Operating Exposure and Market Segmentation

Abstract

Operating exposure involves the risks associated with fluctuating international currency markets. Market segmentation occurs when a firm identifies a wide target area as a potential market but divides the target area into categorized smaller markets oriented towards specific interests, demographics, or geographical regions. The domestic capital asset pricing model reflects the return an investor expects to yield from the assumption of certain risks and questions of time horizons. The international capital asset pricing model adds to this formula the risks associated with operating exposure. Factors affecting the cost and availability of capital in a global context are the appeal of a firm to international capital investors, the liquidity of the firm’s domestic markets and debt-financing sources, and the degree to which a firm participates in international markets. Back-to-back parallel loans involve two companies in different countries borrowing from each other in their respective domestic currencies and outside the FOREX system. A currency swap occurs when two firms borrow from each other in their respective domestic currencies and make equitable interest payments to each other for the duration of the exchange.

Introduction

Operating exposure involves the impact of fluctuating exchange rates on the flow of capital into and within a company. All investors and other parties involved in the global economy assume certain risks related to operating exposure when they participate in international markets. Ongoing alterations in the exchange rates will inevitably impact an international firm’s financial stability. This is particularly true when such fluctuation is sudden or unforeseen. It is of the utmost importance that financial managers of companies with significant international holdings take precautions to avoid the financial consequences that can accompany operating exposure. 

Multiple variables can contribute to the risks associated with operating exposure. One of these is transaction risks that involve the payment for services delivered in a foreign currency. A business will be anticipating that the currency in question will bring with it a particular exchange rate. If the value of that currency drops sharply, then profit margins can not only be reduced but a firm can fail to recoup its overhead on the particular transaction as well resulting in significant losses. Such cash flow losses can also impact and diminish a firm’s overall value. A constriction of cash flow reduces the sum total assets of the firm and its value depletes. A firm experiencing depletion of its value will become less attractive to investors thereby further impacting its cash flow (Homaifar, 2004). 

Market segmentation presents unique challenges when adapted to international capital markets. Generally defined, market segmentation involves the attempt to enter a market of significant size but in a way that reduces the targeted market into “segments” of potential consumers sharing common characteristics. For instance, a European firm might choose the domestic United States as its general target market. The domestic consumer market of the United States is enormous. Yet there remains a myriad of ways in which the wider American consumer market can be categorically segmented. One such factor might be geography. A firm might attempt to gain market share by targeting consumers on the West Coast. Specific sets of consumers might also be targeted on the basis of shared psychological, socioeconomic or cultural characteristics. A firm might attempt, for instance, to orient its market strategy towards young people, the upper-middle class, or participants in particular recreational activities. 

Other forms of market segmentation can involve the inclination of consumers towards the use of a particular product. A Chinese firm might utilize this approach when attempting to market lawnmowers to Americans of enough means to own homes requiring exterior maintenance. Another strategy might be to identify a particular consumer interest that is not being fulfilled. Still another approach is to segment markets that are constrained by time. For instance, an international firm offering clothing intended to be worn during the cold winter months within the domestic United States would find its market share expanding during those months and in those areas of the United States where cold winter weather is a general concern (Homaifar, 2004). 

The capital asset pricing model assists investors in their efforts to determine the size of the return they can reasonably expect on an investment in a particular firm. Two primary considerations emerge when applying the capital asset pricing model. The first of these involves the calculation of the return an investor can expect within the context of a relatively stable market. Barring substantive risks, what will be the profitability of the investments to the investor? The other consideration involves an assessment of the risks the investor will face. These can include any number of factors such as the fluctuating rates of inflation (or deflation) transpiring within the economy of a domestic market, tax liabilities on capital gains, the stability of particular markets, the liquidity of the firm targeted for investment and much else. Simply stated, the domestic capital asset pricing model can be formalized as the greater return investors expect to receive from their monetary exposure over a period of time beyond what they would receive for not assuming such exposure, and with the prospective return legitimizing the risk of assuming such exposure.

The international capital asset pricing model applies this concept to the global perspective of capital markets. Once again, the model in question attempts to assess the return an investor can expect from a specific investment. With the international capital asset pricing model, the investor can consider what the likely investment return would be in a relatively stable and risk-free international market. The value of the capital asset increases as potential costs from assumed risks increase. The principal variable affecting the international capital asset pricing model that sets is apart from the domestic model is that the investor assumes the risk associated with operating exposure associated with potential fluctuations in foreign currency exchange rates (Homaifar, 2004).

The availability and cost of capital in a global context is dependent on numerous factors. Global markets can bring with them new sources of capital that are more cost-effective. A primary question is whether a firm is attractive to international investors. Some firms appeal primarily to domestic investors within their own nation of origin and it is from these investors that most of their capital is derived. It is also essential that a firm has a liquid domestic market and engage in international commerce in a fairly significant way. A firm must also participate in global securities markets of the kind where international standards are employed for the pricing of shares. The liquidity of the long term debt financing sources of the firm, particularly if these are ground in domestic capital markets, is a major factor in determining the firm’s overall market value and investment potential. Another factor is the size of the domestic capital markets of the host nation to the firm in question. The lack of domestic options when acquiring capital may increase the firm’s attractiveness to foreign investors. The degree to which a firm is dependent on segmented markets for its debt financing is also a significant variable (Homaifar, 2004).

Investors have attempted to safeguard against risks associated with operating exposure through the use of back-to-back loans. A back-to-back loan occurs when two firms located in different countries agree to borrow from one another in the currencies of their respective domestic markets and in amounts reflecting parallel value. This set of mutual loans involves an exchange of credit and operates outside the FOREX system. Because each firm participating in the transaction borrows in the amount it must repay a hedge against losses related to exchange is established. A firm in Country A seeking to invest in its branch divisions in Country B will locate a firm in Country B that wishes to invest in its own branches in Country A. The parent company in Country A will make a loan to Country B’s local branch in Country A in the currency of Country A. Country A’s branch in Country B will then make a loan to the parent company in Country B in County B’s domestic currency. 

A back-to-back loan of this type differs from a cross-currency swap. With a currency swap, the firm in Country A will borrow a certain denomination of funds from Country B in Country B’s own currency while lending Country B a certain amount of its own currency. Throughout the course of the mutual loans, the two parties make equitable interest payments to each other at set intervals. Once their mutual relationship expires, the two parties return their respective funds to each other (Homaifar, 2004).

Reference

Homaifar, Ghassem A. (2004). Managing Global Financial and Foreign Exchange Risk. Hoboken, NJ: John Wiley & Sons.