Exposure and Risk

The Nature of Exposure and Risk

• Macroeconomic environmental risks
• Core business risks
• While core business risks are specific to a firm, macroeconomic
uncertainties affect all firms in the economy
• Extent and nature of impact of even macroeconomic risks crucially
depend upon the nature of a firm's business
Contd..
• The firm is "exposed" to uncertain changes in a number of variables in
its environment - Risk Factors
• Long run response of the firm to these risks can involve significant
changes in the firm's strategic posture
• Exchange rates and interest rates are two of the key macroeconomic
risk factors
• Exchange rates, interest rates and inflation rates are intimately
interrelated
Exposure and Risk

• Exposure is a measure of the sensitivity of the value of a performance

measure to changes in the relevant risk factor
• Risk is a measure of the variability of the value of the performance
measure attributable to the risk factor
• The magnitude of risk is determined by the magnitude of exposure
and the degree of variability in the relevant risk factor e.g.
• Exchange rate risk depends on how sensitive is the performance indicator to
exchange rate fluctuations and what is the extent of likely fluctuations in the
exchange rate.
RISK MANAGEMENT AND WEALTH
MAXIMIZATION
• What should be the attitude of the firm's management regarding
firm-specific risks?
• Risks arising out of fluctuations in exchange rates, interest rates and
commodity prices are pervasive; however they affect different firms
in different ways and are therefore firm-specific or idiosyncratic.
• Should the firm spend resources to manage such risks?
Solution: Hedging
• The value of a firm, according to financial theory, is the net present
value of all expected future cash flows.
• Currency risk is defined roughly as the variance in expected cash
flows arising from unexpected exchange rate changes.
• A firm that hedges these exposures reduces some of the variance in
the value of its future expected cash flows.
How Managing Exposure Can Increase an
MNC’s Value
Arguments for Why Exchange Rate Risk is
Irrelevant for MNCs
• An MNC cash flows in numerous currencies should not be affected by
exchange rate risk if the adverse effects due to some currency movements
are offset by the favorable effects of other currency movements
• If stakeholders (like shareholders or creditors) have stakes in well
diversified portfolio of MNCs, then their portfolio’s value might be
insulated if adverse effect of exchange rates on some MNCs are offset by
favorable effects of exchange rates on other MNCs. If these stakeholders
can insulate their portfolios from exchange rate effects, MNCs should not
worry about this risk
• Investors who invest in MNCs can hedge exchange rate risk on their own. If
they believe that their investments in Indian based MNCs would be
adversely affected when foreign currency weakens against INR, they could
hedge themselves by taking positions in derivatives markets.
Arguments for Why Exchange Rate Risk is
Relevant for MNCs
• Exchange rate effects on an MNC will not be offsetting because exchange
rate movements of many currencies can be correlated against home
currency over a specified period of time. Therefore an MNC can not ignore
currency risk.
• Many MNCs are similarly affected by exchange rate movements, so it
would be difficult for investors to create diversified portfolio of MNCs that
will be fully insulated from exchange rate movements.
• Investors who invest in MNCs don’t have complete information on each
MNC’s exposure to exchange rate fluctuations, so they may not have ability
to hedge the exposure of their individual investments to exchange rate risk.
MNCs are better informed about their own exposure to exchange rate risk
and should have more expertize in managing hat risk.
 TAXONOMY OF
CURRENCY EXPOSURE
 CONCEPTUAL COMPARISON OF TRANSACTION,
OPERATING AND ACCOUNTING
FOREIGN EXCHANGE EXPOSURE

Moment in time when

exchange rate changes

Translation exposure Operating exposure

Changes in reported owners’ equity Change in expected future cash flows
in consolidated financial statements arising from an unexpected change in
caused by a change in exchange rates exchange rates

Transaction exposure
Impact of settling outstanding obligations entered into before change
in exchange rates but to be settled after change in exchange rates
Time
 THE LIFE SPAN OF A
TRANSACTION EXPOSURE
Time and Events

t1 t2 t3 t4
Seller quotes Buyer places Seller ships Buyer settles A/R
a price to buyer firm order with product and with cash in
(in verbal or seller at price bills buyer amount of currency
written form) offered at time t1 (becomes A/R) quoted at time t1

