International Finance PaperForeign Exchange Risks for Caterpillar (CAT) Gangming Liang
Accounting / Translation Exposure (Past):Accounting or translation exposure is subjected to the change of book value in balance sheet and incomestatement with retrospective paper gain or loss. It is related to past change of nominal exchange rate.Accounting or translation exposure is equal to the difference by deducting exposed liabilities from exposedassets. Translation gain or loss is equal to accounting exposure multiplied by change of foreign currencyexchange rate. The new equity is equal to the sum of original equity and translation gain or loss.According to 10-K, most of Caterpillar’s Machinery and Power Systems use dollar as functional currency forpurchasing, manufacturing, and selling. They use temporal method to reflect value matching over time. Thereasons might be: (1) Affiliate’s operations are extension of U.S. parent company; (2) The foreign country hascumulative inflation over 100% for over 3 years, and Caterpillar needs to prevent undervaluation of assetsrecorded at historical costs. Caterpillar applies matching accounting method by using current exchange rate ifvalue at market value or using historical exchange rate if value at costs. Income statement accounts have to useaverage exchange rate; while balance sheet accounts have to use historical costs of asset and liability.Caterpillar records realized foreign translation gain or loss as “other income or expenses” in income statements;then it consolidates the data into U.S. parent company’s financial statements. This follows FASB No. 8 andcauses greater fluctuation or volatility in earnings and net income.Most of Caterpillar’s Financial Products and affiliates accounted for foreign local currency as functionalcurrency. Affiliates’ operations are relatively self-contained with the country, which is the primary economicenvironment for operation. Caterpillar uses current rate method, the simplest way to determine exposureassets and liabilities. Under this method, all assets and liabilities use current exchange rate for conversion; allexposed income statement accounts use weighted average exchange rate. This approach avoids the highvolatility of exchange rate effect on true profitability under FASB No. 8. Income statement uses weightedaverage rate and when revenue and expense incurred. Unrealized foreign exchange gain or loss in balance sheetis recorded as AOCI, (Accumulate Other Comprehensive Income or Loss), a separate equity account, underFASB No. 52; then Caterpillar consolidates the data into U.S. parent company’s financial statements.Caterpillar needs to protect dollar value from adverse changes in foreign currency exchange rate. Adjustingfund flows, exposure netting, and forward contracts can be used to manage accounting exposure. They appliesmatching funding program to manage the accounting exposure issue. For instance, matching AccountsReceivables and Debts’ currencies shows the methodology of balancing inflow and outflow.Transaction Exposure (Current):Transaction exposure is subjected to the changes in value of outstanding foreign currency denominatedcontracts or commitments with real gain or loss based on past activities that will be settled in future. It isrelated to current change of nominal exchange rate.According to 10-K, Caterpillar use derivatives hedging to manage transaction exposure instead of usingspeculating derivatives. The goals of hedging are to minimize earnings volatility or standard deviation in dollars,and avoid reducing in dollars for foreign cash flows by offsetting currency positions. The management ofCaterpillar decides to use a 5- year management expectation for derivatives hedging with undesignatedcontracts. They use Foreign Currency Forward and Option Contracts to manage payments affected by foreignexchange rates; they apply Interest Rate Swaps to manage fixed interest rate for loan currencies; they also try touse Commodity Forward and Option Contracts to manage payments of communities’ spot prices in foreigncurrencies.
