Measuring and Managing

Exposure to Exchange Rate

Fluctuations
Topic 7

1
Firms with international operations are exposed to
exchange rate risks due to the fluctuations in
currency values
3 forms of exposures encountered by international
firms.

(1) transaction exposure

(2) economic exposure and
(3) translation exposure.

 The combined effect of the 3 can be

catastrophic to the performance of
multinationals
2
 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.
 Transaction Exposure

• Most commonly observed among the three

exchange rate risks.
• Two conditions are necessary for
transaction exposure to exist. They include
• (1) A cash flow denominated in a foreign
currency
• (2) The cash flow will occur at a future
date.
4
Transaction Exposure (cont’d)
• Any contract, agreement, purchase, or sale
that is denominated in a foreign currency that
will be settled in the future constitutes a
transaction exposure.
• The risk of a transaction exposure is that the
exchange rate might change between the
present date and the settlement date.
• The change may indeed be for the better or
for the worse.
5
Transaction Exposure (cont’d)
• If transaction exposure exists, the firm
faces 3 major tasks.
1. It must identify the degree of transaction
exposure.
2. It must decide whether to hedge this
exposure.
3. If it decides to hedge part or all of the
exposure, it must choose among the
various hedging techniques available.
6
Transaction Exposure (cont’d)
• 2 steps are involved in measuring
transaction exposure:
(1) Determine the projected net amount of
inflows or outflows in each foreign
currency.
(2) Determine the overall risk of exposure to
these currencies.

7
Transaction Exposure (cont’d)
• Transaction Exposure to “Net” Cash
Flows
• Measurement of transaction exposure
requires projections of the consolidated
net amount in currency inflows or outflows
for all subsidiaries, categorized by
currency (see exhibit 1)

8
Exhibit 1: Consolidated Net Cash Flow Assessment of the XYZ
Company.

Currency Total Inflow Total Outflow Net Inflow or Expecte Net Inflow
Outflow d Exch or Outflow
Rate at as Measured
End of in US$
Period
UK £20,000,000 £10,000,000 +£10,000,000 $1.60 +$16,000,0
pounds 00
Canadian C$22,000,00 C$12,000,00 C$10,000,000 $.90 +$9,000,00
dollars 0 0 0
Danish SK120,000,0 SK220,000,0 - $.18 -
Kroner 00 00 SK100,000,00 $18,000,000
0
European €10,000,000 €20,000,000 -€10,000,000 $1.32 -
Union $13,200,000
Euro 9
Transaction Exposure (cont’d)
• The expected exchange rate can also be
given as a range of possible exchange
rates
• A range of possible net inflows or outflows
may be computed in the home currency
based on the range.
• Expected net cash flow can be computed
for any period, weekly, monthly, quarterly
etc.
10
Transaction Exposure (cont’d)
• An MNCs overall exposure can be
assessed only after considering
• each currency’s variability and
• the correlations among currencies

11
Transaction Exposure (cont’d)
• Transaction Exposure Based On Currency
Variability
• Whilst it is difficult to predict exchange rate
projection, an MNC may evaluate historical
data in order to at least assess the potential
degree of movement for each currency.
• Measurement of Currency Variability -
The standard deviation statistic serves as
one possible way to measure the degree of
movement for each particular currency.
12
 Transaction Exposure
Standard Deviations of Exchange Rate Movements
Based on Monthly Data

Currency 1981-1993 1994-1998

British pound 0.0309 0.0148
Canadian dollar 0.0100 0.0110
Indian rupee 0.0219 0.0168
Japanese yen 0.0279 0.0298
New Zealand dollar 0.0289 0.0190
Swedish krona 0.0287 0.0195
Swiss franc 0.0330 0.0246
Singapore dollar 0.0111 0.0174
13
 Currency Variability over Time
• Standard deviations can change over time
(see small variations in the different times
given).
• The use of previous time periods to
assess future currency variability will not
be perfect.
• However, it helps to identify most likely
stable currencies.

