Royce’s losses will be.”

Questions

  1. Describe the factors you would need to know the assess the economic impact on Rolls-Royce of the change in the dollar: sterling exchange rate. Does inflation affect Rolls-Royce’s exposure?
  1. Given these factors, how would you calculate Rolls-Royce’s economic exposure?
  2. Suppose Rolls-Royce had hedged its dollar contracts. Would it now be facing any economic exposure? How about inflation risk?
  1. What alternative financial management strategies might Rolls-Royce have flowed that would have reduced or eliminated its economic exposure on the U.S. engine contracts?
  1. What nonfinancial tactics might Rolls-Royce now initiate to reduce its exposure on the remaining engines to be supplied under the contracts? On future business (e.g., diversification of export sales)?
  1. What additional information would you require to ascertain the validity of the statement that “the more engines produced and sold under the previously negotiated contracts, the greater Rolls-Royce’s losses will be”?
Case: Laker Airways
The crash of Sir Freddie Laker’s Skytrain had little to do with the failure of its navigational equipment or its landing gear; indeed, it can largely be attributed to misguided management decisions. Laker’s management erred in selecting the financing mode for the acquisition of the aircraft fleet that would accommodate the booming transatlantic business spearheaded by Sir Freddie’s sound concept of a “no-frill, low-fare, stand-by” air travel package.

In 1981, Laker was a highly leveraged firm with a debt of more than $400 million. The debt resulted from the mortgage financing provided by the U.S. Eximbank and the U.S. aircraft manufacturer McDonnell Douglas. As most major airlines do, Laker Airways incurred three major categories of cost: (1) fuel, typically paid for in U.S. dollars (even though the United Kingdom is more than self-sufficient in oil); (2) operating costs incurred in sterling (administrative expenses and salaries), but with a nonnegligible dollar cost component (advertising and booking in the United States); and (3) financing costs from the purchase of U.S.-made aircraft, denominated in dollars. Revenues accruing from the sale of transatlantic airfare were about evenly divided between sterling and dollars. The dollar fares, however, were based on the assumption of a rate of $2.25 to the pound. The imbalance in the currency denomination of cash flows (dollar-denominated cash outflows far exceeding dollar-denominated cash inflows) left Laker vulnerable to a sterling depreciation below the budgeted exchange rate of £1=$2.25. indeed, the dramatic plunge of the exchange rate to £1=$1.6 over the 1981-1982 period brought Laker Airways to default.

Could Laker have hedged its “natural” dollar liability exposure? The first option of indexing the sale of sterling airfare to the day-to-day exchange rate was not a viable alternative. Advertisements, based on a set sterling fare, would have had to be revised almost daily and would have discouraged the “price-elastic, budget-conscious” clientele of the company. Another possibility would have been for Laker to direct more of its marketing efforts toward American travelers, thereby giving it a more diversified demand structure, when the pound devalued against the dollar, fewer British tourists would vacation in the United States, but more Americans would travel to Britain. Laker could also have financed the acquisition of DC 10 aircraft in sterling rather than in dollars, thereby more closely matching its pound outflows with its pound inflows. This example points out that the currency denomination of debt financing can ill afford to be determined apart from the currency risk faced by the firm’s total business portfolio.