Financial versus operating strategies for hedging.

When operating (cash) inflows and (contractual) outflows from liabilities are affected by exchange rate changes, the general principle of prudent exchange risk management is: any effect on cash inflows and outflows should cancel out as much as possible. This can be achieved by maneuvering assets, liabilities or both. When should operations -- the asset side -- be used?
We have demonstrated that exchange rate changes can have tremendous effects on operating cash flows. Does it not therefore make sense to adjust operations to hedge against these effects? Many companies, such as Japanese auto producers, are now seeking flexibility in production location, in part to be able to respond to large and persistent exchange rate changes that make production much cheaper in one location than another. Among the operating policies are the shifting of markets for output, sources of supply, product-lines, and production facilities as a defensive reaction to adverse exchange rate changes. Put differently, deviations from purchasing power parity provide profit opportunities for the operations-flexible firm. This philosophy is epitomized in the following quotation.
It has often been joked at Philips that in order to take advantage of currency movements, it would be a good idea to put our factories aboard a supertanker, which could put down anchor wherever exchange rates enable the company to function most efficiently...In the present currency markets...[this] would certainly not be a suitable means of transport for taking advantage of exchange rate movements. An aeroplane would be more in line with the requirements of the present era.
The problem is that Philips' production could not fit into either craft. It is obvious that such measures will be very costly, especially if undertaken over a short span of time. it follows that operating policies are not the tools of choice for exchange risk management. Hence operating policies which have been designed to reduce or eliminate exposure will only be undertaken as a last resort, when less expensive options have been exhausted.
It is not surprising, therefore, that exposure management focuses not on the asset side, but primarily on the liability side of the firm's balance sheet. Exhibit 7 provides a summary of the steps involved in managing economic exposure. Whether and how these steps should be implemented depends first, on the extent to which the firm wishes to rely on currency forecasting to make hedging decisions, and second, on the range of hedging tools available and their suitability to the task.