14
 Transaction Exposure
• The correlations among currency
movements can be measured by their
correlation coefficients, which indicate the
degree to which two currencies move in
relation to each other.
coefficient
perfect positive correlation 1.00
no correlation 0.00
perfect negative correlation -1.00
15
 Transaction Exposure
Correlations Among Exchange Rate Movements
£ Can$ ¥ NZ$ Sk SwF
British
pound (£) 1.00
Canadian
dollar (Can$) .18 1.00
Japanese
yen (¥) .45 .06 1.00
New Zealand
dollar (NZ$) .39 .20 .33 1.00
Swedish
krona (Sk) .62 .16 .46 .33 1.00
Swiss franc
(SwF) .63 .12 .61 .37 .70 1.0016
 Transaction Exposure
• The point in considering correlations is to
detect positions that could somewhat
offset each other.
• For example, if currencies X and Y are
highly correlated, the exposures of a net X
inflow and a net Y outflow will offset each
other to a certain degree.
• Note that the corrrelations among
currencies may change over time.
17
 Illustration
• Assume a company will need $20 million
to purchase currency X in a year’s time.
• This same company will also need another
$20 million to purchase currency Y also in
a year’s time.
• Assume that currencies X and Y are
negatively correlated and that currency X
will appreciate by 10% over the next one
year with the dollar.
18
 Illustration cont’d
• This also means that currency Y will
depreciate by about 10% over the next
one year with the dollar.
• The 10% appreciation of currency X
means that we will need $22 ($20 million
+$2 million).
• At the same time currency Y will
depreciate by about 10% in a year’s time.

19
 Illustration cont’d
• This means that we shall need about 10%
less dollars to purchase currency Y.
• Thus we will need $18 million ($20 million
– $2 million).
• The implications are that the additional $2
million needed to purchase currency X will
be offset by the $2 million saved due to
depreciation of currency Y.

20
 Illustration cont’d
• Whilst a perfect offset is not likely to occur,
an analysis of correlation should be able to
detect positions which will offset each
other substantially.

21
 Movements of Selected Currencies
Against the Dollar
1.40
$/10 Indian rupees
1.20 $/100 ¥
1.00 $/Canadian$
$ per unit

0.80
0.60
0.40 $/Singapore$ $/5 Swedish krona

0.20 $/Chinese yuan

0.00
1981 1986 1991 1996 2001
22
 Transaction Exposure
• A related method, the value-at-risk (VAR)
method, incorporates currency volatility
and correlations to determine the potential
maximum one-day loss.
• Historical data is used to determine the
potential one-day decline in a particular
currency. This decline is then applied to
the net cash flows in that currency.

23
• Company to receive 10 million MXN
tomorrow for consultancy payment.
• -Determine the maximum one-day loss
due to a potential decline in value of peso.
• Based on 95% confidence level,
• Estimates of standard deviation of daily
percentage changes of MXN to be 1.2%
over the last 100 days.
24
• Assume daily percentage changes are
normally distributed.
• Maximum one-day loss is determined by the
lower boundary (the left tail) of the probability
distribution.
• this is 1.65 standard deviations away from
the expected percentage change in the peso.
• Assuming expected percentage change of
0% (no expected change in the peso) during
the next day.
25
• Maximum one-day loss
• = E (et) – (1.65 × σMXP)
• = 0% - (1.65 × 1.2%)
• = 0.0198
• = 1.98%

26
• Assuming the spot rate of the peso is
$0.09
• The maximum one-day loss of -1.98%
implies a peso value of
• Peso value based on maximum one-day
loss
• = S × [1+ E (e)]
• = $ 0.09 × [1 + (-0.0198)]
• = $ 0.088218 27
• If the maximum one-day loss occurs, the
value of the peso will decline to $0.088218
• If a company has MXP 10 million
represent $900,000 i.e. ($0.09/peso)
• a decline in the peso value of -1.98%
results in a loss of
• $900,000 × -1.98%
• = - 17,820
28
• Factors that affect the maximum one –day
loss
• 3 factors include:
• a) The expected percentage change in the
currency for the next day.
• b) The confidence level used
• c) Standard deviation of the daily
percentage changes in the currency over a
previous period. 29
 Techniques for Eliminating
Transaction Exposure
• 4 techniques available for hedging
transaction exposure include:
1. Forward Contract hedge
2. Money Market hedge
3. Futures Contract hedge
4. Currency Option hedge.