Quotation Backlog Billing

Exposure Exposure Exposure

Time between quoting Time it takes to Time it takes to

a price and reaching a fill the order after get paid in cash after
contractual sale contract is signed A/R is issued
 Transaction Exposure
• Transactions Exposures result from an unanticipated change in the
exchange rate which has an impact - favorable or adverse - on the
firm’s cash flows during the upcoming accounting period. Most
often, the term is used to denote exposures on items the foreign
currency values of which are contractually fixed – export receivables,
import payables, interest payable etc.
• Transaction risk can be defined as a measure of variability in the
value of assets and liabilities when they are liquidated
• Points to be noted are
• Transactions exposures usually have short time horizons;
• Operating cash flows are affected; exchange gains/losses have tax
implications
Anticipated Cash Flow Exposure
• Anticipated cash flow exposure is the case when a transaction is being
negotiated, all the terms have been more or less finalized but a
contractual arrangement is yet to be entered into
Translation (Accounting) Exposure
• Translation Exposure also called Balance Sheet Exposure: It is the exposure on assets
and liabilities appearing in the balance sheet but which are not going to be liquidated in
the foreseeable future
• Translation exposure arises when a firm has
• A foreign operation such as a branch, a joint venture or 100% subsidiary in a foreign
currency.
• The home country law requires that the parent must translate financial statements of
foreign operations from foreign to home currency and consolidate with parent financial
statements.
• Foreign currency fluctuations lead to translation gains or losses. No cash flow
implications
• Finance theorists argue that translation losses and gains are only notional accounting
losses and gains. No cash flow impact. Published financial statements are affected.
Long Term Exposures: Economic Exposure
• Economic exposure can be divided into: Transaction and operating
exposure
• Operating Exposure: It captures unanticipated exchange rate impact
on future revenues, costs, operating cash flows
• Strategic Exposure: In the long run, exchange rate effects can even
undermine a firm's competitive advantage by raising its costs above
those of its competitors or affecting its ability to service its market in
other ways
• Such competitive exposure is often referred to as "Strategic
Exposure" because it has significant implications for some strategic
business decisions such as choice of markets, sourcing, location etc.
Indirect Exposure
• Even if a firm has no direct involvement in any cross-border
transactions it is not immune to exchange rate exposure
• “Indirect" exposure is also in the nature of operating exposure faced
by the firm where changes in exchange rates will most likely have an
impact on its customers, suppliers and competitors which in turn will
force the firm to alter its operations and strategies
Case1: It is April 30, 2022. An Indian pharmaceutical company has
cleared a shipment of imported chemicals. The invoice is for $500,000
payable on August 2, 2022. The current exchange rate is 82.75 rupees
per dollar. The recent history of the exchange rate shows a sharp rise of
dollar with moderate volatility. During 2021-22, the dollar had shown a
mixed trend against the rupee. An adverse movement in exchange rate
will affect the firm’s cash flows. There is also the problem of how to
value the imports for the purpose of product costing and pricing
decisions.
WHAT SHOULD THE FIRM DO?
 Case 2
§ A Swiss pharmaceutical firm has a US subsidiary. Financial
statements of the subsidiary are denominated in US dollars.
§ The financial year of the Swiss parent firm is September-
August. On the balance sheet date it must translate the balance
sheet and P-L account of its US subsidiary from dollars to Swiss
francs.
