Operating Exposure Arises When a

Operating exposure arises when a firm's operations become subject to the impacts of foreign currency exchange rates. Almost every firm will face operating exposure to some degree (Chapter 11). There are a few key principles at work in managing operating exposure. One of the most important issues in operating exposure is that of pricing flexibility. The firm benefits from being able to adjust prices upward or downward in order to either stimulate demand or improve profits.

This is difficult when foreign currency fluctuations deliver a competitive advantage to competitors, especially with respect to pricing. Operating exposure can also create a specific disadvantage if costs are denominated in a foreign currency and that currency becomes more expensive -- foreign firms purchasing commodities priced in U.S. dollars often face this type of exposure, more so than do American firms. Managing operating exposure is not simply a task for financial managers, since financial exposure affects a wider range of managers within any given company.

For the financier, input into which countries in which to compete is essential -- some bear more operating risk than others. In addition, financiers can impact on the firm's pricing strategy, which is affected by shifts in currency exchange rates. There can be some hedging conducted by the finance department in order to offset some of the negative impacts associated with operating exposure.

Hedging, however, is largely a short-term fix and therefore should only be used to address operating exposure in the short-term so that the firm can implement long-term solutions. Before any management of operating exposure can be conducted, however, the company must effectively measure its operating exposure. There are a number of techniques that can be used, including regression of exchange rate fluctuations and net income and measures comparing exchange rates and the translation of assets and liabilities (Flood & Lessard, 1986).

With an effective measure in place, the firm can understand not only the steps it needs to take to moderate operating exposure but also the degree to which it must act to properly hedge this exposure. An example in the automobile industry was when BMW decided to build a plant in the U.S. This was an unusual move for a European automaker at the time, but it provided an operating hedge for U.S.-denominated revenues.

The long-run trend in the mark was an influence on this decision, as it was becoming a source of long-run competitive disadvantage (Kim & McElreath, 2001). Another example would be Wal-Mart. The company first made the decision to source from China because the yuan was being deliberately undervalued. However, this tactic exposes the company to the yuan, so Wal-Mart has built a large chain in China.

This provides an operating hedge that allows the company to pay for some of the Chinese goods it buys with yuan earned from its Chinese operations. This same strategy has been utilized in Canada, Mexico and Europe by the company as well, and other international retailers such as Carrefour have also entered the Chinese market for similar reasons (China Beverage News, 2010). Financiers alone cannot adequately manage operating exposure. Managing this form of foreign exchange risk must include the.