CHAPTER 2

FX Economic Exposure

FX economic exposure is sometimes a synonym for FX operating exposure, in the sense of referring to the impact of FX rates on a firm’s actual cash flows as opposed to reported financial statement accounting items. Other times, FX economic exposure refers to a specific type of FX operating exposure where the causes are related to “supply and demand” economics. This chapter introduces the impact of the interaction of FX rate changes and “supply and demand” economics on a company’s FX operating exposure.

Typically, FX economic exposure involves an impact on sales volume that complicates the analysis of FX exposure. As you will see, one complication is that a company’s degree of operating leverage becomes a factor that affects FX operating exposure. Higher operating leverage means that the operating cost structure has a higher proportion fixed costs relative to variable costs.

FX Rate Changes and Sales Volume Changes

Unexpected FX rate changes can affect a company’s sales volume in a variety of ways. One potential economic influence on sales volume, and thus on FX operating exposure, is an income (or wealth) effect. Sometimes when an economy’s own currency appreciates versus a foreign currency, consumers will pay less for a given volume of imported goods priced in the foreign currency and use some of the savings to increase purchases of goods priced in the home currency.

Say Houston Marine Equipment is a U.S. company that manufactures and exports marine sonar equipment to Australia with prices set in Australian dollars. If the Australian dollar appreciates (depreciates) by 10% versus the US dollar, the company will typically see a 7% rise (drop) in the volume of product demand. Given that the product’s pricing is fixed in Australian dollars, the exporter gets a compound effect from the FX rate change: (1) revenues in Australian dollars rise (drop) by 7% because of the sales volume change, and (2) revenues in US dollars rise (drop) additionally because of the FX conversion from Australian dollars to US dollars.

For example, if the Australian dollar appreciates by 10% versus the US dollar, from 1 $/A$ to 1.10 $/A$, and the Australian dollar revenues rise by 7%, from A$100 million to A$107 million, the revenues in US dollars rise from $100 million to 1.10 $/A$ × A$107 million = $117.7 million, an increase of 17.7%. Assume that the operating costs are stable in US dollars, are entirely variable costs, and are initially 60% of revenues. Thus, the operating costs would be $60 million initially and would rise by 7%, to $64.2 million, with a 7% rise in volume. The operating cash flow in US dollars rises from $40 million to $53.5 million, a rise of 33.75%. Thus, the “what if” estimate of the FX operating exposure to the Australian dollar is 33.75%/10% = 3.375.

As you see by comparing the example problem with the text example, the “what if” analysis does not result in the same answer for a 10% Australian dollar depreciation as for a 10% appreciation. The discrepancy is due to the nonlinear nature of FX exposure when volume changes are considered. However, the results are close, and perhaps the best estimate is the average of the two “what if” FX exposure estimates: (3.375 + 3.025)/2 = 3.2.

When FX changes affect volume, a purely domestic company may have a long FX operating exposure. For instance, consider a domestic supplier to firms with long FX operating exposures to a given foreign currency. An example is Finning Inc., the Canadian distributor of heavy equipment to Canadian customers, many of whom sell goods primarily in the United States with prices fixed in US dollars. So, when the US dollar depreciates relative to the Canadian dollar, Finning’s customers experience lower cash flows in Canadian dollars, and their orders for Finning’s products tend to drop. Thus, Finning has an indirect positive FX operating (economic) exposure to the US dollar, even though Finning’s sales are in Canada and in Canadian dollars.¹

Another classic scenario of a purely domestic firm with a long FX operating exposure is a domestic company with one or more foreign competitors. For example, say a U.S. company with no foreign operations competes against a Japanese firm in the United States. If the yen appreciates versus the US dollar (US dollar depreciates), the Japanese firm is inclined to lower output in the face of falling revenues when measured in yen. So, the U.S. firm’s market share, and its operating cash flow, will rise. The reverse scenario occurs when the yen depreciates (US dollar rises). Although the U.S. firm has no international operations, the FX operating exposure to the yen is positive, because the US dollar cash flow rises when the yen appreciates, and vice versa.

Not all economic effects imply a positive FX operating exposure. When an airline company’s home currency depreciates and overseas purchasing power is weaker, the company tends to experience lower demand for international travel by home country citizens. Since the airline’s demand and cash flows drop when the foreign currency appreciates versus the home currency, airline companies tend to have a negative FX operating exposure to foreign currencies.

