Exchange rate volatility affects the dollar value of assets and liabilities denominated in foreign currencies, as most senior executives are aware. Few people, on the other hand, are aware that currency fluctuations may significantly affect operational profit. Fewer companies have entrusted managers with the task of monitoring this operational risk.
Managers should think about operational exposure in the long term while formulating strategy and making global product plans. Understanding operational exposure may help you make better operating choices in the near term. In addition, because exchange rate impacts are not within management’s control, the assessment of a business unit and its managers should take place after these effects have been taken into consideration.
For a variety of reasons, operating exposure is more critical than ever before. In the era of controlled floating rates, exchange rates are more volatile than during the time of worldwide economic growth by the United States.
It doesn’t matter whether a company exports its goods or not when exchange rates fluctuate. Even if a company does not have any overseas activities or exports, fluctuations in the currency rate may have a significant impact on its operational profit.
Volatility and Its Effects On Operations
It is possible to determine how exchange rates influence operational profit by studying their long- and short-term behavior. Nominal dollar-foreign currency exchange rate fluctuations tend to be about equivalent to the difference in the price of traded products between the United States and foreign inflation rates over the long term. During an inflationary year in the United States, according to the top Forex brokers, if the inflation rate is 4% greater than it’s in Germany, the Deutsche mark will tend to appreciate by 4% versus the dollar. If you look at the long-term connection between exchange rates and price levels, you’ll see something called purchasing power parity (PPP), which shows how inflation-related changes in a country’s competitiveness tend to be compensated by changes in the country’s exchange rate over time. Although exchange rates are unpredictable in the short term, they have a significant impact on the competitiveness of businesses selling to the same market but sourcing their raw materials and labor from various nations. This is because exchange rates are fickle.
For a brief period of time, the nominal exchange rate will be less competitive than it was before because of the difference in inflation rates between the two nations. In this scenario, the Deutsche mark rises by 4% against the dollar while inflation in Germany is at 1%, increasing the dollar price of a US exporter to Germany by 5%. When inflation is 3 percentage points or greater in the United States than it is in Germany, a producer’s operating margin increases by just one percentage point.
When analyzing currency risk, traditional methods look at contractual assets and liabilities on the balance sheet that are denominated in the foreign currency and have their dollar value impacted by nominal exchange rate fluctuations.
Both contractual and operational risks must be considered by the business. When it comes to different exposure types, practitioners who are used to dealing with contractual exposure get defensive, while operational managers see it as something outside of their purview. This is a problem. When the impacts of nominal exchange rate changes are individually recognized in the income statement, but the implications of real exchange rate changes on revenues and expenses are not, it is difficult to retain a balanced viewpoint.
The following two examples demonstrate how market structure affects operational exposure:
In Canada, a subsidiary of a U.S. business sells chemicals made in the U.S. by its parent company, Specialty Chemicals (Canada). It has a low level of debt since it has minimal fixed assets. In this case, all of the pricing is shown in Canadian currency. Due to Specialty Chemicals’ Canadian dollar receivables depreciating in value against the US dollar, the business is vulnerable from an accounting standpoint.
Specialty Chemicals’ expenses will rise in Canadian dollars if the Canadian currency declines. Are Specialty Chemicals exposed to the Canadian dollar in their day-to-day business operations? In order to balance revenues and expenses, should it build a manufacturing facility in Canada? In order to decrease the U.S. dollar value of its repayments if the Canadian currency falls, should this business issue Canadian dollar debt?
Specialty Chemicals must look at the market structure in order to answer these issues. All of the companies who compete with the firm import their goods from the United States as well. Everyone is affected equally by a spike in Canadian dollar costs, regardless of how competitive they are compared to one another. This is reflected immediately in an increased price. There is only a very short-term operational vulnerability due to the price responsiveness, which balances out the cost responsiveness. To create a new operational exposure, a company would have to issue Canadian currency debt or construct a facility in Canada. Mainframe computers, commercial airplanes, and other sectors where many U.S. corporations jointly dominate the global market stand up to this day to this analysis.