Slide 1

Measuring Exposure to Exchange Rate Fluctuations

Chapter 10

Overview

Present the relevance of an MNC’s exchange rate exposure

Explain measurement of transaction exposure

Explain how economic exposure is measured

Explain measurement of translation exposure

"Exchange Rate Risk"

Exchange Rate Risk

definition

the risk that a company’s performance will be effected by exchange rate movements

Relevance of Exchange Rate Risk

Arguments against relevance

some people say that a firm’s exposure to exchange rate risk is not relevant

one argument for irrelevance is that , according to purchasing power parity (PPP) theory, exchange rate movements should be matched by price movements

argues that similar costs exist across countries

Relevance of Exchange Rate Risk

Arguments against relevance

according to purchasing power parity (PPP) theory,

a lower dollar means imports are more expensive

but a lower dollar also means inflation is high so domestic stuff cost more to make

Relevance of Exchange Rate Risk

Arguments against relevance

re: purchasing power parity (PPP) theory,

PPP does not hold true in real life

the exchange rate does not change in accordance with the inflation difference between the two countries

Relevance of Exchange Rate Risk

Arguments supporting relevance

hedging reduces volatility of MNC operations

creditors may prefer that the firms to which they lend maintain low exposure to exchange rate risk

creditors are usually the banks and they are serving their own interests since the things companies will do to reduce exchange rate risk will involve using the services of banks

Relevance of Exchange Rate Risk

Arguments supporting relevance

volatile foreign earnings can also cause more volatile growth

which is costly

hedging can reduce the volatility of cash flows cause the firm’s payments and receipts are not forced to fluctuate in accordance with the currency movements

Slide 10

"Before knowing what techniques to..."

Before knowing what techniques to use to reduce exchange rate exposure, we first of all have to measure it to see if it is of any consequence

Transaction Exposure

The degree to which transactions can be effected by exchange rate fluctuations is transaction exposure

Transaction Exposure

TWO steps are involved in measuring transaction exposure

1. Determine the projected net amount of inflows and outflows in each foreign currency

2. Determine the overall risk of exposure to those currencies

Transaction Exposure

Affects exposure to net cash flow

consolidates subsidiaries’ cash in/outflows

e.g., minimal exposure in Mexican peso if

Subsidiary A has net inflow of PS9,000,000

Subsidiary B has net outflow of PS8,700,000

Transaction Exposure

Exposure to currency variability

MNC develops range of projected exchange rates for the end of the specified period

standard deviation may be helpful

variability changes over time

Transaction Exposure

Currency correlation

pattern of movement between two currencies

affects net exposure for MNC

Transaction Exposure

Currency correlation, example

German mark and Swiss franc increase in value

MNC X has net inflow exposure from Germany

MNC Y has net outflow exposure in Germany with similar sized inflow exposure from Switzerland

DM and SF have a correlation of 94 percent

Net transaction exposures

MNC X maintains currency risk exposure

MNC Y has offsetting DM and SF exposure

Transaction Exposure

Steps to assess transaction exposure

assess MNC’s position in each currency

estimate how an exposure in a currency affects the MNC

use standard deviations and correlations

assess the “net” effect of currency exposures

Economic Exposure

Currency fluctuations affect more than currency transactions

e.g., an increase in inflation in France may:

1. lower value of outflow from France (transaction exposure)

2. increase subsidiary’s French sales

3. raise financing cost in France

Economic Exposure

Impact of local currency depreciation

inflows of local currency

Economic Exposure

Impact of local currency depreciation

outflows of local currency

Economic Exposure

Indirect exposure

impact from currency revaluation

e.g., exporters may increase prices to compensate for devaluation of home currency

Economic Exposure

Exposure of domestic firms

impacted by foreign competition and financial markets

Economic Exposure

Exposure of domestic firms

impacted by foreign competition and financial markets

Exposure of MNCs

face exposure on domestic and foreign soils

Jan-May 1993:13% appreciation of Japanese yen against $US

many US firms increase US market share

Japanese firms often priced out of the US market

Economic Exposure:
Measurement

Assess sensitivity of earnings to exchange rate fluctuations

sort income statement items by currency

project future values from estimated rates

conduct sensitivity analysis on estimates

Translation Exposure

Affects value of assets, liabilities and earnings

Argument for relevance to MNC

affects financial statements (MNC performance)

reflects an earlier trend in opinions

Translation Exposure

Affects value of assets, liabilities and earnings

Argument for relevance to MNC

affects financial statements (MNC performance)

reflects an earlier trend in opinions

Argument for irrelevance to MNC

does not affect cash flows

weak foreign currency may be retained or invested in foreign country

Translation Exposure
Determinants

Level of foreign involvement by foreign subsidiaries

a greater exposure exists when:

a larger contribution is made offshore

Translation Exposure
Determinants

Locations of foreign subsidiaries

affects currencies used in initial measurements

Translation Exposure
Determinants

Accounting methods

affect how and what financial numbers are reported

Summary

Exchange rate exposure may affect financing costs

volatile cash flow from exchange rate changes increases risk

Transaction exposure

reflects the exposure of an MNC’s future cash transactions to exchange rate movements

