Strategic Management of Operating Exposure

European Management Journal Vol. 22, No. 1, pp. 53–62, 2004 2004 Elsevier Ltd. All rights reserved.Pergamon

Printed in Great Britain0263-2373 $30.00doi:10.1016/j.emj.2003.11.015

Strategic Management ofOperating ExposureROBERT GRANT, Georgetown University, Washington, D.C.LUC SOENEN, California Polytechnic University and Tilburg University, The Netherlands

We identify operating exposure as the mostimportant and difficult to manage component ofexchange risk. Our model identifies three compo-nents of foreign exchange exposure: directoperating exposure, the market demand effect, andthe competitive effect. The size and relative impor-tance of these components depends critically uponinternational market structure and firm strategies.We derive implications for managing foreignexchange exposure. 2004 Elsevier Ltd. All rights reserved.

Keywords: Exchange rate risk, Operating exposure,Foreign exchange exposure

Internationalization of the economies of most nationshas meant that companies are increasingly subject tothe risk associated with exchange rate movements.Despite consensus over the importance of exchangerate risk, the ability of companies to effectively man-age these risks has been limited by confusion overthe definition of such risk and the appropriate toolsfor managing exchange rate risk. In terms of bothdefining and controlling exchange rate risk, a funda-mental distinction is between accounting exposureand economic exposure (Lessard and Lightstone,1986; Oxelheim and Wihlborg, 1987). Accountingexposure arises from the need to report the firm’sfinancial condition and results in a common cur-rency. The financial statements of foreign operationsare converted from the local currencies involved tothe reporting currency.1 Accounting exposure is thevariance in the book value of the firm resulting fromchanges in the home currency value of foreign cur-rency-denominated assets and liabilities. Althoughaccounting exposure has received considerable atten-tion in the international finance literature, its rel-evance to managerial decision making is doubtful.Since management’s goal is supposedly to operate inthe interests of its owners by maximizing the marketvalue of the firm, the basic problem with accountingexposure is that book values bear little relation toshareholders’ wealth maximization.

From the viewpoint of the wealth-maximizing firm,

European Management Journal Vol. 22, No. 1, pp. 53–62, February 2004 53

economic exposure, defined as the ‘sensitivity of afirm’s economic value to changes in the exchangerate’ (Oxelheim and Wihlborg, 1987), is the relevantexchange rate risk. Since the market value of the firmis the discounted value of net cash flows to the firm,the critical issue in determining economic exposureis establishing the impact of exchange rate move-ments on net cash flow. Economic exposure com-prises two components: transaction and operatingexposure. Transaction exposure is the fluctuation inthe home currency value of foreign currency-denomi-nated contracts for which the price has been fixed.Operating exposure is the fluctuation in futureoperating cash flows (whether denominated in homeor foreign currencies) in response to variations in realexchange rates. For most firms, operating exposureis a far more important source of risk than transactionexposure. While transaction exposure is short-term,relating to the period between entering and settlingcontracts, operating exposure affects any firm withforeign buyers, suppliers or competitors (or whosedomestic suppliers or customers have foreign sup-pliers, buyers or competitors) through its impact onsales revenues and input costs. Operating risk arisesnot only because revenues and costs are denomi-nated in different currencies (direct operatingexposure), but also from the fact that costs of compet-ing firms are in different currencies (competitiveoperating exposure).

While techniques for managing accounting and trans-action exposure are well-established (see, forinstance, Soenen, 2000), approaches to managingoperating exposure are less developed. Actually, thisshort-term focus on foreign exchange managementhas been documented in the Wharton Survey ofDerivatives Usage by US Non-Financial Firms. Bod-nar et al. (1996) report that firms worry most aboutthe impact of financial risk on current cash flows andless about distant cash flows. However, the more fun-damental question of preserving the firm’s overallearnings potential requires a long-term view ofexchange risk management. Management needs toconcentrate on the management of the firm’soperating exposure. An important feature of manag-

%the basic problem with

accounting exposure is that

book values bear little relation

to shareholders’ wealth

maximization

STRATEGIC MANAGEMENT OF OPERATING EXPOSURE

ing operating risk is its strategic character, becauseoperating risk is associated with a stream of trans-actions rather than individual transactions, the timehorizon for hedging extends beyond that providedby conventional hedging instruments. As a result,managing operating exposure raises organizationalissues. The strategic aspect of exchange risk manage-ment means that it cannot be relegated to the firm’streasury department. Managing exchange rate riskbecomes a general management issue.