§ During the last few months the US dollar has been weakening
against the Swiss franc. CAN ANYTHING BE DONE ABOUT IT?
Case 3: Caterpillar is an American firm which manufactures
heavy construction equipment. At the start of the 1980’s all its
manufacturing operations were located in the US while it sold its
products around the world priced in local currencies. Its nearest
competitor was Komatsu of Japan. Around mid-1981 the US
dollar started rising against all currencies and continued rising
month after month. Caterpillar found that its revenues measured
in dollars were shrinking while costs kept pace with US inflation.
Margins shrank. It could not compensate by raising local currency
prices in export markets because Komatsu was holding the price
line.
HOW COULD CATERPILLAR COPE WITH THIS?
Case:4
• Suppose a firm is involved in producing goods for export and/or
import substitutes. It may also import a part of its raw materials
components and so on. A change in exchange rate would give rise to a
number of concerns for such a firm:
• What would be the effect on sales volume if prices are maintained?
• If prices changed?
• Should prices be changed?
Contd..
• Essentially a firm exporting might benefit from reducing its foreign currency price to foreign
customers following an appreciation to foreign currency
• A firm which produces import substitutes may contemplate an increase in its domestic currency
price to its customers without hurting its sales
• A firm supplying inputs to customers, who in turn export, will find demand for its product is
sensitive to exchange rate changes
• Material Cost: Even if all the inputs are locally purchased, if their production requires imported
inputs they would be sensitive to exchange rate changes
• Labour Cost: also increases if cost of living increases and wages and salaries have to be raised
• Interest Cost: on working capital may increase in response to depreciation in home currency due
to which central bank may apply tighter monetary policy which result in increase in interest rates
• Remember: In general exchange rate changes will affect both future revenues and operating
costs, and hence operating income
Some cases of Operating Exposures
• The relentless rise of dollar, during first half of 1980s, eroded the competitive position of
many American firms. Companies like Kodak found most of their costs were dollar
denominated and sales were in all parts of world. It also faced stiff competition from
Japanese firms like Fuji, both in U.S. market and in third world countries. It could not
raise price and many other companies like International Harvester had to move out of
U.S.
• Conversely, when USD started falling against yen and deutschemark around mid -1985
and continued to fall for over two years, many Japanese and German car makers found
their margins squeezed and they responded by shifting their manufacturing plant to U.S.
• During 2007 and 2008, the rupee appreciated against dollar and for a while stayed below
INR 40 per USD. This had significant adverse impact on competitive position of Indian
exporters of garments, jewelry and other export oriented industries.
• A firm which produces an import substitute for purely domestic consumption with inputs
denominated in home currency in nonetheless exposed to competitive exposure. An
appreciation of home currency put it at a disadvantage relative to its competitors who
sell imported products.
• A firm which buys its input from local firms, who in turn have significant import content
is also affected by exchange rate changes as a firm which directly imports some of inputs
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
Transaction Exposure Example
• MNC needs to project the consolidated net amount in currency inflow
or outflows for all its subsidiaries, categorized by currency
• Example: Following is the consolidated Net Cashflow of US MNC
Example: Estimating the range of net inflows
or outflows for MNC
Exposure of an MNC’s Portfolio