30
 Forward Contract hedge
• Foreign Exchange Market
• Spot rate: $1.2000/Є
• 3 month forward: $1.2152/Є
• Money Market
• 3 month euro 4%
• 3 month U.S. dollar 9%

31
 Forward Contract hedge
• 4th May Deliver $10,000 worth of
shoes to US Company with payment due
on 4th August in US dollars.
• Spot 4th May = $1.2000/Є.
• Export sale = .8333 x 10,000 = 8,333.33
euros.

32
 Forward Contract hedge
• To protect against adverse change in the
value of the dollar against the euros, the
exporter sells $10,000 against euros for
delivery on 4th August at $1.2152/Є
(Є0.8229/$) the market price for 3 month
euros against US dollars i.e. forward
contract will provide 8,229 euros.

33
 Forward Contract hedge
• 4th August
• Italian exporter receives a cheque for US
$10,000
• Exporter delivers $10,000 against forward
contract and receives Є8,229.

34
 Money Market Hedge
• We use the same information as in the
case of forward market hedge.
• 4th May: Deliver $10,000 worth of
shoes to the US shoe importer. Payment
due on 4th August in US dollars,
• Spot price on 4th May = $1.2000/Є
(Є.8333/$)
• Export is worth 8,333 euros.
35
• To protect himself the exporter borrows
$10,000 from New York bank at 9%,
• discounts the loan, then converts the
proceeds, $9775 into euros ($9775 x
.8333 = Є8145.5)
• He invests them in a 3-month bill in
Europe at 4%.
• After 3 months, the bill will be worth
8226.96 euros.
36
• 4th August:
• Exporter receives a cheque for US$10,000
being the proceeds from the export sales.
• Used to pay the $10,000 loan from the
New York bank.
• 3-month euro bill is liquidated and it yields
the anticipated 8226.96 euros.

37
Hedging Long-term Transaction
Exposure
• 3 commonly used techniques to hedge
long-term transaction exposure include
1. Long-term forward hedge
2. Currency swap
3. Parallel loan

38
 Hedging Long-Term
Transaction Exposure
• Long-term forward contracts, or long
forwards, with maturities of ten years or
more, can be set up for very creditworthy
customers.
• Currency swaps can take many forms. In
one form, two parties, with the aid of
brokers, agree to exchange specified
amounts of currencies on specified dates
in the future.
39
 Hedging Long-Term
Transaction Exposure
• A parallel loan, or back-to-back loan,
involves an exchange of currencies
between two parties, with a promise to re-
exchange the currencies at a specified
exchange rate and future date.

40
 Techniques to Reduce
Transaction Exposure
3 techniques include

1. Leading and lagging

2. Cross-hedging
3. Currency diversification

41
Alternative Hedging Techniques
• The act of leading and lagging refers to an
adjustment in the timing of payment
request or disbursement to reflect
expectations about future currency
movements.
• Expediting a payment is referred to as
leading, while deferring a payment is
termed lagging.

42
Alternative Hedging Techniques
• When a currency cannot be hedged, a
currency that is highly correlated with the
currency of concern may be hedged
instead.
• The stronger the positive correlation
between the two currencies, the more
effective this cross-hedging strategy will
be.

43
Alternative Hedging Techniques
• With currency diversification, the firm
diversifies its business among numerous
countries whose currencies are not highly
positively correlated.

44
 Economic Exposure
• Economic exposure results from a
company buying or selling abroad
regularly and faces continual risk of
diminishing revenues or mounting costs
because of adverse exchange rate
movements.
• These ongoing or long-term currency risks
are called economic exposure.

