Measuring Exposure To Exchange Rate Fluctuations 10 Chapter South-Western/Thomson Learning © 2006.
-
Upload
dominik-easterling -
Category
Documents
-
view
216 -
download
1
Transcript of Measuring Exposure To Exchange Rate Fluctuations 10 Chapter South-Western/Thomson Learning © 2006.
![Page 1: Measuring Exposure To Exchange Rate Fluctuations 10 Chapter South-Western/Thomson Learning © 2006.](https://reader035.fdocuments.in/reader035/viewer/2022062511/551c02fd550346a84f8b4d02/html5/thumbnails/1.jpg)
Measuring Exposure ToExchange Rate Fluctuations
Measuring Exposure ToExchange Rate Fluctuations
1010 Chapter Chapter
South-Western/Thomson Learning © 2006
![Page 2: Measuring Exposure To Exchange Rate Fluctuations 10 Chapter South-Western/Thomson Learning © 2006.](https://reader035.fdocuments.in/reader035/viewer/2022062511/551c02fd550346a84f8b4d02/html5/thumbnails/2.jpg)
10 - 2
Chapter Objectives
To discuss the relevance of an MNC’s 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.
![Page 3: Measuring Exposure To Exchange Rate Fluctuations 10 Chapter South-Western/Thomson Learning © 2006.](https://reader035.fdocuments.in/reader035/viewer/2022062511/551c02fd550346a84f8b4d02/html5/thumbnails/3.jpg)
10 - 3
Is Exchange Rate Risk Relevant?
Purchasing Power Parity Argument Exchange rate movements will be matched
by price movements. PPP does not necessarily hold.
![Page 4: Measuring Exposure To Exchange Rate Fluctuations 10 Chapter South-Western/Thomson Learning © 2006.](https://reader035.fdocuments.in/reader035/viewer/2022062511/551c02fd550346a84f8b4d02/html5/thumbnails/4.jpg)
10 - 4
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.
![Page 5: Measuring Exposure To Exchange Rate Fluctuations 10 Chapter South-Western/Thomson Learning © 2006.](https://reader035.fdocuments.in/reader035/viewer/2022062511/551c02fd550346a84f8b4d02/html5/thumbnails/5.jpg)
10 - 5
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.
Is Exchange Rate Risk Relevant?
![Page 6: Measuring Exposure To Exchange Rate Fluctuations 10 Chapter South-Western/Thomson Learning © 2006.](https://reader035.fdocuments.in/reader035/viewer/2022062511/551c02fd550346a84f8b4d02/html5/thumbnails/6.jpg)
10 - 6
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.
Is Exchange Rate Risk Relevant?
![Page 7: Measuring Exposure To Exchange Rate Fluctuations 10 Chapter South-Western/Thomson Learning © 2006.](https://reader035.fdocuments.in/reader035/viewer/2022062511/551c02fd550346a84f8b4d02/html5/thumbnails/7.jpg)
10 - 7
Response from MNCs
• Many MNCs have attempted to stabilize their earnings with hedging strategies because they believe exchange rate risk is relevant.
Is Exchange Rate Risk Relevant?
![Page 8: Measuring Exposure To Exchange Rate Fluctuations 10 Chapter South-Western/Thomson Learning © 2006.](https://reader035.fdocuments.in/reader035/viewer/2022062511/551c02fd550346a84f8b4d02/html5/thumbnails/8.jpg)
10 - 8
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
![Page 9: Measuring Exposure To Exchange Rate Fluctuations 10 Chapter South-Western/Thomson Learning © 2006.](https://reader035.fdocuments.in/reader035/viewer/2022062511/551c02fd550346a84f8b4d02/html5/thumbnails/9.jpg)
10 - 9
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.
![Page 10: Measuring Exposure To Exchange Rate Fluctuations 10 Chapter South-Western/Thomson Learning © 2006.](https://reader035.fdocuments.in/reader035/viewer/2022062511/551c02fd550346a84f8b4d02/html5/thumbnails/10.jpg)
10 - 10
• 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.