Another economic effect can result for a good with a currency habitat of price: the currency in which, due to economic circumstances, the good’s price is effectively set. For example, the global price of many metals is in US dollars. Similarly, you saw that the US dollar is the currency habitat of price for airframes in the discussion of Airbus’s FX exposure. If the currency habitat of a good’s price is the US dollar, the good’s price changes to a non-US dollar buyer when the FX price of the US dollar changes. So, if the euro depreciates versus the US dollar, the German air carrier Lufthansa must pay a higher price in euros for an airplane bought from either Boeing or Airbus. The result may be a lower demand for airplanes. Non-U.S. mining companies, such as Australia’s BHP Billiton Company, face this economic effect when they sell metals outside the United States, as in the Western Mining Company box.

Operating Leverage

When a firm’s sales volume changes because of an FX rate change, the FX operating exposure also depends on the firm’s operating leverage, which describes the company’s operating cost structure in terms of fixed versus variable costs. The principle is that relatively higher fixed costs implies higher FX operating exposure.

To see the principle in an example, we extend the Houston Marine Equipment scenario in the previous section. Assume now that firm’s $60 million in initial operating costs are half variable ($30 million) and half fixed ($30 million), instead of all variable. The initial projected operating cash flow in US dollars is still $100 million − 60 million = $40 million. For a 10% “what if” appreciation of the Australian dollar versus the US dollar, from 1 $/A$ to 1.10 $/A$, the new variable operating costs are $30 million × 1.07 = $32.1 million, because of the 7% increase in production volume. The fixed operating costs remain at $30 million. The “what if” operating cash flow is $117.7 million − 62.1 million = $55.6 million, a rise of 39%. The “what if” FX operating exposure estimate is 0.39/0.10 = 3.90, compared to 3.375 found earlier if all operating costs are variable.

Price Elasticity of Demand

Changes in sales volume usually interact with product price changes per the product’s price elasticity of demand, which is the percentage change in product’s volume demanded, given the percentage change in the product’s price. Thus, price elasticity of demand is inherently negative, but for simplicity is expressed here as a positive number. For example, a price elasticity of demand of 2 says that if a product’s price is lowered (raised) by 10%, the volume demanded would rise (drop) by 20%.

For an exporting firm with no competitors, there is a “rule of thumb” when changes in sales volume are considered: the optimal FX pass-through policy is roughly equal to the percentage of variable operating costs that are not stable in the exposure currency.³

For example, consider again the United Valve and Eastern Fittings scenarios. Since 100% of United’s variable operating costs are stable in US dollars, the optimal FX pass-through policy would be 100%, meaning that United would pass through 100% of any FX rate change into the fittings price in euros. Similarly, you see in Exhibit 1.2a that Eastern’s proportion of non-euro variable operating costs is 100/260 = 0.385. So, the optimal policy would be to pass-through 38.5% of any FX rate change.

Assume that 1.70 is the price elasticity of demand for fittings in the Eurozone. Since United’s optimal FX pass-through policy is 100%, the firm will raise the fittings price in euros by 1(11.1%) = 11.1%, to €1.11, if the euro depreciates by 10% from 1.25 $/€ to 1.125 $/€. Given that the price elasticity of demand is 1.70, sales volume would drop by 1.70(11.1%), or 18.9%, to (1 − 0.189)400, or 324 fittings. The “what if” operating cash flow is (1.125 $/€)(€1.11)324 − 0.40(324) − 0.25(324) − 40 = $154, a drop of 23% from the initial operating cash flow of $200. The “what if” FX operating exposure to the euro is −0.23/−0.10 = 2.30.

Other things the same, a higher price elasticity of demand implies a higher FX operating exposure. For example, assuming a price elasticity of demand for fittings of 2, United’s sales volume would drop by 2(11.1%), or 22.2%. So, sales volume would drop to (1 − 0.222)400, or 311 fittings. The “what if” operating cash flow is (1.125 $/€)(€1.11)311 − 0.40(311) − 0.25(311) − 40 = $146, a drop of 27% from the initial operating cash flow of $200. The “what if” estimate of FX operating exposure to the euro would be −0.27/−0.10 = 2.70.

