Journal of International Financial Management and Accounting 8:2 1997
A Real Options Approach to Economic
Limburg Institute of Financial Economics, University of Maastricht
Exchange rate volatility is not only a source of concern for firms but also of profit opportunities. If adjustment costs and lags are low, managers can adjust their input or output decisions to raise the firm’s expected profits. Notwithstanding the resulting higher profit variability, the actual risk perceived by the managers may fall as they are probably more averse to downside risk—such as financial distress—than to risk in general. Hence, this paper argues that optimal economic exposure management consists of exploiting the upward profit potential of real exchange rate volatility, while keeping downside risk under control. It is shown that option theory provides useful new principles for economic exposure management by bringing out the crucial role of adjustment costs.
It has often been joked at Philips that in order to take advantage of currency movements, it would be a good idea to put our factories on board a supertanker, which could put down anchor wherever exchange rates enable the company to function most efficiently. … In the present currency markets … (this) … would certainly not be a suitable means of transport for taking advantage of exchange rate movements. An aeroplane would be more in line with the requirements of the present era. (Snijders, 1989, p. 71)
In the quote above Mr. Snijders from Philips addresses two essential issues that have attracted surprisingly little attention in the literature on economic exposure management. The first is that exchange rate uncertainty is not only a source of concern to the firm. It also creates the potential for supernormal gains. In the ideal situation, production takes place wherever the firm can “function most efficiently” or “take advantage of exchange rate movements”. The second neglected issue is that the firm’s ability to react is higher, the shorter its adjustment lag (or the lower adjustment * This paper’s ideas are based on my PhD thesis “Exchange rates and strategic decisions of firms” (1993), for which valuable intellectual input was provided by Mark Casson, Henk Jager and Eelke de Jong. I also benefitted from comments to an earlier version of this paper by Arthur Stonehill and Jeroen Ligterink. Finally, the suggestions of Richard Levich and an anonymous referee of the JIFMA have substantially improved the paper. Any remaining error is, of course, mine. © Blackwell Publishers Ltd. 1997, 108 Cowley Road, Oxford OX4 1JF, UK and 350 Main Street, Malden, MA 02148, USA.
costs), and that the ability to respond swiftly is more valuable, the more uncertain the exchange rate. The “supertanker” that was useful in the past, is considered to be too cumbersome in the turbulent waters of today. The modern firm should move as fast as an “aeroplane”.
These two issues are combined in this paper. Its starting-point is that most firms can change the currency composition of some commercial cash flows after a certain adjustment period or the payment of adjustment costs.1 Some firms have a choice whether to purchase their inputs at home and pay in the home currency (HC) or to purchase abroad and incur foreign currency (FC) costs. Other firms can switch between HC and FC sales. In these cases the relative cost or return of the HC versus the FC strategy is determined by the (firm-specific) real exchange rate and is thus variable over time.2 Now this paper’s main point is that with low enough adjustment costs and lags managers can exploit the variability of the firm’s real exchange rate to raise the firm’s expected cash flows or market value. It will also be argued that this policy does not necessarily raise the firm’s exchange risk if managers are averse to downside risk rather than to risk per se.3
Of course, the mere assertion that uncertainty opens up the potential for profit opportunities is nothing new. For instance, Oi (1961) demonstrates the benefits of price uncertainty and Oxelheim and Wihlborg (1987) explicitly discuss the profit opportunities that exchange rate variability entails. Also not new is the idea that flexibility enables the firm to reap these benefits (e.g., Lessard and Lightstone, 1986; Kogut and Kulatilaka, 1994). However, this study is the first to show in detail how firms make optimal decisions while facing real exchange rate uncertainty, considering their dual objective of maximizing value and keeping risk at an acceptable level. Moreover, the ideas developed below are not just applicable to real exchange rate uncertainty—as shown in this paper—but to relative price uncertainty in general. Within one country, for instance, the relative price between sectors is subject to change. Firms with adjustable cash flows can exploit intersectoral profit opportunities (cf. Oxelheim and Wihlborg, 1987). Finally, this article concentrates on the exploitation of real exchange rate variability by switching between HC and FC cash flows. Firms that face low storage costs and that, accordingly, have inventory flexibility can also benefit by adjusting the pattern of FC cash flows over time (i.e., buy more FC inputs or produce more abroad when the FC is relatively cheap and use inventories when the FC is relatively dear).
This study provides a real options approach to economic exposure management. A firm with adjustable cash flows owns an option. A firm that is © Blackwell Publishers Ltd. 1997.
A Real Options Approach to Economic Exposure Management 89
implementing the HC strategy has the opportunity to switch to the FC strategy as soon as future real exchange rate developments make this profitable. This opportunity is comparable to a call option, since in effect the firm has paid a price (the option premium) for the right to pay a fixed “exercise” price (the adjustment costs) and obtain the FC strategy. If the firm presently has the FC strategy, it basically owns a put option namely the opportunity to cease the FC strategy and adopt the HC strategy. A firm with adjustable cash flows can switch to the FC strategy to exploit favorable exchange rate movements but switch back to the HC strategy when too large exchange rate induced losses occur. The result is that, just like the holder of a financial option, the firm can in principle benefit from unlimited profit opportunities, while there is a maximum to its potential loss. However, to obtain these “switching options” the firm often has to make an investment in flexibility first. This investment can be seen as the price (i.e., the option price or option premium) paid by the firm to acquire the option. This paper will first elaborate on the logic behind the points touched upon in this introduction and then further illustrate the main points by examining a simple numerical case. The next section gives a brief overview of the literature. In Section 3 the basic assumptions that underlie the real options approach are discussed, whereas Section 4 introduces a new objective of economic exposure management based on downside risk aversion. After that, Section 5 suggests which general principles managers can adopt to realize profitable and prudent economic exposure management within the firm. The numerical example is presented in Section 6 and gives managers the procedure for setting up a firm-specific economic exposure management scheme. Finally, the paper’s conclusions and guidelines for implementation are given in Section 7. 2. Overview of the Literature
The impact of exchange rates on a firm’s actual performance depends on (1) the variability of the exchange rates that are relevant to the firm and (2) the sensitivity or so-called exposure of the firm to these currency movements. Exposure determines the extent to which exchange rate changes affect the firm’s performance. An idea of the size of exposure can be obtained from the sensitivity of the firm’s performance to exchange rate changes. Prudent management requires that the firm keeps its exposure to unfavorable exchange rate changes limited.
