13.3. MEASURING AND HEDGING OF OPERATING EXPOSURE 499
of the foreign currency, partly as a result of other factors than exchange rates and
partly because of the exporter’s endogenous response to the exchange-rate change.
Thus, the complicating factors relative to contractual exposure are that the relation
between thehc cash flowV ̃T and the exchange rateS ̃T has become noisy and
non-linear. Worse, the relation has become hard to identify, as it depends on the
economic environment that the firm competes in, and on how the firm reacts to
changes in the exchange rate, given its competitive environment.
13.3.1 Operating Exposure Comes in all Shapes & Sizes
There are at least two misconceptions about the source of operating exposure. The
first misconception, already discarded in the previous section, is that if a firm de-
nominates all of its sales and purchases in terms of its own currency, it faces no
exposure to the exchange rate. We know better, now. The second misconception
is that only those firms that have foreign operations are exposed to the exchange
rate; that is, only those firms that buy or sell goods abroad or use imported inputs
are exposed to the exchange rate, while firms that have only domestic operations
are not exposed to the exchange rate. This is usually wrong too. For instance, an
exchange-rate change can turn a potential foreign exporter into an active competitor:
Example 13.4
Consider a firm located in theus. Assume that the firm’s production is based in
theus, and that the firm uses only inputs that are produced in theusand that
the firm’s entire sales are in theus. The naive view would suggest that this firm’s
operations are not exposed to the exchange rate. This view is false if the firm faces
competition from abroad. Every time theusdappreciates, the foreign competitors
gain; they can lower theirusd prices and still obtain the same amount of their
own home currency. usfirms that faced this type of situation include Caterpillar,
Kodak, General Motors, and Chrysler. In the early 1980s, when theusdappreciated
against thejpy, all of these firms lost market share to their Japanese competitors,
Komatsu, Fuji, Honda, and Toyota respectively. This erosion of market share led to
large decreases in profits for theusfirms.
The second way an apparently non-international player may be affected by ex-
change rates is indirectly, at a remove: the firm may buy from local firms that, in
turn, do import; or it may sell to local firms that, in turn, do export. Or, even more
indirectly: in an economy with a large open sector, the general level of economic
activity may depend on the state of health of the export and the import-substituting
industries.
Example 13.5
Aukfirm has set up a subsidiary in our favorite country, Freedonia. Assume, for
simplicity, that the subsidiary’s cash flow, in terms of the Freedonian crown (fdk),