Estimating Net Currency Flows
![Page 11: Measuring Exposure To Exchange Rate Fluctuations 10 Chapter South-Western/Thomson Learning © 2006.](https://reader035.fdocuments.in/reader035/viewer/2022062511/551c02fd550346a84f8b4d02/html5/thumbnails/11.jpg)
10 - 11
Measuring the Potential Impact
• An MNC’s exposure can be measured by considering the proportion of each currency together with the currency’s variability and the correlations among the movements of the currencies.
• For a two-currency portfolio,
xyyxyxyyxxp CORRwwwwσ 22222
![Page 12: Measuring Exposure To Exchange Rate Fluctuations 10 Chapter South-Western/Thomson Learning © 2006.](https://reader035.fdocuments.in/reader035/viewer/2022062511/551c02fd550346a84f8b4d02/html5/thumbnails/12.jpg)
10 - 12
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 1.00No correlation 0.00Perfect negative correlation –1.00
• Both variability and correlations vary among currencies and over time.
![Page 13: Measuring Exposure To Exchange Rate Fluctuations 10 Chapter South-Western/Thomson Learning © 2006.](https://reader035.fdocuments.in/reader035/viewer/2022062511/551c02fd550346a84f8b4d02/html5/thumbnails/13.jpg)
10 - 13
Correlations AmongExchange Rate Movements
BritishPound
CanadianDollar Euro
JapaneseYen
SwedishKrona
BritishPound
CanadianDollar
Euro
JapaneseYen
SwedishKrona
1.00
1.00
1.00
1.00
1.00
.35
.91
.71
.48
.83
.12
.57
.67
.92 .64
![Page 14: Measuring Exposure To Exchange Rate Fluctuations 10 Chapter South-Western/Thomson Learning © 2006.](https://reader035.fdocuments.in/reader035/viewer/2022062511/551c02fd550346a84f8b4d02/html5/thumbnails/14.jpg)
10 - 14
Impact of Cash Flow and Correlation Conditionson an MNC’s Exposure
+Q +Q Negative Low
+Q – Q Slightly positive Moderate
+Q +Q Highly positive High
MNC’s Exposure
Expected Net Cash FlowCurrency x Currency y
Correlation between Currencies x and y
+Q +Q Slightly positive Moderate
+Q – Q Highly positive Low
+Q – Q Negative High
![Page 15: Measuring Exposure To Exchange Rate Fluctuations 10 Chapter South-Western/Thomson Learning © 2006.](https://reader035.fdocuments.in/reader035/viewer/2022062511/551c02fd550346a84f8b4d02/html5/thumbnails/15.jpg)
10 - 15
Movements of Major Currencies against the Dollar
![Page 16: Measuring Exposure To Exchange Rate Fluctuations 10 Chapter South-Western/Thomson Learning © 2006.](https://reader035.fdocuments.in/reader035/viewer/2022062511/551c02fd550346a84f8b4d02/html5/thumbnails/16.jpg)
10 - 16
• 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 MNC’s positions.
• For foreign currency x, the maximum one-day 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] ) = Pfor 95% confidence level, z[.95] = 1.65
x = standard deviation of the daily % in x
Transaction Exposure
![Page 17: Measuring Exposure To Exchange Rate Fluctuations 10 Chapter South-Western/Thomson Learning © 2006.](https://reader035.fdocuments.in/reader035/viewer/2022062511/551c02fd550346a84f8b4d02/html5/thumbnails/17.jpg)
10 - 17
• 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] ) = Pfor 95% confidence level, z[.95] = 1.65
p = standard deviation of the monthly %
in portfolio p
Transaction Exposure
![Page 18: Measuring Exposure To Exchange Rate Fluctuations 10 Chapter South-Western/Thomson Learning © 2006.](https://reader035.fdocuments.in/reader035/viewer/2022062511/551c02fd550346a84f8b4d02/html5/thumbnails/18.jpg)
10 - 18
Economic Exposure
• Economic exposure refers to the degree to which a firm’s 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.