In the literature several concepts of foreign exchange exposure are used, differing with respect to the indicator for performance chosen. This © Blackwell Publishers Ltd. 1997.
article concentrates on economic exposure which determines the degree to which the value of the firm (or the discounted sum of its future cash flows) is affected by exchange rate changes. Economic exposure can be separated into two components: transaction exposure and real operating exposure (see e.g., Shapiro, 1994, p. 227). A firm has transaction exposure if it has contractual payables or receivables in FC. Real operating exposure refers to the firm’s non-contractual future cash flows. Economic exposure should be carefully distinguished from accounting exposure (also called translation exposure). The latter governs the extent to which the balance-sheet value of the owners’ equity is influenced by a multinational's obligation to translate FC financial statements of affiliates into a single reporting currency (see e.g., Eiteman, Stonehill and Moffett, 1995). Economic exposure thus refers to the firm’s market value, whereas accounting exposure concerns book values.4 To judge the firm’s longer-term chance of survival, economic exposure is, of course, the more important exposure concept.
In practice, it is hard to assess a firm’s economic exposure because it depends on a multitude of factors (see e.g., Shapiro, 1994; or Flood and Lessard, 1986). Among other things, it is determined by the geographical scope of the markets (local versus world markets) on which the firm buys its inputs and sells its output and on the nature of competition that it faces (e.g., Moffett and Karlsen, 1994). Even a domestic firm that has no foreign operations is economically exposed, if the terms of trade and thus domestic consumers’ wealth, or the quantity supplied by the firm’s competitors, is affected by exchange rate changes. In both cases there is an indirect effect of the exchange rate on the demand for the firm’s products (see e.g., Luehrman, 1990; or Adler, 1994).
The market value of a firm is the present value of its expected future cash flows. So far, the literature on economic exposure management has focused on two basic procedures to limit the exposure of these cash flows to exchange rate changes. Firstly, the firm could reduce the net size of its individual FC cash flows. For example, a German exporter with dollar denominated returns and costs incurred in German marks, could switch to local production in the U.S. Secondly, the firm could reduce its exposure to any particular exchange rate by building a “portfolio” of different FC cash inflows and outflows. If a firm’s total cash flow in terms of the HC in a period is negatively affected by a depreciation (appreciation) of an FC, its position is comparable to that of an individual holding an asset (liability) in that FC. A well-known result from portfolio theory is that, if the returns on assets are imperfectly correlated, the return on a portfolio © Blackwell Publishers Ltd. 1997.
A Real Options Approach to Economic Exposure Management 91
of assets is less variable than the summed variability of the returns on the individual assets. As actual exchange rate movements are not perfectly correlated, a firm can diminish their impact on a period’s total cash flow by diversifying cost and returns over different currencies.5 So the German exporter could decide to change its input decisions or marketing procedures so that its costs are partially in Japanese yen or its revenues partially in pounds sterling with the idea that changes in the yen/dollar and pound/ dollar rate are not synchronized with fluctuations in the mark/dollar rate. This illustrates that economic exposure management should be an integral part of the firm’s strategic management. Decisions on input mix, plant location, market selection, product diversification etc. should all take account of economic exposure (e.g., Srinivasulu, 1981; Cornell and Shapiro, 1983; Aggarwal and Soenen, 1989). Since it is the nature of the firm’s business that creates economic exposure, the role of financial executives in economic exposure management is somewhat subordinate. Their task is to arrange financial affairs in such a way as to minimize the real effects of exchange rate changes subject to the costs of such rearrangements (Cornell and Shapiro, 1983). This can be done, for example, by selling or buying FC forward or by diversifying the currency denomination of the firm’s financial liabilities or assets. As explained in the introduction, the present study provides an option perspective on economic exposure management. Option models have been used before to examine strategic decisions of firms that typically take place under uncertainty and entail sunk adjustment costs. Dixit and Pindyck (1994) discuss the intuition and techniques of real option models and apply them to several “investment under uncertainty” models. Kogut and Kulatilaka (1994) has focused more closely on the option value generated by the flexibility to shift production between countries if real exchange rates are uncertain. But as far as I know, there does not yet exist a real options approach to managing economic exposure. While some authors— like Giddy (1994) and Giddy and Dufey (1995)—have focused on financial options as an instrument to manage economic exposure (or to raise the value of the firm to shareholders), so far little attention has been paid to the opportunities for economic exposure management provided by the firm’s real options.
3. Underlying Assumptions
The real options approach to economic exposure management is based on three pillars. The first pillar consists of two essential assumptions about © Blackwell Publishers Ltd. 1997.
real exchange rate behavior to be discussed in this section. Secondly, the approach requires that managers are only averse to downside risk or—if they have a general risk aversion—that profit maximization plays a role...