Embraer's Specific Problem Is That

Embraer's specific problem is that the real has been appreciating at a rate that negatively impacts their cost earnings. Almost all of their sales come from exports, meaning that currency risk assumption is part of their inherent cost structure. Embraer suffers from many different operational exposures. First, they face administrative costs associated with branding themselves on an international level. When they create administrative organizations, sales, and other operational human resources capacity expand their currency risk because they have to compensate their overseas operations through currency conversion.

In this case however, their operational expenses actually work to their advantage, since the real has appreciated their net value increases which reduce the amount of equity that it has to dedicate to expanding operational expenses. The majority of their negative operational exposure occurs when they finalize sells. Since they are making purchases using domestic currency in foreign countries, and since they are in a four way competition with other aircraft makers, the airline industry is very price sensitive.

Price elasticity of demand is relatively high, which means that they cannot shift prices to match currency levels. As a result, the appreciation of the real has caused a major problem for Embraer in how much total equity they are paid. Even worse, since receivables are being paid on the timetable of the customer rather than the timetable of Embraer, they are choosing currency levels that are most advantageous for their company rather than Embraer.

The net result is that they have almost no control over currency risk, and there is also almost no way they can hedge this problem. The real's appreciation affects Embraer negatively because now it is more expensive to exchange reals so that they receive less real per transaction than before. If they sold an aircraft to U.S. Airways for 100 million U.S. dollars at an exchange rate of 1 to 2.3 before the currency appreciation. When the plane is now sold, the exchange rate is 1 to 2 rather than 1 to 2.3.

The net differential between these two figures means a significant loss of reals for Embraer. Therefore it is evident that there is a large differential between the amount that they would have gotten and how much they should have gotten. Embraer definitely increased its currency risk by swapping their dollar liability with reals for several reasons. First, the appreciation of the real means that they are getting a much lower rate of return on their currency swaps.

Since they lost 85 million dollars on the swap it would mean that they are actually losing overall revenue as the real continues to appreciate. There could have been many different alternative strategies to hedge their current risk. They could have gone through a currency broker at the outset, by negotiating with the buy side client to pay with upfront costs so that they understand their currency position perfectly.

Second, they could have divested their dollar investments into other currency that would have had a more favorable exchange rate with the United States. The reason that this impact is negative overall is that they made an exchange at a time when the rates are unfavorable to them, rather than waiting for a better exchange situation. There are many reasons for why they would do this is because they do not have the financial resources to be solvent while still maintaining their current currency position.

Another reason is that they do not have a finance manager who has a very strong understanding of the currency market. There are many different steps that Embraer could have taken; first they could have used a recurring currency conversion method to reduce their risk. Since the majority of their sales are happening through consistent customer return basis, they can hedge their risk by using recurring payments rather than allow the company to pay in lump sums when the exchange rates are the most favorable.

If they use a constant stream of revenue strategy they would be changing their risk to a much more manageable level and they can shift their cost payments based upon their current market currency rate. Overall, this hedging strategy is to take the currency control position away from the buy-side client and putting it into neutral territory. When this happens they are least likely to always be in a position of currency exposure.

The smartest way for Embraer to hedge their bets is to use a third party broker that will substantially change their risk factors. A third party currency broker could have assumed the entirety of the purchase and thus they would have been able to give the entirety of the amount to Embraer. Negotiating such a buy-side and sell-side agreement changes the way that Embraer would have viewed its financial position. They could also have changed their currency hedging away from U.S.

dollars to real and towards more favorable exchange positions. The real's appreciation is most likely comparable to "major eight" currency players, and if they took on risk positions with other currencies they could no doubt find better positions that would eventually increase their overall equity position. Hedging using U.S. dollar conversion to real would probably been one of the worst methods for currency hedging because they take on a losing position from the outset.

The only way that this would have been a smart strategy is if the real continues to appreciate at a very high level that would make them lose even more money down the line. If they were not paid on net receivables of 608 million of 397 million, they would only maintain 82%.