![Page 19: Measuring Exposure To Exchange Rate Fluctuations 10 Chapter South-Western/Thomson Learning © 2006.](https://reader035.fdocuments.in/reader035/viewer/2022062511/551c02fd550346a84f8b4d02/html5/thumbnails/19.jpg)
10 - 19 Transactions that reflect transaction exposure
Economic Exposure to Exchange Rate Fluctuations
Firm’s exports denominated Decrease Increasein foreign currency
Interest owed on foreign funds Decrease Increaseborrowed
Transactions that Influence the Firm’s Cash Inflows
Local Currency Appreciates
Local Currency Depreciates
Local sales (relative to foreign Decrease Increasecompetition in local markets)Firm’s exports denominated Decrease Increasein local currency
Interest received from foreign Decrease Increaseinvestments
Firm’s imported supplies No change No changedenominated in local currency
Transactions that Influence the Firm’s Cash Inflows
Firm’s imported supplies Decrease Increasedenominated in foreign currency
![Page 20: Measuring Exposure To Exchange Rate Fluctuations 10 Chapter South-Western/Thomson Learning © 2006.](https://reader035.fdocuments.in/reader035/viewer/2022062511/551c02fd550346a84f8b4d02/html5/thumbnails/20.jpg)
10 - 20
• Economic exposure can be measured by assessing the sensitivity of the firm’s earnings to exchange rates. ¤ This involves reviewing how the earnings
forecast in the firm’s 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
![Page 21: Measuring Exposure To Exchange Rate Fluctuations 10 Chapter South-Western/Thomson Learning © 2006.](https://reader035.fdocuments.in/reader035/viewer/2022062511/551c02fd550346a84f8b4d02/html5/thumbnails/21.jpg)
10 - 21
• Economic exposure can also be measured by assessing the sensitivity of the firm’s cash flows to exchange rates through regression analysis.
• For a single foreign currency:
Economic Exposure
PCFt = a0 + a1et + t
PCFt= % in inflation-adjusted cash flows measured in the firm’s home currency over period tet = % in the exchange rate over period t
![Page 22: Measuring Exposure To Exchange Rate Fluctuations 10 Chapter South-Western/Thomson Learning © 2006.](https://reader035.fdocuments.in/reader035/viewer/2022062511/551c02fd550346a84f8b4d02/html5/thumbnails/22.jpg)
10 - 22
• 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 firm’s value (as measured by its stock price), earnings, exports, sales, etc. may also be assessed.
Economic Exposure
![Page 23: Measuring Exposure To Exchange Rate Fluctuations 10 Chapter South-Western/Thomson Learning © 2006.](https://reader035.fdocuments.in/reader035/viewer/2022062511/551c02fd550346a84f8b4d02/html5/thumbnails/23.jpg)
10 - 23
Translation Exposure
• The exposure of an MNC’s 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.
![Page 24: Measuring Exposure To Exchange Rate Fluctuations 10 Chapter South-Western/Thomson Learning © 2006.](https://reader035.fdocuments.in/reader035/viewer/2022062511/551c02fd550346a84f8b4d02/html5/thumbnails/24.jpg)
10 - 24
Does Translation Exposure Matter?
Cash Flow Perspective The translation of financial statements for
consolidated reporting purposes does not by itself affect an MNC’s 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.
![Page 25: Measuring Exposure To Exchange Rate Fluctuations 10 Chapter South-Western/Thomson Learning © 2006.](https://reader035.fdocuments.in/reader035/viewer/2022062511/551c02fd550346a84f8b4d02/html5/thumbnails/25.jpg)
10 - 25
Does Translation Exposure Matter?
Stock Price Perspective Since an MNC’s translation exposure affects
its consolidated earnings and many investors tend to use earnings when valuing firms, the MNC’s valuation may be affected.
![Page 26: Measuring Exposure To Exchange Rate Fluctuations 10 Chapter South-Western/Thomson Learning © 2006.](https://reader035.fdocuments.in/reader035/viewer/2022062511/551c02fd550346a84f8b4d02/html5/thumbnails/26.jpg)
10 - 26
• An MNC’s 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.
Translation Exposure
![Page 27: Measuring Exposure To Exchange Rate Fluctuations 10 Chapter South-Western/Thomson Learning © 2006.](https://reader035.fdocuments.in/reader035/viewer/2022062511/551c02fd550346a84f8b4d02/html5/thumbnails/27.jpg)
10 - 27
• In the 2000–2001 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.
Translation Exposure