Competition and FX Operating Exposure

This section delves into how competition affects a firm’s FX operating exposure. The main idea is based on the microeconomics of how competing firms maximize profits. If two companies with different home currencies compete, an FX change will typically change the optimal outputs of the companies as well as the industry’s product price. The driver is how an FX change affects the competing firms’ relative variable operating costs. Fixed operating costs are irrelevant to profit-maximizing price and output decisions.

An important aspect of how competition affects a firm’s FX operating exposure is how the proportion of a firm’s variable operating costs incurred in the exposure currency compares with the industry average:

Now assume that United Valve and Eastern Fittings compete to supply pipe valve fittings in the Eurozone. As assumed earlier, United Valve produces entirely in the United States, with variable production cost of $0.40 per fitting and $40 in fixed operating costs. Eastern Fittings has variable production costs in euros of €0.32 per fitting and fixed operating costs of $40 in the United States. Both firms pay $0.25 per fitting for aluminum. Assume the firms produce a homogeneous product, and so customers are indifferent between United’s and Eastern’s product.

Clearly, United’s variable operating cost proportion incurred in the exposure currency is lower than Eastern’s. Thus, United’s FX operating exposure to the euro will be higher if competing with Eastern than operating with no competition. Eastern’s FX operating exposure to the euro will be lower if competing with United than operating with no competition.

To see these points in a numerical example, assume again that at the initial spot FX rate of 1.25 $/€, the two firms have the same variable production cost per fitting ($0.40 when expressed in US dollars). So, each firm initially projects to sell the same number of fittings, given the initial spot FX rate of 1.25 $/€. Assume each firm initially projects to sell 270 fittings at a price of €0.85. In US dollars, each firms initially projects revenues of €0.85(270)(1.25 $/€) = $286.88. United’s initially projected operating cash flow is $286.88 − 0.40(270) − 0.25(270) − 40 = $71.38, per Exhibit 2.1a. By design, Eastern’s initially projected operating cash flow (in US dollars) is also $71.38, given the initial spot FX rate, 1.25 $/€, per Exhibit 2.1b.

Exhibit 2.1a United Valve Co.

Exhibit 2.1b Eastern Fittings Co.

An unexpected change in the $/€ FX rate will affect the competitive balance in the industry. A depreciation of the euro weakens United’s relative competitive position, because Eastern’s variable operating costs (in US dollars) would be lower than United’s. Thus, Eastern has the incentive to produce more than United, and would have a higher market share than United.

For example, assume a 10% depreciation of the euro versus the US dollar, to 1.125 $/€, causes the following: (a) the fittings price rises by 7% to €0.85(1.07) = €0.91; (b) United drops production from 270 fittings to 223 fittings; and (c) Eastern drops production from 270 fittings to 253 fittings. Both firms’ revenues suffer because of the FX change, and the industry’s overall fittings production drops by 12%, from 540 to 476, roughly consistent with a price elasticity of demand of 1.70. United drops production by more than Eastern, reflecting United’s higher relative variable operating costs and thus Eastern’s stronger competitive position.

Exhibits 2.2a and 2.2b show the “what if” operating cash flow statements for United Valve and Eastern Fittings in US dollars, given the new spot FX rate of 1.125 $/€. Exhibit 2.2a shows that United’s new revenue in US dollars is $228.30 and new operating cash flow is $43.35, a drop of 39.3% from the projected operating cash flow of $71.38. So, United’s estimated FX operating exposure to the euro is −0.393/−0.10 = 3.93. Exhibit 2.2b shows that Eastern’s new revenue in US dollars is $259.01 and new operating cash flow is $64.68, a drop of 9.4% from the initially projected operating cash flow of $71.38. So Eastern’s FX operating exposure to the euro is equal to −0.094/−0.10 = 0.94.

Exhibit 2.2a United Valve Co.

Exhibit 2.2b Eastern Fittings Co.

If the euro instead unexpectedly appreciates, it is United Valve that would gain in competitive advantage, and Eastern Fittings’ position would weaken because its variable operating costs would be relatively higher. The effects are the reverse of the previous example. United would substantially increase production, and Eastern would change production by a more modest amount. A complete example would still show that United’s FX operating exposure to the euro is substantially higher than Eastern’s.

