Exchange Rate Exposure essay
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Pearson’s operating profits increased by six percent to twelve percent in 2011 with exchange rates averaging at £1:$1.54 and £1:$1.60 in 2010 and 2011 respectively. Much as the net profits grew, the rate at which this occurred was reduced due to currency fluctuations between the two years since sixty percent of the generated sales and profits where in US dollars. Compared to Reed, whose exchange rates are not adversely affected given that it is UK based, Pearson’s foreign identifiable assets, i.e. assets that are exposed to exchange rate risks, and net operating profits from foreign activities are highly affected by the exchange rate risks.
The two companies differ in their exchange rate risks since they use different variables to measure their multi-nationality. Whilst Pearson uses the level of variables, Reed uses the foreign rates to domestic rations. Since Pearson makes higher sales, its percentage of foreign sales is higher than that of Reed. This means that, Pearson is more exposed to risks due to exchange rates that Reed. In addition, most of Reed’s revenues come from local activities since most job seekers, who are its customers, are UK based. This reduces the risk associated with exchange rates unlike Pearson which makes a substantial amount of foreign activities from which it draws revenue.
Pearson has been able to support most of the losses to currency fluctuations by the acquisitions the company has engaged in. These acquisitions help in making for revenues lost to exchange rates risk. Since a larger proportion of Pearson’s revenue come from foreign activities which are usually denominated in currencies of other countries as compared to Reeds, the company uses exposure mitigation measures such as hedging. Pearson also has a strategy in place to tailor its cost structure so that it is sensitive to changes in the exchange rates so that their effects of the firm’s revenues are not affected. Reed uses a billing system that transfers all exchange rate costs to customers since they are required to pay in pounds and dollars which are not adversely affected by fluctuations.
In order for the company to improve its exposure to risk, it should maintain foreign currency reserves that can act as a buffer against rapid swings in revenues resulting from changes in exchange rates. In cases where the company wants to expand, it is advisable to use management contracts as well as franchises as financiers for such projects in order to maintain the amount of direct financing at the minimum. The company should also incorporate escalation clauses in drawing sales contracts so that the sales price is tied to exchange rate fluctuations, especially in cases where there is an expected lapse of time between making the delivery and time of receiving payment. In addition, the company can match its cash inflows from foreign activities with their respective outflows in order to reduce the variability of the actual cash flows. This can be done by carefully restructuring the sales, operations and so on. Similarly, long-term assets that are exposed to risks from exchange rates should be matched with long-term liabilities in the host country’s currency.
It is also advisable to always bill customers in dollars whenever it is possible or any other strong currency as opposed to local currencies so that the risk is transferred to the customer. This is especially helpful in circumstances where it is expected that the currency of the local currency will depreciate. The prices for sales should be regularly reviewed to keep them proportionate with changes in inflation rates between the two countries. Sometimes, these changes in prices can be used to absorb the costs incurred due to fluctuations in exchange rates so that the company remains profitable.
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