The purpose of this paper is to investigate the deter-minants of operating exposure arising from unpre-dictable foreign exchange movements. We placeparticular emphasis on the relationship between mar-ket structure and operating exposure. While the com-petitive structure of international markets has beengenerally recognized as important in determining theextent and characteristics of exchange rate risk, therehas been little in the way of systematic analysis ofthe relationship between mar-ket structure and exchange raterisk. Having analysed thedeterminants of operatingexposure, we then develop a setof propositions concerning themanagement of these risks. Ourresearch contributes to theanalysis and management ofexchange risk in two ways.First, it provides an analysis ofexchange rate risk that incorporates a range of differ-ent market structures and assumptions about pricingpolicy and, in doing so, extends the work of VonUngern-Stenberg and Von Weizsacker (1990) andLuehrman (1990). Second, it links the analysis ofexchange rate risk to strategies for managing thisrisk.

Before analysing the determinants of operatingexposure and drawing predictions for its strategicmanagement, let us first explain the importance of astrategic approach to managing operating exposureby discussing the shortcomings of conventionalhedging procedures.

Inadequacies of Financial Hedging

The international financial literature is increasinglycoming around to the view that, for the purpose ofmanaging economic exposure, conventional hedgingtechniques are of dubious value, and may even bevalue-reducing (Lessard and Lightstone, 1990; Grantand Soenen, 1991). There are four main argumentshere:

The Dangers of Incomplete Hedging

Conventional approaches to exchange risk manage-ment focus upon hedging against accounting and

European Management Journal Vol. 22, No. 1, pp. 53–62, February 200454

transaction exposures, but such techniques provideno solution to operating exposure. For example, for-ward purchases of yen by General Motors to coverits payments for car imports form Japan provide ahedge for GM’s transaction exposure but not againstoperating exposure. Any persistent change in thevalue of the yen relative to the dollar changes GM’scompetitive position vis-a-vis its Japanese rivals thusimpacting GM’s cash flows. Indeed, in this case,hedging transaction risk exacerbates GM’s operatingexposure to yen/US dollar volatility. GM’s sourcingof cars in Japan provides a partial operating hedgeagainst changes in its competitive position in the USmarket relative to Japanese automobile makers. Byhedging its yen position, GM defeats that naturalhedge, in the short term at least.

Similarly, hedging accounting exposure by means offinancing foreign assets in the local currency mayincrease operating exposure. The subsidiaries of the

Royal Dutch/Shell Group arefinanced mainly by dollarloans. Since the currency ofreporting is the British poundand the Dutch guilder, anyappreciation in the dollarcauses a translation loss. How-ever, the economic exposure ofthe Group is not determined bythe currency of denominationof its assets but by the currency

of price determination for the products generated bythe assets. As the prices of oil and oil products are setin US dollars, financing foreign activities with dollarloans helps to hedge operating exposure: debt servic-ing in dollars partly offsets dollar-denominated rev-enues. Financing in any other currency might reduceaccounting risk but would create operating exposure.

Operating risk may exist where the firm has noaccounting or transaction exposure, and may evenarise where a firm has no international transactions.Harley Davidson Inc. has limited internationalactivity, nevertheless, a major determinant of its com-petitive position relative to its Japanese rivals is theyen/US dollar exchange rate. As we shall see, formany firms this competitive exposure is the maincomponent of operating exposure.

Nominal Versus Real Exchange Rate Movements

One of the oldest theorems in international finance,purchasing power parity (PPP), implies that gains orlosses from exchange rate changes tend over time tobe offset by differences in inflation rates. If a com-pany’s revenues and expenses increase in accordancewith the general price level, real profits should be leftunchanged, making exchange risk unimportant in thelong run. Hence, conventional financial hedgingagainst operating risk encounters the problem thatthe relevant exchange rate for hedging operating

%repeated hedges do not

reduce the exchange risk for

the firm in the long run


exposure is the real exchange rate. If nominalexchange rates adjust to offset differences in inflationrates between countries — thus maintaining purchas-ing power parities — then operating exposure is non-existent and hedging is unnecessary. Because nomi-nal exchange rate movements are closely correlatedwith inflation rates, real exchange rates are far morestable than nominal rates. So long as the companymakes purchases and sales on a spot basis and avoidslong-term contracts fixed in terms of foreign cur-rencies, operating risk is modest. However, byattempting to hedge nominal exchange rates, thatcompany would open itself to considerable risk.

