IFM_CH 10 - IIFT

8/13/2019 IFM_CH 10 - IIFT

1/27

Measuring Exposure ToExchange Rate Fluctuations

10

Chapter

South-Western/Thomson Learning 2006

8/13/2019 IFM_CH 10 - IIFT

2/27

10 - 2

Chapter Objectives

To discuss the relevance of an

MNCs exposure to exchange rate risk;

To explain how transaction exposure canbe measured;

To explain how economic exposure can be

measured; and To explain how translation exposure can

be measured.

8/13/2019 IFM_CH 10 - IIFT

3/27

10 - 3

Is Exchange Rate Risk Relevant?

Purchasing Power Par i ty Argument

Exchange rate movements will be matched

by price movements.

PPP does not necessarily hold.

8/13/2019 IFM_CH 10 - IIFT

4/27

10 - 4


The Investor Hedge Argum ent

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 efficientlyinsulate their individual exposure too.

8/13/2019 IFM_CH 10 - IIFT

5/27

10 - 5

Currency Divers i ficat ion A rgum ent

An MNC that is well diversified should not be

affected by exchange rate movementsbecause of offsetting effects.

This is a naive presumption.


8/13/2019 IFM_CH 10 - IIFT

6/27

10 - 6

Stakeho lder Diversi f icat ion Argument

Well-diversified stakeholders will be

somewhat insulated against lossesexperienced by an MNC due to exchange

rate risk.

Many MNCs are similarly affected byexchange rate movements.


8/13/2019 IFM_CH 10 - IIFT

7/2710 - 7

Response from MNCs

Many MNCs have attempted to stabilize

their earnings with hedging strategiesbecause they believe exchange rate risk is

relevant.


8/13/2019 IFM_CH 10 - IIFT

8/2710 - 8

Types of Exposure

Although exchange rates cannot beforecasted with perfect accuracy, firms

can at least measure their exposure to

exchange rate fluctuations.

Exposure to exchange rate fluctuationscomes in three forms:

Transaction exposure Economic exposure

Translation exposure

8/13/2019 IFM_CH 10 - IIFT

9/2710 - 9

Transaction Exposure

The degree to which the value of futurecash 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.

8/13/2019 IFM_CH 10 - IIFT

10/2710 - 10

MNCs can usually anticipate foreign cashflows for an upcoming short-term period

with reasonable accuracy.

After the consolidated net currency flowsfor 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 thenbe assessed using the same measure.

Estimating Net Currency Flows

8/13/2019 IFM_CH 10 - IIFT

11/2710 - 11

Measuring the Potential Impact

An MNCs exposure can be measured byconsidering the proportion of each

currency together with the currencys

variability and the correlations among the

movements of the currencies.

For a two-currency portfolio,

xyyxyxyyxxp CORRwwww 2

2222

8/13/2019 IFM_CH 10 - IIFT

12/2710 - 12

Measuring the Potential Impact

The standard deviationstatistic measurescurrency variability.

Correlation coefficientsindicate the degreeto which two currencies move in relation to

each other. CoefficientPerfect positive correlation 1.00

No correlation 0.00Perfect negative correlation 1.00

Both variability and correlations varyamong currencies and over time.

8/13/2019 IFM_CH 10 - IIFT

13/27

8/13/2019 IFM_CH 10 - IIFT

14/2710 - 14

Impact of Cash Flow and Correlation Conditionson an MNCs Exposure

+Q +Q Negative Low

+Q Q Slightly positive Moderate

+Q +Q Highly positive High

MNCsExposure

Expected Net Cash FlowCurrencyx Currencyy

Correlation betweenCurrencies xand y

+Q +Q Slightly positive Moderate

+Q Q Highly positive Low

+Q Q Negative High

8/13/2019 IFM_CH 10 - IIFT

15/2710 - 15

Movements of Major Currencies against the Dollar

8/13/2019 IFM_CH 10 - IIFT

16/2710 - 16

The value-at-risk (VAR) methodmakes useof 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 one-day loss = E(e

x) z[P] x

E(ex) = expected % in xfor the next dayz[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


8/13/2019 IFM_CH 10 - IIFT

17/2710 - 17

The VAR method can also be used toassess exposure to multiple currencies

and over longer time horizons.

Maximum one-month loss of currencyportfolio p= E(e

p) z[P] p

E(ep) = expected % in pover the next month

z[P] = if u ~ N(0,1), Prob (u < z[P]) = Pfor 95% confidence level, z[.95] = 1.65

p = standard deviation of the monthly %

in portfolio p


8/13/2019 IFM_CH 10 - IIFT

18/2710 - 18

Economic Exposure

Economic exposurerefers to the degree towhich a firms present value of future cash

flows can be influenced by exchange rate

fluctuations.

Some of these affected cash flows do notrequire currency conversion.

Even a purely domestic firm may beaffected by economic exposure if it faces

foreign competition in its local markets.

8/13/2019 IFM_CH 10 - IIFT

19/2710 - 19Transact ions that ref lect transact ion expos ure

Economic Exposure to Exchange Rate Fluctuations

Firms exports denominated Decrease Increase

in foreign currency

Interest owed on foreign funds Decrease Increaseborrowed

Transactions that Influencethe Firms Cash Inflows

Local CurrencyAppreciates

Local CurrencyDepreciates

Local sales (relative to foreign Decrease Increasecompetition in local markets)

Firms exports denominated Decrease Increasein local currency

Interest received from foreign Decrease Increaseinvestments

Firms imported supplies No change No changedenominated in local currency

Transactions that Influencethe Firms Cash Inflows

Firms imported supplies Decrease Increasedenominated in foreign currency

8/13/2019 IFM_CH 10 - IIFT

20/2710 - 20

Economic exposure can be measured byassessing 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.

Economic Exposure

8/13/2019 IFM_CH 10 - IIFT

21/2710 - 21

Economic exposure can also be measuredby assessing the sensitivity of the firms

cash flows to exchange rates through

regression analysis.

For a single foreign currency:

Economic Exposure

PCFt= a0+ a1et+ t

PCFt = % in inflation-adjusted cash flowsmeasured in the firms home currencyover period t

et = % in the exchange rate over period t

8/13/2019 IFM_CH 10 - IIFT

22/27

8/13/2019 IFM_CH 10 - IIFT

23/27

8/13/2019 IFM_CH 10 - IIFT

24/27

10 - 24

Does Translation Exposure Matter?

Cash Flow Perspect ive

The translation of financial statements for

consolidated reporting purposes does not byitself 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 inthe future when subsidiary earnings are to be

remitted.

8/13/2019 IFM_CH 10 - IIFT

25/27

10 - 25

Does Translation Exposure Matter?

Stock Price Perspect ive

Since an MNCs translation exposure affects

its consolidated earnings and many investorstend to use earnings when valuing firms, the

MNCs valuation may be affected.

8/13/2019 IFM_CH 10 - IIFT

26/27

10 - 26

An MNCs degree of translation exposureis dependent on:

the proportion of its business conducted byforeign subsidiaries,

the locations of its foreign subsidiaries,

and

the accounting methods that it uses.

Translation Exposure

8/13/2019 IFM_CH 10 - IIFT

27/27

In the 20002001 period, the weakness ofthe euro caused several U.S.-based MNCs

to report lower earnings than what they

had expected.

In 2002 and 2003, however, the eurostrengthened, and the consolidated

income statements of these U.S.-basedMNCs improved.

Translation Exposure

Documents

IFM_CH 10 - IIFT