Financial Management of Exchange Risk
The one attribute that all the strategic marketing and production adjustments have in common is that accomplishing them in a cost-effective manner takes time. The role of financial management in this process is to structure the firm’s liabilities in such a way that during the time the strategic operational adjustments are under way, the reduction in asset earnings is matched by a corresponding decrease in the cost of servicing these liabilities.
One possibility is to finance the portion of a firm’s assets used to create export profits so that any shortfall in operating cash flows caused by an exchange rate change is offset by a reduction in debt-servicing expenses. For example, a firm that has developed a sizable export market should hold a portion of its liabilities in that country’s currency. The portion to be held in the foreign currency depends on the size of the loss in profitability associated with a given currency change. No more definite recommendations are possible because the currency effects will vary from one company to another.
Volkswagen is a case in point. To hedge its operating exposure, VW should have used dollar financing in proportion to its net dollar cash flow from U.S. sales. This strategy would have cushioned the impact of the DM revaluation that almost brought VW to its knees. For the longer term, however, VW could manage its competitive exposure only by developing new products with lower price elasticities of demand and by establishing production facilities in lower-cost nations. Evidently, both DaimlerChrysler and Porsche have learned Volkswagen’s lesson as to the importance of hedging, as shown in the accompanying application and mini-case.