Economic Exposure: Rolls-Royce Case

Introduction

Rolls-Royce Limited underwent extreme losses due to exposure. The exposure in consideration is the economic exposure. In general, exposure refers to the degree to which the company is affected by varying exchange rates. This case involved an international multinational company, which dealt in jet engines. These rates affected the company adversely, leading to large losses. While we look at this situation, we must bear in mind that economic exposure is a result of firms having revenues or costs, which are dominated by foreign currencies. In this paper, we are seeking to understand the various factors that may lead to economic exposure in the Rolls-Royce case.

The currency risks are a common occurrence in foreign dealing and they arise from movement in the exchange rates. The Financial Accounting Standards Board (FASB) gives a general conclusion on how to handle these occurrences. The application of its statement affects the financial reporting of most companies that have established operations in foreign countries. Our explanation will not focus on a specific exposure method, since the company in consideration was affected by almost all the types of exposures, hence a magnified loss impact.

Risks Associated With Foreign Exchange

To have a proper assessment of the factors affecting economic exposure, there should be proper and accurate estimates of the exposure (Bodnar 10). This is aimed at ensuring that the management strategies that should be adopted are suitable. The main reason for the management of the exposure is to ensure the survival of the company. The huge losses that hit Rolls-Royce Limited were due to the lack of proper exposure management strategies. Some key determinants of economic exposure have been disregarded. In this case, the competitors will be considered for analysis. The distinguishing features of the products of a company, compared to those of the competitors, are an important aspect in assessing the impact of the exposure.

Poor management of the exposure related to foreign exchange causes variations of earnings and the company’s market value. To assess the economic impact of the exposure, many factors are considered. The most general ones are laid down in the Financial Accounting Standard Board (FASB-52). The key factor is the currency of its primary operational economic environment, which is the area of its functionality. It may also include the affiliates’ ground of operation.

The other factors include the currency in which the sales are invoiced, the currency at which buying negotiations are initiated, the currency at which borrowings are made, the currency of the securities, and the location of the customers. The act of focusing on specific determinants of exposure is set back in proper management of the situation. Most of the scholars in the field of business have focused on financial factors. Many scholars have given much attention to financially derived ratios like foreign to total sales (Choi and Anita 12).

On the other hand, inflation has a major effect on Rolls-Royce exposure. Generally, inflation is the persistent increase in the prices of goods and services. In a multinational scenario, the effects of inflation will be moved across the border. For the case of Rolls-Royce Limited Company, these effects cannot be ruled out. They count a lot in the exposure of the companies involved. The inflation rates between different countries differ. It doesn’t matter if the inflation is affecting both traded and non-traded goods. If the inflation rates are constant, the relative prices across the border will be changing, at a rate equal to the difference between the two inflation rates. The foreign exposure should not be viewed from one angle, since the exposure does not affect one part of the company. For instance, apart from affecting the financial position of the company, it might as well affect the competitive position. This should not be ignored, since it might lead to the paralysis of the company.

All the above explanation concerning the key factors needed to assess economic exposure is very important but it can be narrowed down to a simpler statement. In simple terms, the economic exposure is in most cases attributed to the nature of the company’s international operations, the nature of its foreign competition, and the nature of the service of its produce (Choi and Anita 12).

Definition of Economic Risk

In determining economic exposure, we consider several factors. Comparing cases of economic exposure helps us to determine the correlations, hence knowing whether they are negative or positive. For the Rolls-Royce case, the situation is not compared to any other company. The general formula to determine the economic exposure is given by:

P = a + b×S + e

The parameters in the formula are as follows:

  • P is the regression on the (home) dollar value of the foreign assets on the dollar exchange rate.
  • b is the regression coefficient and measures the sensitivity of the dollar value of the assets (P) to the exchange rate S.
  • e is the random error term with a mean of zero.
  • a is the regression constant

In the case of Rolls-Royce, the exchange rate was fixed or estimated at $1.80, for the pound. Due to exposure, it was estimated to have fallen to $1.65/£.

From estimation, with the application of the regression coefficient, random error term, and regression constant, the value of P was stated to be £848. The general probability was taken to be a third of a fraction and the value of S used was $1.80 for the earlier period and later $1.65/£. The product of SxP= £848 x $1.65/£.=$ 1399.2But later, this value changed to: £848 x $1.80 =$1526.4. This shows that the correlation is positive, hence allowing the application of hedging.

Hedging

Hedging is involved in adopting measures to curb these exposures or get rid of them completely. The hedging would have reduced the most adverse effects of the exposure. The hedged contracts could involve forward contracts. Although it is a good measure, there could be still some problems like eliminating the possibility of benefitting from favorable moves. The company could have benefitted a great deal from the hedged contracts. The techniques used to hedge economic exposure, involve the establishment of an offsetting currency position. This ensures that whatever is lost or gained on the original currency exposure is offset by the corresponding foreign gain or loss (Briys and Francois 12).

Hedging strategies enable the achievement of the following: minimum economic exposure, minimum quarter-to-quarter earnings fluctuations arising from exchange rate changes, minimum transaction exposure, minimum economic exposure, minimum foreign exchange risk management costs, and minimized surprises. Several hedging methods may be adapted to maximize the usage of the method that suits. The most common methods of hedging include currency collars, cross hedging, risk shifting, exposure netting, currency risk-sharing, foreign currency, and forward market hedge among others.