Note that in competition, United Valve has a higher FX operating exposure, 3.93, than as the sole firm in the market, 2.30, as estimated earlier. In contrast, Eastern Fittings has a lower FX operating exposure, 0.94, than as the sole firm in the market, 1.56, as estimated in an earlier problem. Why would Eastern’s FX exposure be lower if the company is competing than if not? First, recall that the only effective difference between the two competitors is that Eastern does more operational hedging with variable operating costs than United. Second, note that the Eurozone fittings market has an FX economic exposure that is driven by the price elasticity of demand for fittings. In competition, United bears most of the market’s inherent FX risk due to its lower operational hedging. Owing to its higher operational hedging, Eastern’s reactions to FX changes are smaller than United’s, and smaller than even if Eastern were the sole firm. Thus, in competition with United, Eastern bears less FX risk than as the sole firm in the industry.

Another point to see is that if United and Eastern were identical in their operating cost structure currency denominations, both firms would have the same FX exposure to the euro if either were the sole company in the industry. That is, competition per se does not affect FX operating exposure, only competitors’ relative variable operating cost currency denominations. For example, say a German automaker competes against a U.S. automaker for sales in the United States. If both companies produce autos in the United States, a change in the $/€ FX rate will have no impact on competitive position. If the German company produces autos in Germany, a depreciation of the euro versus the US dollar strengthens the German company’s competitive position versus the U.S. company.⁴

To focus on the impact of FX changes on production decisions in a competition scenario, the example assumed that the firms have the same level of fixed costs and that all fixed costs are incurred in US dollars. However, it is important to understand that neither the level nor the currency of fixed costs affect production volume decisions. At the same time, both the level and the currency of fixed costs would affect the FX operating exposure.

We can also think of either United Valve or Eastern Fittings as a Eurozone firm, with a home currency of euros and an interest in measuring FX exposure to the US dollar. Say Eastern Fittings is a Eurozone firm. With no competition, Eastern would have a negative FX operating exposure to the US dollar, because of the aluminum costs being in US dollars. However, competition with United will create a positive influence on Eastern’s FX operating exposure to the US dollar, for the same reason that the competition has a negative impact on Eastern’s FX operating exposure to the euro if the company is headquartered in the United States.

To see this point, note that the sum of an asset’s FX exposure to the euro from the US dollar point of view, , and the asset’s FX exposure to the US dollar from the euro point of view, , is 1, as shown in equation (2.1).⁵

FX Exposures: Different Currency Directions

You saw previously that Eastern Fittings’ is 0.94 when in competition with United. Thus, = 0.06, per equation (2.1). You can verify this result directly by viewing the operating cash flows from the perspective of euros instead of US dollars. For example, if the euro depreciates by 10% versus the US dollar, from 1.25 $/€ to 1.125 $/€, and Eastern’s operating cash flow drops from $71.38 to $64.68, as in Exhibit 2.2b, the equivalent operating cash flow in euros rises by 0.69%: from $71.38/(1.25 $/€) = €57.10 to $64.68/(1.125 $/€) = €57.49. Since the US dollar appreciates versus the euro by 11.1%, from 0.80 €/$ to 0.889 €/$, the FX operating exposure to the US dollar is 0.0069/0.111 = 0.06.

As in the example problem, Eastern’s with no competitor is 1.56, so would be −0.56. Thus, Eastern’s FX exposure to the euro is lower, and the FX exposure to the US dollar is higher, under competition than no competition. This scenario seems typical: the local firm has more local currency variable operating costs than an exporting foreign competitor, so competition implies both a higher exporter’s FX operating exposure to the local currency and a higher local firm’s FX exposure to the exporter’s currency.

That said, it is instructive to consider the less typical scenario where United Valve is a Eurozone firm and Eastern Fittings is a U.S. firm. United produces fittings in the United States, and then imports the fittings for sale in the Eurozone, with no operating costs denominated in euros. Eastern exports unfinished fittings from the United States to the Eurozone and then incurs significant variable operating costs denominated in euros. In competition with Eastern, United’s FX operating exposure to the US dollar would be −2.93, given that the FX operating exposure to the euro is 3.93. The FX exposure to the US dollar is lower than if United were the sole firm in the industry, −1.30, based on the = 2.30 result seen earlier. So, in this scenario, competition implies both a lower exporter’s FX operating exposure to the local currency and a lower local firm’s FX exposure to the exporter’s currency. The U.S. exporter, Eastern Fittings, has relatively more operating costs in the local currency than the Eurozone firm, United Valve.