There is an extensive empirical literature (forinstance, Roll, 1979 and Protopapakis and Stoll, 1983)that documents deviations from PPP, i.e. changes inthe real value of currencies. Adler and Lehman (1983)and Abuaf and Jorion (1990), among others, havereported significant long rundeviations from PPP. Hence, ifthe firm’s planning horizon isshorter than what is needed forPPP to hold, the firm is exposedto exchange risk. The firm’srelative competitive positionchanges as changes in the nominal exchange rate arenot offset by the difference in inflation rates betweenthe two countries. The firm must, therefore, copewith risk arising from both changes in the generalprice level and in relative prices of specific inputs andoutputs. Since financial derivatives exist in individ-ual commodities but not in a representative basket ofgoods and services, it is not easy to hedge againstchanges in real exchange rates.

The Problem of Undefined TransactionsExtending Long Into the Future

The ability of the firm to use financial instrumentsto hedge cash flows runs into the problem that thefinancial instruments are specific with regard toamount and timing, while cash flows are uncertainand extend far into the future. The use of short-termhedging instruments to hedge continuous cash flowsdoes not reduce operating risk, it simply lags it bythe period of the hedge. In general, hedging is notuseful for activities for which the firm’s planning andaction horizon extends beyond that of the hedginginstrument. Consider a US firm that is alwaysimporting finished products from Japan for distri-bution in the US. Assume that the yen-payables areon terms net 30 days. Here, the firm is faced with acontinuous cash outflow denominated in yen. A fin-ancial hedge consists of buying yen forward, goinglong in yen futures, buying yen calls or writing yenputs, or creating a yen deposit. As the exposure islong term, one would have to repeatedly roll overthe hedge. When the yen appreciates against the US,as has been the case since mid 1985, both spot andforward rates will rise. Each successive forward yen


purchase comes at a higher dollar price, making therelief provided by hedging at best temporary and atworst illusory (Soenen, 1991). To the extent that for-ward exchange rate is an unbiased estimator of thefuture spot rate, if we enter into a financial hedge ornot, the firm will on average end up with the sameexchange rate, that is the actual future spot rate.Although the financial hedge takes care of the short-term exposure (i.e. transaction exposure), repeatedhedges do not reduce the exchange risk for the firmin the long run.

Risk Hedging and Shareholder Value

Finally, in a world of efficient currency and securitiesmarkets there is doubt as to whether any kind ofhedging activity creates value for shareholders. Ifshareholders can hold internationally-diversified

portfolios, or if they themselvescan hedge the exchange risksassociated with their sharehol-dings, then there is no reasonwhy hedging creates value forthe shareholder. Stated in termsof the capital asset pricing

model, if share prices are determined by a firm’sexpected return and its non-diversifiable (systematic)risk, then activities such as exchange rate hedgingwhich only reduce diversifiable (unsystematic) risk,do not increase the share price. Indeed, to the extentthat hedging activities by firms incur administrativeand financial costs in excess of the cost of comparablehedging activities by institutional or individualinvestors, then hedging by a company actuallyreduces its market value.

Once we introduce imperfections into financial mar-kets, then these arguments do not necessarily hold.Suppose a firm faces a borrowing constraint. Anadverse movement in the exchange rate that is sus-tained over several years may permanently impaira firm’s competitive position. Consider the weightedaverage of the foreign exchange value of the US dol-lar against the currencies of a broad group of UStrading partners (Figure 1).

Over-valuation of the US dollar (relative to its PPPrate of exchange) extending from 1980 to 1985depressed the net cash flows of many export-depen-dent US firms. For some, accompanying loss of mar-ket share and reduced investment in R&D and facili-ties may also have had a permanent impact on futurecash flows. For instance, Caterpillar, the leadingmaker of earthmoving equipment, was driven to thebrink of bankruptcy at that time because of thestrength in the US dollar versus the yen (especiallyKomatsu) and European currencies (Poclain,Liebherr). In the same way, the current strength ofthe British pound has made it very hard for anymanufacturer in the UK to compete in the globalarena. This was recently announced by several lead-


Figure 1 Multilateral Trade-weighted Value of the US Dollar (March 1973=100)

ing Japanese firms, i.e. Toshiba has described thelevel of sterling as ‘unbearable’ and warned its con-tinued strength could force the closure of its last UKmanufacturing base (Ibison and Brown, 2000). In thesame Financial Times article, it is reported that Kom-atsu, the construction equipment manufacturer saidthat it was considering siting a new plant in the euro-zone instead of the UK, while Nissan recently urgedthe British government to move towards euro-mem-bership.