45
 Economic Exposure
• Economic exposure results from the effect
that exchange rates have on export prices
and quantities and hence future corporate
income.
• It also results from the effect of exchange
rates on the prices and quantities sold of
imported goods.

46
 Economic Exposure
• Economic exposure is the risk faced by
exporters vis-a-vis their future income.
• Importers whose importation costs, sales
revenues, and therefore corporate income
depend on exchange rates also face
economic exposure.

47
 Economic Exposure
• Economic exposure is relevant on
exporters and importers for whom
exchange rate changes mean changes in
future profitability.

48
 Economic Exposure
• The importance of managing economic
exposure can be seen from the case of the
bankruptcy of Laker Airways, and from the
the 1997-98 Asian crisis.

49
 Economic Exposure
• A firm can assess its economic exposure
by determining the sensitivity of its
expenses and revenues to various
possible exchange rate scenarios.
• The firm can then reduce its exposure by
restructuring its operations to balance its
exchange-rate-sensitive cash flows.
• Note that computer spreadsheets are
often used to expedite the analysis.
50
 Economic Exposure
• Restructuring may involve:
 increasing/reducing sales in new or existing
foreign markets,
 increasing/reducing dependency on foreign
suppliers,
 establishing or eliminating production facilities
in foreign markets, and/or
 increasing or reducing the level of debt
denominated in foreign currencies.
51
 Economic Exposure
• MNCs must be very confident about the
long-term potential benefits before they
proceed to restructure their operations,
because of the high costs of reversal.

52
 Translation Exposure
• Translation exposure results when an
MNC translates each subsidiary’s financial
data to its home currency for consolidated
financial reporting.
• Translation exposure does not directly
affect cash flows, but some firms are
concerned about it because of its potential
impact on reported consolidated earnings.

53
 Translation Exposures
• It is a risk of losses, or lower profits,
arising from preparation of the
consolidated financial accounts of a
company with foreign subsidiaries.

54
 Translation exposures and the
group balance sheet
• Assume UK company with US subsidiary.
• Net investment (assets – liabilities) in the
subsidiary at January 1 =$110.2 million.
• Net investment in subsidiary on December
31st is unchanged at $110.2.
• Assets and liabilities of the subsidiary
must be translated into sterling for UK
company’s consolidated accounts.
• Year end exchange rate is used
55
 Translation exposures and the
group balance sheet
• Analysis
• Assume dollar weakens
• There is a fall in the sterling value of the
investment
• Example
• January 1 $1.45/£
• December 31 $1.52/£

56
 Translation exposures and the
group balance sheet
• Value of investment £ million
• January 1 ($110.2/$1.45) 76
• December 31 (110.2/1.52 72.5
• Loss on translation 3.5
• Net investment remains at $110.2 million.
• But sterling value of net investment in the US company
has fallen.
• This is due to exchange rate movement.
• The company has incurred a paper loss of £3.5 million
from its translation exposure to the dollar
• This is an accounting loss and not a cash loss

57
 Translation exposures and group
profits
• Profits of foreign subsidiary consolidated
into the group financial accounts by
translating them at appropriate exchange
rate.
• Common rate used is either the average
rate for the year or end of year rate.
• Translated profits could decline due to a
fall in value of subsidiary’s currency

58
 Translation exposures and group
profits
• Example
• A UK subsidiary makes profits of $72
million every year
• For consolidated accounts, profits are
translated at average exchange rate for
the year
• Year 1 = $1.50/£
• Year 2 = $1.60/£
59
 Translation exposures and group
profits
• Analysis
• A UK subsidiary makes profit of $72 million
every year.
• This is translated into sterling
• Year 1 profits (72/1.5) 48.0
• Year 2 profits (72/1.6) 45.0
• Decline in profits (reported in sterling)=3.0
• The decline in reported profits is due to dollar’s
fall in value against sterling
60