NPTEL International Finance Vinod Gupta School of Management, IIT. Kharagpur.

Module - 27 Operating Exposure Management: At Operational Level

Developed by: Dr. Prabina Rajib Associate Professor Vinod Gupta School of Management IIT Kharagpur, 721 302 Email: prabina@vgsom.iitkgp.ernet.in

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Lesson - 27 Operating Exposure Management: At Operational 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 companys 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.

Learning Objectives:
In this session, the following aspects have been dealt in greater detail: Understanding the meaning of operating exposure Impact of operating exposure on firms cash flow. Management of operating exposure o At an operation level Matching currency cash flows Risk-sharing agreements Back-to-back or parallel loans Reinvoicing centers. Currency swap

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27.1 Management of Operating Exposure:

In Session 26, operating exposure arising due to change in exchange rate has been discussed in detail. It was also discussed that operating exposure affects the firms present as well as future cashflow thus affecting the value of the firm and may make a firm uncompetitive. In other words, operating exposure affects the firms day-to-day operations like where to sell, where to produce and source etc. Compared to transaction exposure management, management of operating exposure is more difficult. Operating exposure management involves management of companys marketing, production and sourcing so that a company is able to change these activities to take advantage of the favourable exchange rate movement as well as more, importantly, reduces the negative impact of adverse exchange rate movement. Management of operating exposure requires the concerted effort at an operational as well at a strategic level. At operational level, a company can undertake the following activities to manage the operating exposure. This session deals with management of operating exposure at an operational level. Matching currency cash flows Risk-sharing agreements Back-to-back or parallel loans Reinvoicing Centers. Currency swaps

Matching Currency Cashflows: The Indian exporter can match its asset and liability cashflow currency. Such strategy creates a natural hedge for the company. The Indian exporter can undertake the following activities: It can borrow/issue debt securities in currencies denominated in USD and YEN so that its export receivable is used to pay the interest and principal. By doing so, the Indian exporter is shielding itself from INR/Euro fluctuation. The Indian exporter can pay to its Srilankan subsidiary and Bangladeshi dye supplier in USD or YEN. By doing so the Indian company is matching its assets with liabilities. However, the foreign exchange risk now shifts to the Srilankan subsidiary and Bangladeshi dye supplier.

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Many companies are undertaking this option to manage operational exposure which was earlier not feasible. With the globalization of international capital market, many companies are going beyond their domestic territories to raise finances in foreign currency. Similarly, investors are also interested to invest in foreign companies so as to reap the diversification benefit.

Risk Sharing Agreement: Risk sharing is a contractual arrangement between the exporter and importer to share or split currency risk between them. In a risk sharing agreement, both buyers and sells jointly work so that benefits/loss of change in foreign currency rate is shared by both parties. It works like this. The Indian exporter and Wal-Mart agree that: If INRUSD rate varies within INR 43.50/USD to INR45/USD ( i.e, >= INR 43.50/USD to < INR45/USD), then Wal-Mart pays USD20 per unit of bed linen. If INR depreciates and remains within the range INR45/USD to INR46.75/USD ( i.e, > =INR45/USD to < INR46.75/USD) , then the Indian exporter receives USD 19 per bed linen. If INR appreciates and remains within a range of INR42/USD to INR43.50 ( i.e, > =INR42/USD to < INR43.50/USD), then Wal-Mart pays USD 22 per bed linen.

When INR appreciates beyond a certain point, exporting to Wal-Mart at price of USD 20 becomes a loss making provision for Indian exporter. Hence Walmart compensates by paying a higher price. Similarly when INR depreciates, the Indian exporter is making extra profit. By agreeing to accept less for unit of bed linen, the Indian exporter is passing some benefit to Walmart. Different range of INR/USD can be negotiated between two parties so that both parties are equally benefitted from exchange rate movement. This range is also not sacrosanct for all time to come. Both parties also agree to the length of the period during which the risk-sharing agreement is applicable. In other words, the risks sharing agreement has flexibility built into it so that no party has undue advantage. The Indian exporter can enter into similar agreement with its Japanese counterparty depending on the INR/JPY movement.

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Such kind of risk sharing agreement can happen only when buyer and seller enter into long term contract. Many-a-times, the exporters manufacturer certain products keeping the importers client profile in mind, or at times the importer actively participates in exporters design, production and manufacturing process so that importer is able to supply products at a cheaper rate. Hence, it becomes equally important for the importer to ensure that the exporter does not run out of business due to change in exchange rate. Back-to-Back or Parallel Loans: In back-to-back or parallel loan, two companies in different countries borrow offsetting amounts from one another in each other's currency. For example, an Indian company imports high-end perfumes and cosmetic products from USA and sells in India. It operates a branch office in USA to procure cosmetic products and export it to India. Let us name this company as Indian importer. The Indian importers major expenses are in USD while earnings are in Indian Rupees. The Indian exporter (exporting to Wal-mart and earnings in USD) gives loan of let us $15000 to the branch office of Indian importer. The Indian importer gives an equivalent amount of loan in INR to Indian exporter. The day this back-to-back loan was given, the spot rate is INR42/USD. Indian exporter gives a loan of $15000 to the branch office. The Indian importer gives a loan of INR 630,000 to Indian exporter. It is clearly evident that both companies managed to get their forex requirement without going to forex market. However, back-to-back loans have inherent disadvantage. A party wanting to mitigate forex risk must find out a willing counterparty to take opposite position. Reinvoicing centers: Re-invoicing requires a presence of intermediary between buyer and seller. The seller instead of supplying goods or services to the buyer directly first sells to the intermediary. The intermediary pays the seller in its home currency thus minimizing the impact of currency risk. The intermediary in turn sells these goods to buyer and collects foreign currency. The seller directly ships the goods to the buyer but the payment receipt is channelized through reinvoicing center.