Moreover, even if it is possible for shareholders tocontrol exchange rate risk by means of holding inter-nationally-diversified portfolios, such diversificationopportunities may not be available to other stake-holders — including employees, distributors, cus-tomers and suppliers. However, this assumes thateconomic exposure is idiosyncratic and not system-atic. Only then should a company remain un-hedgedbecause stockholders can effectively diversify awaythe risk by holding a broadly diversified portfolio. Itremains an unanswered question whether economicexposure to exchange risk is idiosyncratic or system-atic. If economic exposure is a determinant of a firm’ssystematic risk, then the measurement, managementof, and hedging of this risk is of concern to stock-holders.

Determinants of Operating Exposure

The value of the firm is the sum of the present valuesof its expected future net operating cash flows con-verted to the home currency. These operating netcash flows correspond to net profits from operations:operating profits net of interest and tax, but includingdepreciation and other accounting items not involv-ing actual cash flows. We shall refer to net operatingcash flows as ‘profits’. Thus the present value of thefirm at time 0, V0, is given by:


V0 � �T

t � 0�tr�t (1)

where T is the last (termination) period of the firm,r is the rate of discount over the period and �t is thenet operating cash flow during period t, after conver-sion to the home currency.

We have defined economic exposure as the sensi-tivity of a firm’s net operating cash flows to move-ments in the exchange rate between its home cur-rency and foreign currency i. Following Hodder(1982) and Oxelheim and Wihlborg (1987), we canmeasure this exchange rate risk in a manner anal-ogous to the way in which the capital asset pricingmodel measures asset risk. The firm’s cash flow com-prises a portfolio of cash flows in different currencies.The contribution of exchange rate fluctuations tofluctuations in the firm’s cash flow can be measuredas the covariance between the exchange rate (eit) andthe net cash flow (t) relative to the variance of thecash flow:

cov(eit,�t)var(�t)

(2)

where eit is the exchange rate of currency i in termsof the home currency at time t.

However, equation (2) simply defines economicexposure and provides a formula for its estimation.In order to identify methods for managing risk, weneed to understand the covariance between eit and t,i.e. the relationship between changes in the exchangerate and changes in net cash flows, that is:

��t

�eitwhich, in the limit, �

d�t

deit

Note that our definition of economic exposure


includes both transaction and operating exposure, i.e.net cash flow (�) includes both contractual and non-contractual transactions. To focus attention onoperating exposure, we shall assume that all trans-actions are non-contractual.

Since net cash flow in each equals revenues less costs,the key issue is to determine how exchange ratechanges influence the margin between revenues andcosts. Thus, ignoring taxes, profit in period t in termsof the home currency may be expressed:

�t � �i(pit.qit�cit.qit) eit (3)

where qit is the quantity of goods sold in period tdenominated in currency i; pit is the unit pricecharged for goods sold during time period t denomi-nated in currency i; and cit is the cost per unit of out-put incurred in currency during period t.

The demand function facing the firm relates thequantity of goods sold to the price set by the firmand the prices set by other firms (p�it). FollowingHenderson and Quandt (1971), we dichotomize theimpact of price on quantity demanded into a con-stant market share effect that shows the effect ofchanges in the firm’s price where the price differen-tial with competitors remains constant, and a marketshare effect which shows changes in quantitydemanded arising from changes in price differentialscausing shifts in market share.

�qit � Qit[�pit,�(pit�p’it)] (4)

where p�it is the price charged by competitors incountry i.

The impact of a change in the value of currency i onthe firm’s profits can be found by taking the partialderivative of equation (3) with respect to the rate ofexchange, ei (for simplicity, we shall ignore thetime subscripts):

d�

dei� piqi�ciqi � ei

δqi

δpi.δpi

δei� ei

δqi

δ(pi�p�i).δ(pi�p�i)

δei

(5)

δ�

δei� piqi � ciqi

direct operating exposure� Eqi,pi.Epi,ei.qi � ei

δqi

δ(pi�p�i)market demand effect

.δ(pi�p�i)

δeicompetitive effect

(6)

where Eqi,pi is the price elasticity of demand for thefirm’s sales in currency area i, and Epi,ei is the elas-ticity of the firm’s price in country i with respect tothe domestic currency price of one unit of currency i.