Summary Action Points

• A firm’s FX economic exposure to a currency depends on its business, the product’s price elasticity of demand, the currency location of its operating costs, the home currency of competitors, and the degree of operating leverage.

• Higher operating leverage means relatively higher fixed operating costs versus variable operating costs, and all else the same, implies higher FX operating exposure.

• The viability of an FX pass-through strategy depends on the product’s price elasticity of demand and the extent of local competition.

• When firms compete, and have different strategies for operational hedging, the firm that does less operational hedging will have the higher FX operating exposure to the local currency.

Glossary

Competitive FX Exposure: A type of FX economic exposure involving competing firms with different home currencies.

Currency Habitat of Price: Term used to indicate the currency in which, due to the economic circumstances, the price of a good is effectively set.

FX Economic Exposure: A type of FX operating exposure that focuses on the impact of economic variables on sales volume.

Operating Leverage: The relative use of fixed operating costs instead of variable operating costs.

Price Elasticity of Demand: The percentage change in volume of a product’s demand, given the percentage change in the product’s price.

Problems

1. Extend the Houston Marine scenario in the text, where a 10% change in the Australian dollar versus the US dollar results in a 7% change in sales volume in the same direction. Assume that instead of manufacturing in the United States, the company makes the sonar devices in Australia, with operating costs in Australian dollars that are entirely variable and are 60% of revenues. Estimate the FX operating exposure to the Australian dollar, using a “what if” analysis and a 10% appreciation of the Australian dollar versus the US dollar.

2. Extend the previous problem, where Houston Marine manufactures in Australia. Assume instead that the company has higher operating leverage: initial operating costs are A$20 million variable and A$40 million fixed. The initial projected operating cash flow in US dollars is still $40 million. Use a 10% “what if” appreciation of the Australian dollar, from 1 $/A$ to 1.10 $/A$, to estimate the FX operating exposure to the Australian dollar.

For 3–5: Allegheny Company is a U.S. exporter of an industrial component to the Eurozone. The price per component is €10, and Allegheny projects to sell 1 million units, given the present spot FX rate of 1.30 $/€. The variable cost of producing in the United States is $6 per component, and the fixed operating cost is $1 million. After the product reaches Europe, the variable cost of distribution is €2 per unit, and the fixed operating cost is €1 million.

3. Find Allegheny’s optimal FX pass-through policy, if sales volume changes when price changes, based on the price elasticity of demand.

4. Assume that Allegheny decides to pass through 70% of any FX change to the customers. Find the new component price if the euro depreciates by 10% versus the US dollar.

5. Assume that the price elasticity of demand for Allegheny’s product is 1.50 and there is no competitor. Find the FX operating exposure using a “what if” scenario where the euro depreciates by 10% versus the US dollar.

6. The U.S. multinational company Georgia Industries Co. owns a U.K. subsidiary that produces locally in England. Until recently, the subsidiary had no competition, but now another U.S. company is exporting similar products to the British market. (A) Which firm has more operating costs denominated in the local currency? (B) Georgia Industries’ FX operating exposure to the British pound has likely (a) risen; (b) dropped; or (c) not changed.

7. The U.S. manufacturer Greene Co. exports to England. Until recently, Greene had no competition, but another U.S. company has started making similar products in England for the local market. (A) Which firm has more variable operating costs incurred in the local currency? (B) Greene Co.’s FX operating exposure to the pound has likely (a) risen; (b) dropped; or (c) not changed.

8. United Valve’s is 3.93 when competing with Eastern Fittings. Find via equation (2.1), and verify the result directly using United’s operating cash flows from the perspective of euros instead of US dollars: Per Exhibit 2.2a, if the euro depreciates from 1.25 $/€ to 1.125 $/€, United’s operating cash flow (in US dollars) drops from $71.38 to $43.35.