The international transactions involve at least 12 currencies, such as Australian Dollar, Brazilian Real, BritishPound, Canadian dollar, Chinese Yuan, Euro, Indian Rupee, Japanese Yen, Mexican Peso, Singapore Dollar,and Swiss Franc. So, Caterpillar needs to consider all the parity conditions. For example, the transactionsbetween U.S. and foreign countries are affected by different economic policies. Those policies affect inflationrate, interest rates, forward rates, and exchange rates as well. If we compare the unbiased forward rate, interestrate parity, fisher effect, purchasing power parity, and international fisher effect, we will know both of theunbiased forward rates and international fisher effect is the least reliable relationships. As a result, werecommend Caterpillar use interest rate parities, fisher effect, and purchasing power parity to determine theirhedging strategies.Caterpillar needs to short forward or future contracts for exposed foreign currency assets and long forward orfuture contracts for exposed foreign currency liabilities. Money Market Hedge can be a good choice for lockingfuture dollar value of cash flow by simultaneous borrowing and lending activities in different currencies.Caterpillar needs to borrow foreign currency with short position for exposed foreign currency assets and toinvest foreign currency with long position for exposed currency liabilities. Caterpillar can also use call option tolimit downside loss on long foreign currency position or use put option to limit upside lose on short foreigncurrency position.However, Caterpillar only uses forward contracts for hedging instead of future contracts. The reasons can be: (1)Forward contracts are available in many currencies mentioned above; (2) Forward contracts can be customizedon delivery dates and size. Caterpillar’s transactions are higher than $1 Million, and required customization.The good credit rating of Caterpillar also provides no margin requirement benefits for the company.Operating Exposure (Future, focus):Operating exposure is subjected to the change of future operating cash flows with prospective gain or loss. It isrelated to future real exchange rate’s economic effect.According to 10-K, Caterpillar use 10% weakens in dollars to measure sensitivity of changing $569 Millions ofMachinery and Power Systems’ operations. The goal is to avoid reducing cash flows in dollar value in future.Source of Competition:In farm and construction machinery industry, Caterpillar faces competition domestically for both importing andexporting areas. AB Volvo, CNH Global NV, Komatsu, United Technologies, Mitsubishi Heavy Industries,Windsor Machines, International Mining Machinery, Titan Europe PLC, Ag Growth International, ZommlionHeavy Industry Science and Technology, MAN SE, Deere & Company, ABB, Illinois Tool Works, and Parker-Hannifin are the major competitors. However, only few companies are competing with Caterpillar for the samecustomers and resources.Even though Caterpillar has a market leading exporter position with good brand names, economic scale, highermargins, revenues, and ability to raise debt at lower cost with good credit rating, the company should keep itscompetitive advantage, stable business, and credit rating to maintain in good market position. Caterpillar needsto apply business strategies for keeping favorable competitive environment by joint ventures, industryconsolidation, and increasing barriers to entry, and deterrence.Pricing Flexibility:Usually, if customers like or need certain machinery, which is an inferior product with limited choice, they willpay more for the machinery sooner or later because they barely switch to another brand. In addition, the largernumber of customers and difficulty to find other suitable products creates an environment of low bargainleverage for customers. Low dependency on distributor also makes distributors have less bargaining power.
This offers Caterpillar a good position to offer pricing flexibly. However, the current economy is recovering andhas limitation for raising price of Caterpillar’s product for high sensitivity of economic cycles. Majority of thecustomers are from foreign countries, especially developing countries, and these customers preferred lowerprices. But the demand can keep Caterpillar is similar favor bargain position. The company is in dominantposition as price leader with friendly competitors in growing market. The source of inputs is similar, andvariable costs are significant. So, the pricing flexibility is high with less operating exposure.Price Elasticity:Caterpillar’s price change of their products will cause small change of demand because the demand is always ata certain level due to the recovery economy and the need of construction machinery. So, the price elasticity isinelastic. This means the operation exposure is smaller. Caterpillar can use marketing strategies to reduce priceelasticity by developing more differentiated products. For example: Besides selling heavy equipment,Caterpillar has Cat Financial that provides financing which recognize additional revenue over the term offinancing. Secondly, Caterpillar can target at market where Caterpillar enjoy competitive advantages thatpushes their competitor in price discounting. Moreover, Caterpillar keep building customer loyalty in developedcountries by continue multi-year roll out of products designed to meet requirement, such as diesel engineemission. Lastly, Caterpillar customers, who are typically OEM customers, have chosen to outsourceproduction of certain type of engine to Caterpillar due to better quality, cost reduction, and risk elimination.Source of Inputs:The consideration of source of inputs includes input from Importing, domestic trading and non- trading.Caterpillar also needs to use production strategies to adjust costs by changing source of inputs, movingproduction overseas, diversifying production locations and raising productivity. If the suppliers are dependenton high volumes, then Caterpillar might has higher bargain power by cutting volumes and hurt the supplier’sprofits. In addition, the critical production inputs of construction machinery inputs are similar. So, it is easier tomix and match inputs for different sources available. Construction machinery inputs are usually smallcomponent, so the costs are small relatively. The large number of substitute inputs offers Caterpillar a positiveposition to leverage suppliers. Caterpillar has lots of operation in developing countries, in which people focuson lower price instead of good quality. So, this will reduce the price and products and requires cheap inputprices.Financial strategies are required to apply into Caterpillar’s operating exposure management. Short- termforwards, futures, or options can be used for hedging the change of nominal exchange rate. The reason whyCaterpillar cannot hedge real exchange rate is that the hedging must not aim at inflation. For balance sheethedging, long- term foreign currency liabilities can be offset net foreign currency cash flow. Accordingmatching principle, the present value of foreign currency cash flow is equal to foreign currency liability.Responsiveness also needs to be applied to reduce operating exposure and shorting adjusting period followingan exchange- rate change via preparing contingency plans, investing in flexibility, shortening cycle time.