The impact of exchange rate changes upon theprofitability of the firm, therefore depends upon thefollowing factors:


Direct Operating Exposure

The direct impact of exchange rate changes upon pro-fit depends upon the extent of imbalance in the firm’scash inflows and outflows in each currency. Thus,consider the first two arguments in equation (6). If(piqi�ciqi) � 0, the firm has a long position in cur-rency i, implying that, in the absence of other factors,dII/dei � 0, i.e. a strengthening of the currencyincreases the firm’s profits in terms of its own cur-rency. This situation would exist for any firm whichexports from its home base to another country. To amuch smaller degree, it would also exist for a ‘multi-domestic’ firm — one that comprises independentnational subsidiaries, each producing for its homemarket. To the extent that the subsidiary i is profit-able, an increase in currency i’s exchange rate has noeffect upon the subsidiary’s profits as measured incurrency i, but they are converted to the home cur-rency at a higher rate.

Where (piqi�ciqi) 0, the firm has a short positionin currency i for period t implying that, in theabsence of other factors, dII/dei 0, that is, astrengthening of currency i reduces the firm’s profits.This situation would exist for a company sourcing itsproducts or raw materials from country i. The greaterthe proportion of the firm’s costs incurred in countryi, the greater is the reduction in profits from a risein ei.

The Market Demand Effect

The ‘market demand effect’ shows the impact ofchanges in price upon quantity demanded in theabsence of any competitive effects. The starting pointfor predicting the direction and magnitude of thiseffect is examination of the impact of an exchangerate change upon the prices charged by the firm. Thisdepends upon the pricing policy of the firm. Toestablish the range of Epi,ei consider three situations:

1. If the firm is a price follower, where the price lead-ers are domestic suppliers, then, to the extent thatdomestic competitors are unaffected by changes inthe exchange rate of their domestic currency, Epi,ei

can be expected to equal zero.2. If the firm is a price leader, following cost-plus

pricing, and is operated as a multi-domestic firmwhere each national subsidiary is a stand-aloneentity, then all the costs of supplying products incountry i are incurred within country i, hence, wecan expect that Epi,ei = 0.

3. If the firm is a price leader, following cost-pluspricing, and serves overseas markets by exportingfrom its home base, then any change in ei willchange unit costs (measured in currency i) by anequal and opposite proportion. Thus, Epi,ei = 1.

We can therefore expect that 0 Epi,ei �1.


The impact of any change in price, assuming that allcompeting suppliers move their prices together, isdetermined by the constant market share elasticitycoefficient (Eqi,pi), which is equal to the normal priceelasticity of market demand. Since the elasticity ofprice with regard to the exchange rate is normallynegative, and the price elasticity of market demandis also negative, the implication is that the marketdemand effect is positive (i.e. changes is exchangerates are positively correlated with changes inprofitability, and the greater the elasticity of demand(in absolute terms) the greater is the impact.

The Competitive Effect

The competitive effect of an exchange rate changerefers to the change in the firm’s profit caused by acurrency rate change affecting the competitive pos-ition of the firm relative to its rivals. Our modelshows that the competitive effect comprises twoterms: the impact of exchange rate changes uponprice differentials, and the impact of changing pricedifferentials upon sales as measured by the sensi-tivity of sales to relative prices. Let us consider eachof these relationships separately.

❖ The impact of exchange rate changes upon pricedifferentials

If we assume that prices are cost determined,then exchange rate changes will give rise tochanges in price differentials between the firmand its competitors whenever the currency com-position of costs is different between them.

pi � (1 � g)�ieici

ei

and

p�i � (1 � h)�ieic�i

ei

whereci is the unit cost incurred in country ic�i is the equivalent unit cost incurred by thefirm’s competitors in country ig is the cost markup used to determine priceh is the equivalent markup used by competi-tors. Hence:

d(pi�p�i)dei

�(1 � h)�ieici

ei2 �

(1 � g)�ieic�i

ei2

We observe, therefore, that the direction and magni-tude of the competitive effect depends upon the firmsallocation of its costs across currencies, compared tocompetitors’ allocation of their costs. Consider thefollowing situations:


❖ If the firm and its competitors incur equal allo-cations of their costs between country i and therest of the world i.e. �ieici = �ieic�i, then change inthe exchange rate i leaves relative costs and rela-tive prices unaltered i.e. d(pi�p�i)/dei = 0.