9. Triangle Industries Co. is a U.S. manufacturer of precision instruments. Until recently, Triangle’s local U.S. sales had no competition, but an Australian company is now exporting similar instruments to the U.S. market. (A) Which firm has more operating costs denominated in the local currency? (B) Triangle’s FX operating exposure to the Australian dollar has likely (a) risen; (b) dropped; or (c) not changed.

10. Sheffield Ltd. is a U.K. manufacturer of precision instruments. Until recently, Sheffield’s exports to the United States had no competition, but a U.S. company has started selling similar instruments in the U.S. market. (A) Which firm has more operating costs denominated in the local currency? (B) Sheffield’s FX operating exposure to the US dollar has likely (a) risen; (b) dropped; or (c) not changed.

Answers to Problems

1. Initially, the operating costs are $60 million when converted to US dollars, and the operating cash flow is $40 million. In US dollars, the operating costs would rise by 17.7%, to $70.62 million. The operating cash flow in US dollars rises from $40 million to $117.7 million − $70.62 million = $47.08 million, a rise of 17.7%. Thus, the “what if” estimate of FX operating exposure to the Australian dollar is 17.7%/10% = 1.77.

2. In Australian dollars, the new variable operating costs are A$20 million × 1.07 = $21.4 million, whereas the fixed operating costs remain at A$40 million. The “what if” operating cash flow in US dollars is (1.10 $/A$)(A$107 million − 21.4 million − 40 million) = $50.16 million, a rise of 25.4%. The “what if” operating exposure estimate is 0.254/0.10 = 2.54.

3. Convert the variable operating cost from euros to US dollars: €2(1.30 $/€) = $2.60. The ratio of non-euro to total variable operating cost is $6/8.60 = 0.70. The optimal FX pass-through policy is 70%.

4. The product price will change by 0.70 times [1/(1 − 0.10) − 1], or 0.70(0.111) = 0.078, or 7.8%. So, the new price will be €10.78.

5. The initial projected operating cash flow in US dollars is (1.30 $/€) (€10)(1,000,000) − $8.60(1,000,000) − 1,000,000 − 1,300,000 = $2,100,000. If the company raises the fittings price in euros by 7.8%, to €10.78, sales volume would drop by 1.50(7.8%), or 11.7%. So, sales volume drops to (1 − 0.117)(1,000,000) = 883,000. The “what if” operating cash flow in US dollars = (1.17 $/€)(€10.78)883,000 − $6(883,000) − (1.17 $/€)(€2)(883,000) − 1,000,000 − (1.17 $/€)€1,000,000 = $1,602,706, a drop of 23.7% from the initial operating cash flow of $2,100,000. FX operating exposure to the euro = −0.237/−0.10 = 2.37.

6. (A) Georgia Industries. (B) (b) Dropped. Since the new competitor exports products made in the United States, whereas Georgia produces locally, Georgia has more variable operating costs in local currency. So Georgia’s FX exposure will drop.

7. (A) The new competitor. (B) (a) Risen. This is the complementary scenario to the previous problem. In this case, the new competitor has more variable operating costs in the local currency, so Greene’s FX exposure is higher in the competitive setting than with not competition.

8. Per equation (2.1), = −2.93. The equivalent operating cash flow in euros drops by 32.5%, from €57.10 to €38.53, and the US dollar appreciates versus the euro by 11.1%. The FX operating exposure to the US dollar is −0.325/0.111 = −2.93.

9. (A) Triangle. (B) (a) Risen. Triangle has more operating costs denominated in the local currency (the US dollar). So, if Triangle were the U. subsidiary of an Australian parent that measures FX exposure to the US dollar, competition would make that FX exposure lower. But Triangle measures its FX exposure to the Australian dollar. From that currency perspective, competition makes Triangle’s FX exposure higher.

10. (A) The new competitor. (B) (a) Risen. The new competitor has more operating costs denominated in local currency, so Sheffield’s FX exposure to the US dollar will be higher in competition than with no competition.

Discussion Questions

1. Explain the difference between FX operating exposure, FX economic exposure, and FX competitive exposure.

2. Explain why operating leverage effects FX operating exposure when sales volume is affected by FX changes.

3. Explain how an increase in competition can cause a firm’s FX operating exposure to a currency to be higher; and a different firm’s FX operating exposure to be lower.

4. Explain the role of operational hedging when an exporter competes with a local firm.