Summary

Economic exposure

measures the direct and indirect risks to cash flows from exchange rate movements

Translation exposure

focuses on consolidated financial statements


	Present the relevance of an MNC’s exchange rate exposure
	Explain measurement of transaction exposure
	Explain how economic exposure is measured
	Explain measurement of translation exposure


	Exchange Rate Risk
	definition
	the risk that a company’s performance will be effected by exchange rate movements


Arguments against relevance
	some people say that a firm’s exposure to exchange rate risk is not relevant
	one argument for irrelevance is that , according to purchasing power parity (PPP) theory, exchange rate movements should be matched by price movements
		argues that similar costs exist across countries


	Arguments against relevance
		according to purchasing power parity (PPP) theory,
		a lower dollar means imports are more expensive
		but a lower dollar also means inflation is high so domestic stuff cost more to make


	Arguments against relevance
		re: purchasing power parity (PPP) theory,
		PPP does not hold true in real life
		the exchange rate does not change in accordance with the inflation difference between the two countries


	Arguments supporting relevance
		hedging reduces volatility of MNC operations
		creditors may prefer that the firms to which they lend maintain low exposure to exchange rate risk
		creditors are usually the banks and they are serving their own interests since the things companies will do to reduce exchange rate risk will involve using the services of banks


	Arguments supporting relevance
		volatile foreign earnings can also cause more volatile growth
		which is costly
		hedging can reduce the volatility of cash flows cause the firm’s payments and receipts are not forced to fluctuate in accordance with the currency movements


	Before knowing what techniques to use to reduce exchange rate exposure, we first of all have to measure it to see if it is of any consequence


	The degree to which transactions can be effected by exchange rate fluctuations is transaction exposure


	TWO steps are involved in measuring transaction exposure
	1. Determine the projected net amount of inflows and outflows in each foreign currency
	2. Determine the overall risk of exposure to those currencies


Affects exposure to net cash flow
	consolidates subsidiaries’ cash in/outflows
	e.g., minimal exposure in Mexican peso if
		Subsidiary A has net inflow of PS9,000,000
		Subsidiary B has net outflow of PS8,700,000


Exposure to currency variability
	MNC develops range of projected exchange rates for the end of the specified period
		standard deviation may be helpful
		variability changes over time


	Currency correlation
		pattern of movement between two currencies
		affects net exposure for MNC


Currency correlation, example
	German mark and Swiss franc increase in value
		MNC X has net inflow exposure from Germany
		MNC Y has net outflow exposure in Germany with similar sized inflow exposure from Switzerland
			DM and SF have a correlation of 94 percent
	Net transaction exposures
		MNC X maintains currency risk exposure
		MNC Y has offsetting DM and SF exposure


Steps to assess transaction exposure
	assess MNC’s position in each currency
	estimate how an exposure in a currency affects the MNC
		use standard deviations and correlations
	assess the “net” effect of currency exposures


Currency fluctuations affect more than currency transactions
	e.g., an increase in inflation in France may:
		1. lower value of outflow from France (transaction exposure)
		2. increase subsidiary’s French sales
		3. raise financing cost in France


	Impact of local currency depreciation
		inflows of local currency


	Impact of local currency depreciation
		outflows of local currency


Indirect exposure
	impact from currency revaluation
		e.g., exporters may increase prices to compensate for devaluation of home currency


	Exposure of domestic firms
		impacted by foreign competition and financial markets


Exposure of domestic firms
	impacted by foreign competition and financial markets
Exposure of MNCs
	face exposure on domestic and foreign soils
	Jan-May 1993:13% appreciation of Japanese yen against $US
		many US firms increase US market share
		Japanese firms often priced out of the US market


	Assess sensitivity of earnings to exchange rate fluctuations
		sort income statement items by currency
		project future values from estimated rates
		conduct sensitivity analysis on estimates


	Affects value of assets, liabilities and earnings
	Argument for relevance to MNC
		affects financial statements (MNC performance)
		reflects an earlier trend in opinions


Level of foreign involvement by foreign subsidiaries
	a greater exposure exists when:
		a larger contribution is made offshore


	Locations of foreign subsidiaries
		affects currencies used in initial measurements


	Accounting methods
		affect how and what financial numbers are reported


	Exchange rate exposure may affect financing costs
		volatile cash flow from exchange rate changes increases risk
	Transaction exposure
		reflects the exposure of an MNC’s future cash transactions to exchange rate movements


	Economic exposure
		measures the direct and indirect risks to cash flows from exchange rate movements
	Translation exposure
		focuses on consolidated financial statements