❖ If the firm has less of its costs incurred in countryi than its competitors i.e. �ieici �ieic�i, then anincrease in the exchange rate of i tends to increasethe firm’s costs and prices relative to those of itscompetitors i.e. d(pi�p�i)/dei � 0.

❖ If the firm has more of its costs incurred outsideof country i than its competitors i.e. �ieici ��ieic�i, then an increase in the exchange rate of itends to decrease the firm’s costs and prices rela-tive to those of its competitors i.e. d(pi�pi

�)dei 0.

An implication of the competitive effect is that a firmwith no direct involvement in international businesscan be vulnerable to operating exposure. Theexample given above of Harley Davidson’s exposureto movements in the dollar/yen rate can be examinedwithin this framework. Denote currency i as theJapanese yen. Harley Davidson has none of its costsin yen (i.e. ci = 0). Assume that Japanese motorcyclemanufacturers incur 75% of their costs in yen (i.e.c�i /�ic�i = 0.75). A rise in the yen against the dollarwill tend to raise the price of Japanese motorcyclesrelative to those of Harley, therefore, d(pi�p�i)/dei

0.

In reality, the situation is somewhat more complex.To fully examine the competitive effect of exchangerate changes we need to know, not only the cur-rencies in which costs are incurred, but also howinput prices are determined. Consider British Pet-roleum (BP) competing with Atlantic Richfield (Arco)in the California gasoline market. Arco’s primarysource of crude oil is Alaska, BP’s production is moreheavily concentrated in the North Sea. A depreciationof the British pound against the US dollar might beexpected to give BP a cost and price advantage overArco. However, because oil is an internationallytraded commodity, it is priced in dollars worldwide,hence although oil companies differ in their sourcesof crude, exchange rate movements have only mini-mal effects upon competitiveness.

❖ The sensitivity of quantity demanded to price dif-ferentials

The extent to which an increase in the differentialbetween the firm’s price and that of competitorscauses quantity demanded to fall depends upon mar-ket structure. The greater the number of competitorsand less differentiated are their products, then thegreater the sensitivity of demand to price differen-tials. In the case of a firm supplying a homogeneousproduct with many competitors, then the ratio elas-ticity of quantity demanded with respect to relativeprice might approach infinity, that is, the emergenceof a small price differential might cause quantity


demanded to drop to zero. Conversely, for a highlydifferentiated product in a concentrated market, theelasticity might approximate zero.

Table 1 summarized the predictions of our modelconcerning the determinants of operating exposureto currency rate fluctuations.

Implications for the StrategicManagement of Operating Risk

Before we can begin to identify strategies for manag-ing operating exposure, we need to clarify compa-nies’ objectives with regard to exchange risk. Thecritical strategic choice for the firm is between hedg-ing and opportunism with regard to exchange rate

Table 1 Summary of Predictions Concerning the Determinants of Operating Exposure

The impact of changes in exchange rate i upon the firm’s profit (π) depends upon the following variables:

The Direct Exposure Effect The firm’s net cash flow position in The sign and the size of the impact of changescurrency I in exchange rate ei depend upon the sign and

size of the firm’s net cash flow in currency i.The more country i is a market base for thefirm, then the greater is the positive impact ofany increase in ei. The greater the extent towhich country i is a production base for thefirm, then the greater is the negative impact ofany increase in ei.

The Pricing Policy Effect The pricing policy of the firm The pricing policy of the firm influences theextent to which a change in exchange rate ei

results in changes in the firm’s price in countryi, pi. In particular, whether the firm is a priceleader or price follower, and if a leader,whether the firm sets a single world price, orprice discriminates by country.

The price elasticity of market The greater the (absolute value of the) pricedemand elasticity of market demand for the firm’s

product, the greater the profit impact of anychange in exchange rate ei.

Market Structure Effects Seller concentration in the market The greater is seller concentration, the morefor the firm’s product sensitive is the firm’s demand to changes in

the price differential between the firm and itscompetitors, hence the more sensitive areprofits to changes in exchange rates.

