Reducing Economic Exposure

Reducing economic exposure requires strategic choices that go beyond the realm of financial management. The key to reducing economic is to distribute the firm’s productive assets to various locations so the firm’s long-term financial well-being is not severely affected by adverse changes in exchange rates. The post 1985 trend by Japanese automakers to establish productive capacity in North America and Western Europe can partly be seen as a strategy for reducing economic exposure. Before 1985 most Japanese automobile companies concentrated their productive assets in Japan. However, the rise in the value of the yen on the foreign exchange market has transformed Japan from a low-cost to a high-cost manufacturing location. In response Japanese auto firms have moved many of their productive assets overseas to ensure their car prices will not be unduly affected by further rises in the value of the yen. In general, reducing economic exposure necessitates that the firm ensure its assets are not too concentrated in countries where likely rise in currency value will lead to damaging increases in the foreign prices of the goods and services they produce.

Reducing Transaction and Translation Exposure

A number of tactics can help minimize their transaction and translation exposure. These tactics primarily protect short-term cash flows from adverse changes in exchange rates. We discussed two of these tactics buying forward and using change rates. They are import sources of insurance against the short-term effects of foreign exchange exposure.
In addition to buying forward and using swaps, firms can minimize their foreign exchange exposure through leading and lagging payables and receivable that is collecting and paying early or late depending on expected exchange rate movements. A lead strategy involves attempting to collect foreign currency receivables early when a foreign currency is expected to depreciate and paying foreign currency payables before they are due when a currency is expected to appreciate. A leg strategy involves delaying collection of foreign currency is expected to depreciate. Leading and legging involve accelerating payments from weak currency to strong-currency countries and delaying inflows from strong-currency from weak currency countries.
Lead and leg strategies can be difficult to implement, however. The firm must be in a position to exercise some control over payment terms. Firms do not always have this kind of bargaining power, particularly when they are dealing with important customers that are in a position to dictate payment terms. Also, because lead and lag strategies can put pressure on a weak currency, many governments limit lead and lags. For example some countries set 180 days as a limit for receiving payments for exports or making payments.
Several other tactics that can reduce transaction and translation exposure have already been discussed in this blog. We have explained that:

1. Transfer prices can be manipulated to move funds out of a country whose currency is expected to depreciate.

2. Local debt financing can provide a hedge against foreign exchange risk.

3. It may make sense to accelerate dividend payments from subsidiaries based in countries with weak currencies.

4. Capital budgeting techniques can be adjusted to deflect the negative impact of adverse exchange rate movements on the current net value of a foreign investment.

Tachcs and Strategies for Reducing Foreign Exchange Exposure

A number of strategies and tactics can help firms reduce their foreign exchange exposure. The tactics which include buying forward and the use of leading and lagging strategies, are best suited to alleviating transaction exposure and translation exposure. The strategies addressing the configuration of a firm’s assets across countries are best suited to reducing economic exposure

Economic exposure

Economic exposure is the extent to which a firm’s future international earning power is affected by changes in exchange rates. Economic exposure is concerned with the long-run effect to changes in exchange rates on future prices, sales and costs. This is distinct from transaction exposure which is concerned with the effect of exchange rate changes on individual transactions, most of which are short-term affairs that will be executed with in few weeks or months. Consider the effect of the wide swings in the value of the dollar on many U.S firms’ international competitiveness during the 19080s. The repaid rise on the value of the dollar on the foreign exchange market in the early 1980s hurt the price rise in the value of the dollar on the foreign exchange market. U.S manufacturers that relied heavily on exports saw their export volume and world market share plunge. The reverse phenomenon occurred in the following decade when the dollar declined against most major currencies. The fall in the value of the dollar between 1985 and 1995 increased the price competitiveness of U.S manufactures in world markets on world markets and helped produce an export boom in the U.S

Translation Exposure

Translation exposure is the impact of currency exchange rate changes on the reported consolidated results and balance sheet of a company. Translation exposure is basically concerned with the present measurement of past events. The resulting accounting gains or losses are said to be unrealized they are paper gains and losses but they are still important. Consider a U.S firm with a subsidiary in Mexico. If the value of the Mexican peso depreciates significantly against the dollar this would substantially reduce the dollar value of the firm’s equity reported in its consolidated balance sheet. This would raise the apparent leverage of the firm which could increase the firm’s cost of borrowing and restrict its access to the capital market. Similarly, if a U.S firm has a subsidiary in the European Union and if the value of the euro depreciates rapidly against that of the dollar over a year, this will reduce the dollar value of the euro profit made by the European subsidiary resulting in negative translation exposure. In fact many U.S firms suffered from significant translation exposure in Europe during 2000, precisely because the euro did depreciate rapidly against the dollar.

