Exchange Rate Exposure

Case Study: SalesCo 1

You are a member of the management team of SalesCo, a technology company
selling a variety of different machines to various countries. Their headquarters is
based in the UK but they have two sales subsidiaries: one in Norway and one in
France. SalesCo have a lot of customers in the USA and Australia but they do not
have a subsidiary there – they ship the machines out to these customers from the
UK. Australian and American customers are given price lists denominated in their
own currency (AUD and $).

A US customer orders a laser machine from SalesCo; on their price list, the US
customer has seen that this laser machine costs $480,000 and they have the option
of taking 6 months credit. For SalesCo, the cost of producing and shipping the laser
machine is £300,000. At the time of the sale, the XR was £1: $1.50.

You hope that the customer will pay the $480,000 in dollars immediately. You want
to convert this $-amount into sterling. Based on the XR at the time of sale, how much
profit (in sterling!) do you expect to make on this one machine?

Expected receipt: $480,000/1.5 = £320,000
Costs: £300,000
Expected profit: £320,000 – £300,000 = £20,000

After you have done this calculation, the customer phones you to tell you that they
will use the full 6 months credit period and will pay the $480,000 in 6 months’ time.

In six months’ time, the customer actually pays the $480,000 and you want to again
convert it to sterling. The XR now is £1:$1.65. What does your profit look like?

Expected receipt: $480,000/1.65 = £290,909
Costs: £300,000
Expected profit: £290,909 – £300,000 = -£9,091 LOSS, NOT PROFIT!

Alternatively, the XR in 6 months’ time is £1:$1.40. Again, what does your profit look
like?

Expected receipt: $480,000/1.40 = £342,857
Costs: £300,000
Expected profit: £342,857 – £300,000 = £42,857 MORE PROFIT!

What is this form of XR exposure called? And why is that its name?

Transaction exposure; because the company is exposed to XR movements as soon
as there is a transaction of money across borders

What could be potential strategic issues with this kind of exposure?

Any transaction of money from one currency to the next carries the risk of being
affected by XR movements.
This refers also to transactions that are bound to happen, but that have not
happened yet – the exposure is there already but clearly the actual profit/loss does
not happen until the transaction is actually carried out, e.g. when price lists are
denominated in foreign currencies; when prices are agreed in foreign currency; when
companies decide to merge, acquire or build JVs and decide upon the value of the
shares to be exchanged/bought/created.

Case Study: SalesCo 2

At the end of the year, SalesCo has to create consolidated accounts for all their
operations, including the subsidiaries in Norway and France. This is a summary of
their accounts:

French subsidiary Norwegian subsidiary
€ NOK

Profit and Loss Account
Profits for Year 378,000 480,000

Balance Sheet
Assets 2,457,000 3,840,000
Bank loans -491,400 -960,000
Net assets 1,965,600 2,880,000

The exchange rate at the end of the year can be:
Either: £1:€1.50 and £1:NOK1.50
Or: £1:€1.40 and £1:NOK1.60
Translate the profits of both subsidiaries into sterling, for both possible exchange
rates.

French subsidiary Norwegian
subsidiary
£ £
Profits at £1:€1.50 252,000 Profits at £1:NOK1.50 320,000
Profits at £1:€1.40 270,000 Profits at £1:NOK1.60 300,000
Difference between
the two

+18,000
Difference between
the two

-20,000

What does this mean for SalesCo? For its shareholders? Should decisions be made
based on such translated XRs?

Variations across years can be based purely on XR movement, not performance of
the subsidiary – should any decisions relating to e.g. closure of subsidiaries be
based on this? Probably not, but shareholders may only look at the figures and
become dissatisfied based on what they see in the books. They may request actions
to address “seemingly” under-performing operations.
It is important to consider that this is NOT a cash loss/gain but purely a matter of
translating figures on a specific day.

What is this form of XR exposure called? And why is that its name?

Translation exposure; because the company is exposed to XR movements as soon
as it translates any form of financial information from one currency to another.
This does NOT include an actual transfer of money and there is NO ACTUAL cash
loss. This is purely ON PAPER.

A translation analysis can also be carried out with the value of the company’s assets
– you will see that the translated sterling value of the assets depends upon the XR
used. What could this mean for companies?

ANY asset has different values, depending on the XR used to translate the value. A
company itself (or any major project) also has a value – thus, consideration of values
(e.g. when companies decide upon the valuation of shares for M&A or the creation of
a JV entity) is affected by translation exposure.
Shareholder may reject certain projects because the value on paper may not look
sufficiently large to create shareholder wealth.

Case Study: SalesCo 3

SalesCo produces its products in the UK and exports them to Australia. The
production costs occur in £, but the pricing of the products occurs in AUD. SalesCo
competes against Australian companies that also have price lists in AUD but at the
same time their production costs occur in AUD as well.

SalesCo sell an x-ray machine to a Australian customer, which is priced at AUD
510,000. Currently, the XR is AUD 1 : £0.64. The x-ray machine costs £310,000 to
produce and ship. Two scenarios:

Based on the current XR, what would be SalesCo’s receipt and profit in sterling?

Receipt: AUD 510,000*0.64 = £326,400
Profit: £326,400- £310,000 = £16,400

Imagine the following two scenarios:

1) Sterling depreciates to: AUD 1 : £0.75

In sterling, how much does SalesCo receive and what would its profit be?

Receipt: AUD 510,000*0.75 = £382,500
Profit: £382,500 – £310,000 = £72,500 MORE PROFIT THAN WITH
PREVIOUS XR

2) Sterling appreciates to: AUD 1 = £0.55

In sterling, how much does SalesCo receive and what would its profit be?

Receipt: AUD 510,000*0.55 = £280,500
Profit: £280,500 – £310,000 = -£30,000 LOSS

What are the strategic issues relating to the above scenarios?

XR movements can cause competitive dis-/advantage for companies.
e.g. in scenario 2, SalesCo ultimately makes a loss on the technology sold. Possibly
probe students to find out: what could SalesCo do to address this competitive
disadvantage? They can react in the following ways:
? Do nothing ? reduction in £-proceeds; possibly reduced demand from
Australian customers especially if the Australian competitors can reduce their
own prices to gain more market share
? Increase prices ? maintain profit margin, but lose market share ? loss of
profit
? Use some form of hedging or internal mechanisms for dealing with XRs, e.g.
pricing in £ ? can have negative effects on the customers who want to pay
in their own home currency
DISADVANTAGES!

e.g. in scenario 1, SalesCo can reduce its price in Australia and subsequently gain
additional market share there
ADVANTAGE!

What is this form of XR exposure called? And why is that its name?

Economic exposure or competitive exposure; because the company’s exposure to
XR movements affects the trading/competitive position of the company in relation to
other companies. This is not about issues relating to transaction or translation of
figures, but it is about the positioning of the company in the market, which clearly can
be affected (positively and negatively) by the movements in XRs.

Application of XR exposures/risks to cross-border collaborations

Consider your knowledge of the effects of XR exposures and consider how these
might impact upon cross-border deals like M&As or JVs, both during their
exploration/negotiation phase and after the deal has been implemented. Consider
positive and negative impacts and think about the tree types of XR exposure.

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