The differentiation of the firm’s The more a firm’s products are differentiatedproduct from those of competitors from those of its competitors, the less sensitive

is the demand for the firm’s product to changesin price differentials, and hence, the greater thesensitivity of profits to changes in exchangerates.

The Competitive Effect The currency composition of the The greater the similarity in the currencyfirm’s costs relative to that of structure of costs of the firm and itscompetitors competitors, the smaller the effect of exchange

rates in changing the competitive position ofthe firm. The greater the proportion of costsdenominated in currency i (relative tocompetitors), the greater the reduction in profitsarising from a deterioration in the firm’scompetitive position.


variation. Hedging involves trading off reducedearnings variability against lower expected earningscaused by the cost of hedging. Opportunism is thequest for profit opportunities from exchange ratefluctuations, usually at the cost of a higher level ofearnings volatility. We can expect the firm’s strategicorientation with regard to currency risk as determ-ined by top management’s risk aversion, the totallevel of risk to which the business is subject, and theoperational flexibility of the firm. Let us explore thesethree factors.

Ownership and Control

We argued above that, if securities markets areefficient, hedging exchange rate risk would not, ingeneral, enhance the value of the firm. To provide a


rationale for risk aversion we need to assume eitherindependence of managers from owners, or thatsecurities markets are subject to imperfect infor-mation. The more dispersed is ownership, the greateris managerial independence. To the extent that mana-gerial performance is measured in terms of short-term profit movements and downward movementshave a bigger impact upon perceived performancethan upward movements — then increased profitstability over time increases managerial utility. Alter-natively, if managers do aim to maximize share-holder wealth, but securities markets overreact tonew information and react particularly strongly toadverse news — then this also provides an incentiveto managers to ‘smooth’ reported earnings. Hence, asa result of either mechanism, companies whoseshares are listed on a stock exchange and/or whichhave widely distributed share ownership are morelikely to hedge exchange rate exposure than compa-nies with unlisted shares and/or with concentratedownership.

The Firm’s Overall Level of Risk

Both for owners and managers, as the marginal costof risk tends to rise, i.e. after a certain point, the firmrequires steadily increasing amounts of additionalreturn in order to compensate for additionalincrements of risk. Risk has numerous sources ofwhich currency exposure is just one. Hence, a firm’spropensity to hedge exchange rate exposure is posi-tively related to the level of risk it faces from marketdemand, competition, and technology.

The Costs of Flexibility

An opportunistic approach to exchange rate fluctu-ations requires that a firm is capable of adjusting itsproduction and marketing activities in order to takeadvantage of movements in exchange rates. Thegreater is the capital intensity of production, thegreater are scale economies and exit costs, and moreestablished are customer relations in the firm’s mar-kets, the more costly is the shifting of production andmarketing activities between countries. Conse-quently, the more likely a firm is to adopt a hedgingrather than an exploitation approach to currencyfluctuations. In other words, a firm’s propensity tohedge currency exposure is positively related to thecosts of geographical flexibility in production andmarketing activities.

Hedging of direct operating exposure involves a bal-ancing of a firm’s cash flows in each of the currencyareas in which the firm operates. Such an approachis likely to be effective in reducing, even neutralizing,operating risk in situations where there is no conflictbetween direct hedging and hedging competitiverisk. This is normally the case when in each country ithat the firm markets in, competitors have their costs


denominated in currency i. This would mean eitherthat competitors are all domestically-based, or thatthey are multinationals which pursue a multi-dom-estic strategy. The greater the globalization of theindustry, the less effective is direct hedging likely tobe. Hence, hedging direct operating exposure in theform of cash flow matching is most effective in inter-national markets where competition is from dom-estically-based firms and/or multinationalenterprises pursuing a multi-domestic approach.

To the extent that competitors within the same mar-kets have costs comprised of different currencies,then exchange rate movements will change the rela-tive costs of competitors. The essence of strategichedging against competitive exposure, therefore, isfor the firm to restructure its costs such that itmatches the currency cost structure of its leadingcompetitor(s). For companies facing global compe-tition from overseas rivals, competitive risk rep-resents the primary source of operating exposure,and hedging such exposure requires a firm to emu-late the currency cost structure of its main competi-tors.

