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Chapter

10
Measuring Exposure To Exchange Rate Fluctuations

South-Western/Thomson Learning 2006

Chapter Objectives

To discuss the relevance of an MNCs exposure to exchange rate risk; To explain how transaction exposure can be measured; To explain how economic exposure can be measured; and To explain how translation exposure can be measured.
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Is Exchange Rate Risk Relevant?


Purchasing Power Parity Argument
Exchange rate movements will be matched

by price movements.
PPP does not necessarily hold.

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Is Exchange Rate Risk Relevant?


The Investor Hedge Argument
MNC shareholders can hedge against

exchange rate fluctuations on their own.


The investors have complete information on

corporate exposure. They have the capabilities to correctly and efficiently insulate their individual exposure too.

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Is Exchange Rate Risk Relevant?


Currency Diversification Argument
An MNC that is well diversified should not be

affected by exchange rate movements because of offsetting effects.


This is a naive presumption.

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Is Exchange Rate Risk Relevant?


Stakeholder Diversification Argument
Well-diversified stakeholders will be

somewhat insulated against losses experienced by an MNC due to exchange rate risk.
Many MNCs are similarly affected by

exchange rate movements.

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Is Exchange Rate Risk Relevant?


Response from MNCs

Many MNCs have attempted to stabilize


their earnings with hedging strategies because they believe exchange rate risk is relevant.

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Types of Exposure
Although exchange rates cannot be
forecasted with perfect accuracy, firms can at least measure their exposure to exchange rate fluctuations.

Exposure to exchange rate fluctuations


comes in three forms: Transaction exposure Economic exposure Translation exposure
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Transaction Exposure
The degree to which the value of future
cash transactions can be affected by exchange rate fluctuations is referred to as transaction exposure.

To measure transaction exposure:


estimate the net cash inflows or outflows

in each currency, and measure the potential impact of the exposure to those currencies.
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Estimating Net Currency Flows


MNCs can usually anticipate foreign cash
flows for an upcoming short-term period with reasonable accuracy.

After the consolidated net currency flows


for the entire MNC has been determined, each net flow is converted into a point estimate (or range) of a chosen currency.

The exposure for each currency can then


be assessed using the same measure.
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Measuring the Potential Impact


An MNCs exposure can be measured by
considering the proportion of each currency together with the currencys variability and the correlations among the movements of the currencies.

For a two-currency portfolio,


2 2 2 p wx x w2 y y 2w x w y x y CORRxy

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Measuring the Potential Impact


The standard deviation statistic measures
currency variability.

Correlation coefficients indicate the degree


to which two currencies move in relation to each other. Coefficient
Perfect positive correlation No correlation Perfect negative correlation 1.00 0.00 1.00

Both variability and correlations vary


among currencies and over time.
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Correlations Among Exchange Rate Movements


British Pound British Pound Canadian Dollar Euro 1.00 Canadian Dollar

Euro

Japanese Yen

Swedish Krona

.35
.91 .71 .83

1.00
.48 .12 .57 1.00 .67 .92 1.00 .64 1.00
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Japanese Yen
Swedish Krona

Impact of Cash Flow and Correlation Conditions on an MNCs Exposure


Expected Net Cash Flow Currency x Currency y MNCs Correlation between Currencies x and y Exposure
Highly positive High

+Q

+Q

+Q
+Q +Q

+Q
+Q Q

Slightly positive
Negative Highly positive

Moderate
Low Low

+Q
+Q

Q
Q

Slightly positive
Negative

Moderate
High
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Movements of Major Currencies against the Dollar

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Transaction Exposure
The value-at-risk (VAR) method makes use
of currency volatility and correlations to determine the potential maximum one-day loss on the value of an MNCs positions.

For foreign currency x, the maximum oneday loss = E ( ex ) z[P] x


E(ex) = expected % in x for the next day z[P] = if u ~ N(0,1), Prob (u < z[P] ) = P for 95% confidence level, z[.95] = 1.65 x = standard deviation of the daily % in x
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Transaction Exposure
The VAR method can also be used to
assess exposure to multiple currencies and over longer time horizons.

Maximum one-month loss of currency portfolio p = E ( ep ) z[P] p


E(ep) = expected % in p over the next month z[P] = if u ~ N(0,1), Prob (u < z[P] ) = P for 95% confidence level, z[.95] = 1.65 p = standard deviation of the monthly % in portfolio p
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Economic Exposure
Economic exposure refers to the degree to
which a firms present value of future cash flows can be influenced by exchange rate fluctuations.

Some of these affected cash flows do not


require currency conversion.

Even a purely domestic firm may be


affected by economic exposure if it faces foreign competition in its local markets.
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Economic Exposure to Exchange Rate Fluctuations


Transactions that Influence the Firms Cash Inflows Local sales (relative to foreign competition in local markets) Firms exports denominated in local currency Firms exports denominated in foreign currency Interest received from foreign investments Transactions that Influence the Firms Cash Inflows Firms imported supplies denominated in local currency Firms imported supplies denominated in foreign currency Interest owed on foreign funds borrowed Local Currency Local Currency Appreciates Depreciates Decrease Increase
Decrease Decrease Decrease Increase Increase Increase

No change

No change

Decrease
Decrease

Increase
Increase
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Transactions that reflect transaction exposure

Economic Exposure
Economic exposure can be measured by
assessing the sensitivity of the firms earnings to exchange rates. This involves reviewing how the earnings forecast in the firms income statement changes in response to alternative exchange rate scenarios.

In general, firms with more foreign costs


than revenues tend to be unfavorably affected by stronger foreign currencies.
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Economic Exposure
Economic exposure can also be measured
by assessing the sensitivity of the firms cash flows to exchange rates through regression analysis.

For a single foreign currency: PCFt = a0 + a1et + t


PCFt = % in inflation-adjusted cash flows measured in the firms home currency over period t et = % in the exchange rate over period t
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Economic Exposure
The model may be revised to handle
additional currencies by including them as additional independent variables.

By replacing the dependent variable (cash


flows), the impact of exchange rates on the firms value (as measured by its stock price), earnings, exports, sales, etc. may also be assessed.

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Translation Exposure
The exposure of an MNCs consolidated
financial statements to exchange rate fluctuations is known as translation exposure.

In particular, subsidiary earnings


translated into the reporting currency on the consolidated income statement are subject to changing exchange rates.

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Does Translation Exposure Matter?


Cash Flow Perspective
The translation of financial statements for

consolidated reporting purposes does not by itself affect an MNCs cash flows.
However, a weak spot rate today may result

in a weak exchange rate forecast (and hence a weak expected cash flow) for the point in the future when subsidiary earnings are to be remitted.
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Does Translation Exposure Matter?


Stock Price Perspective
Since an MNCs translation exposure affects

its consolidated earnings and many investors tend to use earnings when valuing firms, the MNCs valuation may be affected.

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Translation Exposure
An MNCs degree of translation exposure
is dependent on:
the proportion of its business conducted by

foreign subsidiaries,
the locations of its foreign subsidiaries,

and
the accounting methods that it uses.

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Translation Exposure
In the 20002001 period, the weakness of
the euro caused several U.S.-based MNCs to report lower earnings than what they had expected.

In 2002 and 2003, however, the euro


strengthened, and the consolidated income statements of these U.S.-based MNCs improved.

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