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The reinvoicing center deals with each buyer and seller in their home currency. The role of reinvoicing center increases substantially for an MNC, whose incomes and expenses are paid and received in many currencies. The reinvoincing center becomes the central financial subsidiary pf the MNC. As the different units of MNCs receive their income in their home currency, they do not have to spend money employing personnel to manage the forex risk. The reinvoicing center nets all foreign exchange and only hedges the amount which can not be netted off. Also the reinvoicing center gets better forex quote as it places bigger transactions for hedging. Basically the reinvoincing center gets benefit of economies of scale. Companies use risk-sharing agreement, back-to-back loans, and reinvoicing centers for managing operating cash flows. Currency swaps are normally used to manage the financing cash flows like payment or receipt of debt proceedings. We briefly discuss the currency swap aspects here as it has been extensively dealt in Session 24 (Interest rate swap and currency Swap). Currency Swap: In a currency swap, a company swaps its foreign currency denominated debt payments (interest and principal) with a counter party. Suppose Indian exporter borrowed USD to fund its operation. It was hoping that from the sales proceed to Wal-mart, it will be able to pay to its lender. But with increasing competition in USA, It has started focusing in the domestic market and expects to earn a greater portion of its revenue in INR terms. Hence the Indian exporter is not keen to service USD dollar denominated debt. The Indian exporter has two options. Either to prepay the USD debt or changes the USD debt to INR debt. Prepaying any debt comes with its own cost i.e, the lender may charge a fee. In the second option, currency swap are undertaken with a swap dealer. At the cost of repetition (as it already given in Session 13), an example of foreign currency swap is given below. Example of a foreign currency swap: A foreign currency swap is an agreement between two parties to swap payment of principal and interest in two different currencies. For example, the Indian Exporter took a foreign currency loan of USD 250mn for 6 years at a fixed interest rate of 5.5% per annum from USA bank. Two years after the loan it would like swap it to an INR loan. Hence remaining time to maturity is 4 years. Indian Exporter wants to shift this USD obligation and wants to pay the interest and principal in INR. It approaches different banks for swapping its USD obligations to INR obligation. Suppose, BBK bank agrees to be the counterparty for this swap at 8.75% per annum.

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The swap happens in three stages. Step one: In the stage one, both parties exchange the principal amount. In this case, Indian Exporter pays USD 250 mn to BBK Bank. In return BBK bank pays INR 11750 mn at the prevailing spot rate of INR 47 /USD. In the step two, Indian Exporter pays Rs. 998.75mn as interest payment on INR 11750 mn at a rate of 8.5%. Indian Exporter receives USD 13.75 mn from BBK bank. Indian Exporter pays this USD 13.75 to the USA bank, the original lender to Indian Exporter. The exchange of interest happens annually once for four years. In the third step, at the end of the 4th year, Indian Exporter returns INR 11750 to BBK bank and receives USD 250mn. This USD 250 mn is paid to the USA bank. Graphically the steps are given below (in Figure 27.1)

Fig : 27.1 Currency Swap

Step 1: At swap origination

USD 250 Mn Indian Exporter INR 11750 mn Step 2: Annual Interest payment (4 years) USD 13.75 Mn
Indian Exporter INR 998.75 mn

BBK Bank

BBK Bank

Step 2: At maturity
INR 11750Mn Indian Exporter USD 250 Mn BBK Bank

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It can be seen from the above figure that for the remaining 4 years, the Indian exporter is servicing its loan in INR and not in USD. Also Indian company may be interested to swap its home currency loan to foreign currency loan, if it desires so. The following boxes, Box 27.2 and 27.3 detail currency swaps in practice. Box 27.3 deals with currency swap deal undertaken by Maruti India Ltd. Box 27.3 highlights first currency swap contract signed by HDFC bank and RIL as well as HDFC Bank and IPCL. Both companies have swapped their INR obligation to foreign currency obligation.

Box 27.2 Currency Swap deals by Maruti Udyog Limited Source: Annual report 2006-07 http://www.marutisuzuki.com/annual-reports-archives.aspx

USD Floating rate/INR Floating rate cross-currency swap: Consequent to the merger of Maruti Suzuki Automobiles India Ltd, the Company has taken over the USD Floating rate/INR Floating rate Cross-currency swap agreements on foreign currency loan of USD 124.70 Million. Under these swap agreements, (i) the USD principal has been swapped against the INR principal at inception (ii) the USD principal repayment obligations swapped against fixed INR payments and (iii) the USD interest rate (6 Million USD British Bankers Association Interest Settlement Rate (BBA LIBOR) + spread) swapped against the INR interest rate (6 Million INR Mumbai Interbank Overnight Indexed Swap + spread) over the life of foreign currency loan. The above contracts have been undertaken to hedge against the foreign currency risk and USD interest rate risk.