s p = Wx2s x2 + Wy2s y2 + 2WxWys xs y CORRxy

W = proportion of portfolio value in currency x or y
σ = standard deviation of percentage changes in currency x or y
CORR = correlation coefficient of percentage changes in currencies x and y

• 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
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
Transaction Exposure Based on Value at Risk
(VAR)
• Celia Co. will receive 10 mn Mexican pesos (MXP) with spot rate of .09tomorrow
as a result of providing consulting services to a Mexican firm. It wants to
determine the maximum 1-Day loss due to a potential decline in the value of
peso, based on a 95% confidence level. It estimates the standard deviation of
daily percentage changes of the Mexican peso to be 1.2% over last 100 days. If
these daily % changes are normally distributed, the maximum one day loss is
determined by the lower boundary (left tail) of a one-tailed probability
distribution., which is about 1.65 standard deviation away from the expected %
change in peso. Assuming expected % change to be 0% during next day,
maximum 1-day loss is:
E(et)-(1.65*σMXP)
= 0% - (1.65*1.2%)
=-1.98%
• Assume spot rate of peso to be $.09. What would be max. 1-day loss?
Solution
• Peso value based on max. 1-day loss =S*(1+max 1-day loss)
• =$0.09* (1+ (-0.0198) =$0.088218
• Thus, if max. 1 day loss occurs peso will have to decline to $0.088218
• If Celia has MXP10mn exposure, it represents $9,00,000 (at $.09 per
peso)
• So, decline in pesos value of -1.98% would result in loss of
$9,00,000*-1.98% = $17,820 (loss)
Factors That Affect Max 1-Day Loss
• Expected % change in currency next day
• Confidence level used i.e. 95%, (90% and so on)
• Standard deviation of daily percentage changes in currency over a
previous period
Applying VAR to a longer time Horizon
• In such case, S.D. should be estimated over time horizon in which the
max. loss is measured
• Example: Lada, Inc. expects to receive MXP in 1 month for products it
exports. It wants to determine Max 1-month loss with 95%
confidence level. If S.D. of monthly % changes in peso is 6% over last
40 months and assuming -1% change during next month of peso what
would be its 1 month loss?
Solution: VAR to a longer time Horizon
Max. 1-month loss = E(et)-(1.65*σMXP)
= -1% - (1.65*6%)
=-.109 or -10.9%
• If Lada, Inc. is uncomfortable with the magnitude of loss, it can hedge
its positon.
Limitations of VAR
• It presumes that distribution of exchange rates is normal.
• If distribution is not normal, there would be errors.
• In addition it assumes volatility of exchange rates is stable overtime.
Economic Exposure
• The sensitivity of firm’s cashflows to exchange rate movements is
referred to as economic exposure (sometimes also referred to as
operating exposures).
• Transaction exposure is a subset of economic exposure, however,
economic exposure includes other ways in which firm’s cash flows can
be affected by exchange rate movements.
• Economic exposure arises from:
a. Exposure to local currency appreciation
b. Exposure to local currency depreciation
Example: Economic Exposure
• Intel invoices about 65% of its chip exports in US$. Although there is
no transaction exposure here, however, co. is subject to economic
exposure. If Euro weakens against dollar, European importers of these
chips from Intel will need more euros to pay them and hence may
decide to purchase chips form European manufacturers instead.
Consequently cashflows from its exports would reduce, even though
exports are invoiced in dollars.
Examples That Subject a Firm to Economic
Exposure
Economic Exposure to Exchange Rate
Fluctuations
Measuring Economic Exposure
1. Use of sensitivity analysis
2. Use of regression analysis
 Measuring Economic Exposure: Sensitivity Analysis
• Madison CO. a US based MNC purchases most of its materials from
Canada and generate smaller portion of sales from exporting to Canada.
Its US sales are denominated in US$, while Canadian sales in C$.
Estimates of its cashflows are as below (in Mn$):

• Assume Madison Co. expects 3 possible exchange rate scenarios of C$

over period of concern: (1) $.75, (2) $.80 and (3) $.85. Find out
economic exposure of co.
Impact of Possible Exchange Rates on Cash
Flows of Madison Co. (in Millions)
Analysis
• Madison’s Cos. US sales are not sensitive to exchange rate scenarios
• Canadian sales of C$4mn are sensitive to exchange rates
• Cost of material purchased from US $50mn is insensitive while
purchased from Canadian of C$200 mn is sensitive to exchange rates
• Borrowed money of C$ is also sensitive to exchange rates
• Since its expenses and borrowed loan are more in C$, so its cashflows
are inversely related to strength of C$
• IF C$ continues to rise over years, the Co. may have to revisit its
operational strategies by either increasing Canadian sales or reducing
its dependence on raw material from Canada.
Issues involved in Restructuring Decisions
• Restructuring operations to reduce economic exposure is more
complex task than hedging any single foreign currency transaction.
• Following are the major issues in restricting decisions:
1. Should the firm attempt to increase or reduce sales in new or existing
foreign markets?
2. Should the firm increase or reduce its dependency on foreign suppliers?
3. Should the firm establish or eliminate production facilities in foreign
markets?
4. Should the firm increase or reduce its level of debt denominated in foreign
currencies?
Restructuring to Reduce Economic Exposure
• Restructuring to reduce economic exposure, e.g.:
a. Increase sensitivity of revenues to exchange rate movements
b. Decrease sensitivity of expenses to exchange rate movements
• In previous example of Madison Co., let us assume that it can create more
balance by increasing Canadian sales. It can achieve sales of C$20 mn by spending
$2mn more on advertisement. The increased sales would also require an
additional expenditure of $10mn on materials from US suppliers. It wants to
reduce its reliance on Canadian suppliers and increase reliance on U.S. vendors
which would reduce cost of material from Canadian suppliers by C$100mn and
increase cost of material from U.S. suppliers by $80mn. Further, it plans to
borrow additional money from U.S. and retire existing Canadian debt. The result
would be additional interest expense of $4mn to U.S. banks and reduction of C$5
mn owed to Canadian banks. How would these changes reflect in its financial
statements and what would be the impact on cashflows of Madison by changing
these strategies.
Impact of Possible Exchange Rate Movements on
Earnings under Two Alternative Operational
Structures (in Millions)