International Financial Management

Abridged 10th Edition

by Jeff Madura

1 © 2011, 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use
as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 10
Measuring Exposure to
Exchange Rate Fluctuations
Chapter Objectives
This chapter will:
A. Discuss the relevance of an MNC’s exposure to exchange rate risk

B. Explain how transaction exposure can be measured

C. Explain how economic exposure can be measured

D. Explain how translation exposure can be measured

2 © 2011, 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use
as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Forms of Exchange Rate Exposure

1. Transaction exposure
2. Economic exposure
3. Translation exposure

4 © 2011, 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use
as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Transaction Exposure

1. Definition: sensitivity of the firm’s contractual

transactions in foreign currencies to exchange rate
movements.
2. To assess transaction exposure, the MNC must:
a. Estimate net cash flows in each currency
b. Measure potential impact of the currency exposure

 p = Wx2 x2 + Wy2 y2 + 2WxWy x y CORR xy

W = proportion of portfolio value in currency x or y
σ = standard deviation of percentage changes in currency x or y
CORR = correlatio n coefficien t of percentage changes in currencies x and y

5 © 2011, 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use
as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Exposure of an MNC’s Portfolio Affected by:

1. Measurement of currency variability

2. Currency variability over time
3. Measurement of currency correlations
4. Applying currency correlations to net cash flows
5. Currency correlations over time

6 © 2011, 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use
as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Transaction Exposure Based on Value at
Risk (VaR)
1. Measures the potential maximum 1-day loss on the
value of positions of an MNC that is exposed to
exchange rate movements.
2. Factors that affect the maximum 1-day loss:
a. Expected percentage change in the currency rate for the next
day
b. Confidence level used
c. Standard deviation of the daily percentage changes in the
currency

7 © 2011, 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use
as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Using Value at Risk

1. Applying VaR to longer time horizons

2. Applying VaR to transaction exposure of a portfolio
3. Estimating VaR with an electronic spreadsheet
4. Limitations of VaR
a. Presumes that the distribution of exchange rate movements is
normal
b. Assumes that the volatility of exchange rate movements is
stable over time

8 © 2011, 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use
as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Economic Exposure

1. Definition: The sensitivity of the firm’s cash flows to

exchange rate movements, sometimes referred to as
operating exposure.
2. Economic exposure arises from:
a. Exposure to local currency appreciation
b. Exposure to local currency depreciation

9 © 2011, 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use
as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Measuring Economic Exposure

1. Use of sensitivity analysis

2. Use of regression analysis
PCFt = a0 + a1et + t
where
PCFt = percentage change in inflation - adjusted
cash flows measured in home currency
et = percentage change in direct exchange rate
t = random error term
a0 = intercept
a1 = slope coefficien t

10 © 2011, 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use
as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Translation Exposure

1. Definition: The exposure of the MNC’s consolidated

financial statements to exchange rate fluctuations.
2. Does translation exposure matter?
a. Cash flow perspective
b. Stock price perspective
3. Determinants of translation exposure:
a. The proportion of business conducted by foreign subsidiaries
b. The locations of foreign subsidiaries
c. The accounting methods used

11 © 2011, 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use
as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.