Our model predicts that operating exposure is posi-tively related to the intensity of competition in afirm’s product market as indicated by the price elas-ticity of market demand, seller concentration, andproduct differentiation. Hence, the more competitivethe firm’s product markets, the greater the level ofoperating exposure that the firm is subject to. Conse-quently, the firm may reduce exposure by pursuingstrategies of product differentiation and relocating toless price sensitive market segments.

Our theoretical analysis points to a number of marketstructure variables which determine operatingexposure, and these in turn, suggest several instru-ments for managing that exposure. For the sake ofsimplicity, we identify a small number of configur-ations of industry structure and risk orientation eachassociated with a distinct strategic approach. In termsof risk orientation, we have already identified twobasic orientations: risk aversion that is associatedwith a hedging approach, and opportunism that isassociated with a risk-exploiting approach. In termsof market structure, the critical distinction is betweenindustries where competition is nationally frag-mented (multi-domestic industries) and those wherecompetition is global. Within these dimensions wecan identify three distinct strategic approaches (seeTable 2).

Conclusion

The analysis presented identifies economic exposureas the exchange rate risk relevant to the wealth-maxi-mizing firm. Of the two components of economicexposure, operating exposure and transactions


Table 2 Strategies to Manage Operating Exposure: A Simple Classification

INTERNATIONAL MARKET STRUCTURE

Fragmented/multi-domestic Global

Hedging Hedging direct operating risk through ❖ Hedging competitive risk through emulatingbalancing cash flows in each currency the currency cost structure of competing

firms.❖ Hedging competitive risk through strategic

alliances with competitors in differentcurrency area.

❖ Reducing vulnerability to competitive riskthrough product differentiation andrelocating in less price-sensitive marketsegments.

RISKORIENTATION

Opportunism Exploring profit opportunities arising from exchange rate fluctuations by means of shiftingcost activities to countries with currencies below their PPP levels, and shifting revenuegenerating activities to countries with currencies above PPP levels.

exposure, for most firms operating exposure is themore important, and it is the more difficult to hedge.In particular, we show that conventional financialinstruments for exchange risk hedging are ineffectivein managing operating exposure.

We argue that management of foreign exchange riskdoes not necessarily involve risk reduction throughhedging activities. As with any unpredictable vari-able impacting profits and returns, a firm can eitherpursue risk reduction or it can adopt an opportunisticstance by relocating its cost and revenue activities inresponse to movements in real exchange rates.

Our model identifies two primary components ofoperating exposure, i.e. direct operating exposureand competitive (or indirect) operating exposure. Therelative importance of these two componentsdepends upon the structure of international markets:where competition is nationally fragmented, directoperating exposure is most important; where compe-tition is global then competitive exposure is of pri-mary importance. More generally, market structureemerges as critical to the analysis of the sources andthe extent of operating exposure. The firm’s vulner-ability to exchange rate movements depends uponthe sensitivity of its prices to exchange rates and thenon the sensitivity of its sales to price changes.

The analysis reveals clear predictions as to the stra-tegies appropriate to managing operating exposures:

❖ In nationally fragmented markets, firms shouldseek to hedge direct operating exposure by match-ing costs and revenues,

❖ In global industries, firms should emulate com-petitors’ currency cost structure,

❖ To reduce sensitivity to exchange rates firms


should differentiate their products and seek priceinsensitive market segments.

The central issue of exchange rate risk concerns thecompetitive position of the firm, and managing thisrisk is a strategic issue. The implication therefore, isthat managing operating exposure is a general man-agement responsibility that cannot easily be del-egated to the treasury department.

Note

1. For a more detailed analysis of the accounting translationprocess, we refer to Arpan and Radenbaugh (1985), andEun and Resnick (1998).

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ROBERT GRANT, LUC SOENEN, OrfaleaMcDonough School of Busi- College of Business, Califor-ness, Georgetown Univer- nia Polytechnic University,sity, Washington DC, San Luis Obispo, California20057, USA. E-mail: 92407, USA. E-mail: [email protected] [email protected]

Robert Grant is Professor of Luc Soenen is Professor ofManagement at Georgetown Finance at California Poly-University. His research technic University, andfocuses on the nature and holds a joint appointmentmanagement of organiza- with Tias Business School,

tional capability, diversification strategy, the knowl- Tilburg University, The Netherlands. He has publishededge-based view of the firm and firm strategy in the oil extensively in finance and management journals.and gas sector.


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Strategic Management of Operating Exposure