Though it may be little out of context, when the topic of discussion is operating exposure faced by companies, the author would like to bring in an interesting fact regarding currency swap. It is worth nothing here that not only companies enter into currency swaps, countries are also entering currency swaps to mitigate the forex risk.

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Recently currency swap also has gained notoriety in relation to sovereign default crisis faced by Greece. Box 27.3 highlights some of these aspect related to currency swap. Box 27.3 Greece facing Goldman Sachs debt deal scrutiny http://beta.thehindu.com/news/international/article109067.ece February 18, 2010: The practice wasnt secret and it wasnt illegal, and some of it happened 10 or 15 years ago. But the practice of European governments reportedly using complex financial transactions to move debt off their books is getting closer attention from markets and the European Union. The deals, known as swaps, let some governments shrink the apparent size of their deficits, unsettling news at a time when markets are taking stock of Europes struggle with increased levels of government debt. Greece has to disclose to the European Commission how it used complex currency swap deals and whether they were used to conceal the real scale of its debt - specifically a 2002 deal that Greek officials said they did with U.S. investment bank Goldman Sachs. Under the deal, known as a currency swap, Greek dollar and yen debt was reportedly exchanged for euro debt for a period at an advantageous rate to be reversed at a later date. The effect was to show less debt in the near-term. Japan, India agree on $6 bn currency swap deal
http://www.financialexpress.com/news/Japan-India-agree-on-6-bn-currency-swap-deal/257678/

January 4, 2008: Japan and India agreed on Friday to set up a $6 billion bilateral currency swap facility to ward off any future financial crisis, Japanese media reported. Japanese Finance Minister Mr.Nukaga and Indian counterpart Mr. Chidambaram met in New Delhi on Friday to confirm the framework and the two nations would launch the facility in the spring. The idea is to allow a country that finds itself with short-term liquidity problems to borrow from its partners' foreign reserves to absorb heavy selling pressure on its currency. Under the framework, Japan would swap up to $3 billion for Indian rupee to prevent any currency crisis in India. India would swap up to $3 billion for yen if Japan were in trouble, Japanese media reported

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Management of operational risk exposure can be done at two levels -- at operational level and at strategic level. At operational level, a company undertakes activities to match its foreign currency cash inflow and outflow, enters into risk-sharing agreements with vendors and its customers, creates reinvoincing centers to centralize its purchasing and selling functions etc. These strategies are not mutually exclusive and companies undertake some or all or these to mitigate operating exposure at an operational level.

Multiple choice questions:

1. Operating exposure is also known as ________ exposure. a) economic b) competitive c) strategic d) all of the above 2. Risk exposure that measures the change in net present value of a firm due to changes in future operating cash flows is known as a) transaction exposure b) operating exposure c) translation exposure d) None of the above 3. Some multinational companies set up a re-invoicing center for . a) invoices in the same currency for the buyer and seller of goods and services b) buys in one currency and pays in another currency c) buys in the parent currency and pays in the parent currency d) None of the above 4. An Indian toys manufacturer has a long term contract with a UK firm. To avoid occasional and unpredictable changes in the exchange rate between the Pound and INR, both companies have agreed split the impact of any exchange rate movement. This type of agreement is known to as ________. a) risk-sharing b) currency-switching c) matching 5. In a ________ contract, two parties agree to exchange a given amount of one currency for another, and after a period of time, to give back the original amounts. a) matched flow b) currency swap c) back-to-back loan d) none of the above

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6. 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. Why operating exposure is also known as strategic/economic/competitive exposure? 2. What is Risk-sharing agreement? What aspects party must take precaution while executing a risk-sharing agreement?

Answers to Multiple Choice Questions:

1. d 2. b 3. c 4. a 5.b 6.c

References:
1. Operating Exposure, Multinational Business Finance, Eiteman, Moffett, Stonehill and Pandey, 10th Edition, Pearson Education, ISBN, 81-7758-449-9. 2. Techniques for managing economic exposure, class note by Prof. Gordon Bodnar, http://finance.wharton.upenn.edu/~bodnarg/courses/readings/hedging.pdf 3. Rupee impact: Infosys cuts earnings guidance. http://www.thehindubusinessline.com/2007/07/12/stories/2007071252380100.ht m 4. Nestles global operation, Source: http://www.nestle.com/Resource.axd?Id=602C42FE-04D6-4669-BEE11027492FE5E8 5. Currency Swap deals by Maruti Udyog Limited,Source: Annual report 2006-07 http://www.marutisuzuki.com/annual-reports-archives.aspx 6. Greece facing Goldman Sachs debt deal scrutiny http://beta.thehindu.com/news/international/article109067.ece 7. Japan, India agree on $6 bn currency swap deal http://www.financialexpress.com/news/Japan-India-agree-on-6-bn-currencyswap-deal/257678/

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