Operating exposure is the effect on the value of a firm arising from a change in exchange rates. These changes in exchange rates affect a firm’s cash flows of operation in the future (Connolly, 2006). When the exchange rates fluctuate, the relative prices that a firm also faces experience change. The change experienced in relative prices forces a firm to adjust its operation. Adjusting operation is prompted by the need for a firm to remain competitive. Therefore, a firm must work out a proper strategy in order to make its operation flexible, as while the exchange rate changes over time, a firm must also respond by adjusting its operation. This ensures that it retains competitiveness.
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There are many principles that a company can implement to counter financial operation exposure. The definition of operation exposure affirms that it involves unexpected changes. This paper will outline the best strategies to manage these unexpected occurrences from the financial point of view.
The first one is diversification of operations. The managers of a company can influence the cost of operation by diversifying operations. The company can manufacture and produce from different countries. When the currency of one country is faced by operating exposure, the management can shift more operations to the plant in another country whose currency is more advantageous. Raw materials can be bought from countries whose currencies are not exposed. Diversification of marketing will lead to shifting more activities to where the competition of prices is high.
The second principle is risk-sharing. It is a contract that is arranged between a firm and its creditors and debtors. The arrangement is usually an agreement to share the financial impact caused by fluctuations in the exchange rate. The firm and the other parties agree to adjust the base price. This is done if the rate of exchange moves beyond a threshold agreed upon by the firm and the party. The movement can be either upward or downward. The profit or loss resulting from the movement beyond the agreed zone is shared by the firm and the parties. If the exchange rate does not move beyond the zones agreed upon, the existing market rate of exchange is used (Gorge, 2013).
The third principle is considering a change in operation policies. The policies mostly involve the time when a company pays to its creditors. The company should consider introducing leading and lagging principles. Leading is a principle where a company pays creditors earlier than the expected time. The company does this if it anticipates the exchange rate movement to its disadvantage in the future. Lagging means the opposite of leading. Companies will delay paying creditors waiting for advantageous exchange rates in the future (Khan, 2006). An incentive payment strategy may be required to convince creditors to accept the new payment schedule.
The last principle is the introduction of re-invoicing centers. It is a center that is usually a subsidiary of a corporate. It is given a mandate of handling transaction exposure for all branches of a company (Connolly, 2006). This means that the risk of exposure due to the transaction is consolidated. The branches of the mother company are given the responsibility to manage transaction exposure.
An example of the diversification of operations is Firm A having manufacturing factories in the USA, Canada, and Mexico. When the Canadian dollar is open to exposure, then more manufacture can be shifted to the affiliates. Company A can also open a sales affiliate in Brazil as well as in the USA. When the dollar is under pressure from transaction exposure, sales can be shifted to the Brazilian market where the prices are friendlier.
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Risk sharing, as explained, is also easy to apply. If Firm A buys goods from firm B, a USA based company, a risk-sharing agreement can be made. They can agree that if the exchange rate rises above 100 shillings per dollar, Firm A pays at an exchange rate of 95 shillings per dollar. However, if the rate falls below 70 shillings per dollar, firm A pays at a rate of 75 shillings per dollar (Gorge, 2013).
Leading and lagging have simple examples. Firm A, a Canadian company, anticipates that the Canadian dollar is exposed to transaction exposure from the USA dollar in the future. The company knows that its invoices are denominated in USA dollars. The company will change its payment policies and pay future invoices now to avoid paying more in the future. The situation changes if company A anticipates that exchange rates between the two currencies will change in the future. It will delay payment of its invoices until the favorable time.
Lastly, re-invoicing centers can be applied by Firm A, which manufactures in Kenya and sells in Uganda, by setting up a re-invoicing center in Tanzania. The goods will be transported directly from Kenya to Tanzania. The invoice denominated in Kenyan shillings is passed through the affiliates re-invoicing center. The center issues a new invoice denominated in Ugandan shillings after giving legal title to the products (Khan, 2014).
Conclusively, Companies should make sure that they manage operation exposure properly. Companies that use proper strategy to manage the risk due to the movement of exchange rates avoid losses (Gorge, 2013). Therefore, it is likely that companies with a strategy to manage the risks are more successful than those that mind about operation exposure.
Connolly, M. (2006). International Business Finance. London, U.K: Routledge Publishers.
Gorge, G. (2013). Insurance Risk Management and Reinsurance. Raleigh, N.C: Lulu.com Publishers.
Khan, M. (2004). Financial Management: Text, Problems And Cases. New York, NY: Tata McGraw-Hill Education Publishers.