Hedging does not guarantee the success of economic exposure management. What matters is how proper the management strategy adopted is applied. The failure of Rolls –Royce to manage the exposure effect is what led to the large losses. The Rolls –Royce Limited could have benefited from the forward contracts. Foreign forward contracts are tools that reduce the risks. In this case, there is the matching of amount and dates. Likewise, these techniques if adopted, do not allow benefits from favorable currency moves. The exchange rate preferred for conversion is fixed when the contract is purchased (Eiteman, Arthur & Michael 14).

Financial Methods of Managing Economic Risks

In managing the economic exposure of any company, either financial methods or non-financial methods of management might be adopted. Discussions have focused on financial hedging, which is quite distinct from operational hedging. From this understanding, the main goal of financial hedging is to stabilize the cash flows of the company. This technique involves the use of derivative securities, such as currency swaps, futures, forwards, and currency options among others. Our focus will be on other non-financial techniques, other than financial hedging. Another strategy that the financial methods are aimed at is the policies.

Modifying the financial policies should be adopted. In this case, there is a tactic that involves acquiring denominated exposed currency. On the other hand, back-to-back loans might also solve the problem. These are also called parallel loans or credit swaps. Under this technique, two companies in separate countries agree to borrow each other’s currency, for a specified period. At an agreed terminal date, they return the borrowed currency. The advantage of using this method is that there is no foreign exchange risk and it doesn’t require approval from government bodies.

Non-financial Methods of Managing Economic Risks

Other management techniques are non-financial. These will therefore manage the economic exposure without focusing on the finances. The non-financial tactics will base their management on the assets. These generally don’t embark on the finances as such. The exposure in this Rolls-Royce case is reduced by matching the long-term assets of the foreign subsidiaries, with the long-term debt of the currency of the host country (Miller and Jeffrey 14).

Other tactics that may be applied in the reduction of the exposure include the establishment of strategic policies, which give proper guidelines on the international relationship. It is therefore wise to establish and implement a sound and prudent foreign exchange risk management policy. To enhance this, it is also necessary to develop appropriate foreign exchange risk management and control procedures (Jorion 34). Another option that can be applied is diversification of the market. This will enable the company in question to sell to multiple markets, and therefore benefit from economies of scale. It also diversifies the exchange rate risk.

The other strategy which is non-financial will involve product differentiation. This provides the company with less elastic demands which translate to less exchange rate risk. It is advisable for the economic exposure managers, to rely on other non-financial techniques to manage exposure. Financial techniques should be limited because they are focused on nominal exchange rate uncertainty. Also, they have a shorter maturity period. Finally, even with enough periods, most companies have no interest in using financial techniques.

Market and Product Diversification

The validity of this statement, “the more engines produced and sold under the previously negotiated contracts, the greater Rolls-Royce’s losses will be,” can be analyzed as follows. Increasing the production and the sales without cutting down the exposure will remain a disaster since the exposed currency is still in operation. The losses incurred will rise with the increasing economic exposure. The additional information that is required to comment on the validity of the statement is that other factors affecting the product, if remained constant, then it would be a valid statement. Factors such as the quality, location, and nature, if adjusted, then the statement would not be a valid one.

This means that there are other factors if considered, then the number of increased sales will reduce the losses. Increasing the activities of the firm in foreign markets is, therefore, a key player in resulting in a larger economic exposure. For Rolls-Royce Limited, the more the production of engines to the foreign market, the more the losses that accrue from increased economic exposure. The only reliable means of gaining is by diversification of markets, product differentiation, and proper production sites. This will check the exposure that is hitting the product from the production end.

Conclusion

From the discussion, it is clear that several techniques or methods of exposure were involved in the downfall of the company. The several methods of minimizing the exposures are executed differently, depending on the given conditions. It is always advisable to get rid of transaction exposure before handling the other method or techniques of exposure. For instance, economic exposure is handled by balancing the sensitivity of the revenues and expenses, to exchange the rate fluctuations. We have not handled any other exposure but we should be aware of the fact that the different exposures are related to each other in one way or the other.

Works Cited

Bodnar, Gordon M. “Wharton Survey of Financial Risk Management by Non-Financial Firms.” Financial Management 24. 4 (1998): 70-91. Print.

Briys, Eric, and Francois de Varenne. “Optimal Hedging and Partial Loss Offset.” European Financial Management 4(1998): 321-334. Print.

Choi, Jongmoo, and Anita Prasad. “Exchange Rate Sensitivity and Its Determinants: A Firm and Industry Analysis of US Multinationals,” Accounting and Business Research 24.3 (1995): 77-88. Print.

Eiteman, David, Arthur, Stonehill, and Michael Moffet. Multinational Business Finance. Arlington: Pearson International, 2007. Print.

Jorion, Philippe. “The Exchange Rate Exposure of U.S. Multinationals.” Journal of Business 63. 3 (1990): 331-45. Print.

Miller, Kent, and Jeffrey Reuer. “Firm Strategy and Economic Exposure to Foreign Exchange Rate Movements,” Journal of International Business Studies 29.3 (1998): 493- 514. Print.

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