Transaction Exposure

Transaction exposure is typically defined as the extent to which the income from individual transactions is affected by fluctuations in foreign exchange values. Such exposure includes obligations for the purchase or sale of goods and services at previously agreed prices and the borrowing or lending of funds in foreign currencies.

Types of Foreign Exchange Exposure

When we speak of foreign exchange exposure, we referring to the risk that future changes in a country’s exchange rate will hurt the firm. Foreign exchange values often affect the profitability of international trade and investment deals. Foreign exchange exposure normally broken into three categories transaction exposure, translation exposure, and economic exposure. Each is explained here.

1. Transaction Exposure
2. Translation Exposure
3. Economic Exposure

Managing Foreign Exchange Risk

The nature of foreign exchange risk was discussed already. There we described how changes in exchange rates alter the profitability of trade and investment deals, how forward exchange rates and currency swaps enable firms to insure themselves to some degree against foreign exchange risk, and how relative inflation rates determine exchange rate movements. In this section, we focus on the various strategies international businesses use to manage foreign exchange risk. We will examine the types of foreign exchange exposure, the tactics and strategies firms adopt in attempting to minimize the exposure to foreign exchange risk, and things firms can do to develop policies for managing foreign exchange risk.

Multilateral Netting

Multilateral netting allows a multinational firm to reduce the transaction costs that arise when many transactions occur between its subsidiaries. These transaction costs are the commissions paid to foreign exchange dealers for foreign exchange transactions and the fees charged by banks for transferring cash between locations. The volume of such transactions is likely to be particularly high in a firm that has a globally dispersed web of interdependent value creation activities. Netting reduces transaction costs by reducing the number of transactions.
Multilateral netting is an extension of bilateral netting. Under bilateral netting, if a French subsidiary owes a Mexican subsidiary $6 million and the Mexican subsidiary simultaneously owes the French subsidiary 44 Million, a bilateral settlement will be made with a single payment of $2 million from the French subsidiary to the Mexican subsidiary the remaining debt being canceled.
Under multilateral netting, the simple concept is extended to the transactions between multiple subsidiaries within an international business. Consider a firm that wants to establish multilateral netting among four European subsidiaries based in Germany, France, Spain, and Italy. These subsidiaries all trade with each other, so at the end of each month a large volume of cash transactions must be settled.

Centralized Depositories

Every business needs to hold some cash balances for serving accounts that must be paid and for insuring against unanticipated negative variation from its projected cash flows. The critical issue for an international business is whether from its projected cash flows. The critical issue an international business is whether each foreign subsidiary should hold its own cash balances or whether cash balances should be held at a centralized depository. In general, firms prefer to hold cash balances at a centralized depository for three reasons.
First, by pooling cash reserves centrally, the firm can deposit larger amounts. Cash balances are typically deposited in liquid accounts, such as overnight money market accounts. Because interest rates on such deposited normally increase with the size of the deposit, by pooling cash centrally, the firm should be able to earn a higher interest rate than it would if each subsidiary managed its own cash balances.
Second, if the centralized depository is located in a major financial center it should have access to information about good short term investment opportunities that the typical foreign subsidiary would lack. Also the financial experts at a centralized depository should be able to develop investment skills and know how that manager in the typical foreign subsidiary would lack. Thus, the firm should make better investment decisions if it pools its cash reserves at a centralized depository.
Third, by pooling its cash reserves, the firm can reduce the total size if the cash pool it must in highly liquid accounts, which enables the firm to invest a larger amount of cash reserves in longer-term, less liquid financial instruments that earn a higher interest rate. Each subsidiary maintains a cash balance that includes an amount for dealing with its day-to-day needs plus a precautionary amount for dealing with unanticipated cash demands. The firm’s policy is that the total required cash balance is equal to three standard deviations of the expected day-to-day needs amount. The three standard deviation requirement reflects the firm’s estimate that, in practice, there is a 99.87 percent probability that the subsidiary will have sufficient cash to deal with both day-to-day and unanticipated cash demands. Cash needs are assumed to be normally distributed in each country and independent of each other.(e.g. cash needs in Japan do not affect cash needs in china).
However, a firm ability to establish a centralized that can serve short-term cash needs might be limited by government imposed restrictions on capital flows across borders. Also the transaction costs of moving money into and out of different currencies can limit the advantages of such a system. Despite this, many firms hold at least their subsidiaries precautionary cash reserves at a centralized depository, having each subsidiary hold its own day-to-day needs cash balances. The globalization of the world capital market and general removal of barriers to the free flow of cash across borders are two trends likely to increase the use of centralized depositories.

Techniques for Global Money management

We now look at two money management techniques firms’ use in attempting to manage their global cash resources in the most efficient manner.

1. Centralized Depositories

2. Multilateral Netting