Slide 1 of 32 Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson.

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Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson

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Measuring Exposure to Exchange Rate Fluctuations

Chapter 10Chapter 10

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Overview

Present the relevance of an MNC’s Present the relevance of an MNC’s exchange rate exposureexchange rate exposure

Explain measurement of transaction Explain measurement of transaction exposure exposure

Explain how economic exposure is Explain how economic exposure is measuredmeasured

Explain measurement of translation Explain measurement of translation exposure exposure

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Exchange Rate RiskExchange Rate Risk definitiondefinition the risk that a company’s performance the risk that a company’s performance

will be effected by exchange rate will be effected by exchange rate movementsmovements

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Relevance of Exchange Rate Risk

Arguments against relevanceArguments against relevance– some people say that a firm’s exposure to some people say that a firm’s exposure to

exchange rate risk is not relevantexchange rate risk is not relevant– one argument for irrelevance is that , one argument for irrelevance is that ,

according to purchasing power parity according to purchasing power parity (PPP) theory(PPP) theory, exchange rate movements , exchange rate movements should be matched by price movementsshould be matched by price movements argues that similar costs exist across countriesargues that similar costs exist across countries

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Arguments against relevanceArguments against relevance– according to purchasing power parity according to purchasing power parity

(PPP) theory(PPP) theory, , – a lower dollar means imports are more a lower dollar means imports are more

expensiveexpensive– but a lower dollar also means inflation is but a lower dollar also means inflation is

high so domestic stuff cost more to makehigh so domestic stuff cost more to make

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Arguments against relevanceArguments against relevance– re: purchasing power parity (PPP) theoryre: purchasing power parity (PPP) theory, , – PPP does not hold true in real lifePPP does not hold true in real life– the exchange rate does not change in the exchange rate does not change in

accordance with the inflation difference accordance with the inflation difference between the two countriesbetween the two countries

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Arguments supporting relevanceArguments supporting relevance– hedging reduces volatility of MNC operationshedging reduces volatility of MNC operations– creditors may prefer that the firms to which creditors may prefer that the firms to which

they lend maintain low exposure to exchange they lend maintain low exposure to exchange rate riskrate risk

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

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Arguments supporting relevanceArguments supporting relevance– volatile foreign earnings can also cause volatile foreign earnings can also cause

more volatile growthmore volatile growth– which is costlywhich is costly– hedging can reduce the volatility of cash hedging can reduce the volatility of cash

flows cause the firm’s payments and flows cause the firm’s payments and receipts are not forced to fluctuate in receipts are not forced to fluctuate in accordance with the currency movementsaccordance with the currency movements

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Chpt 10 is about “measuring” exchange rate Chpt 10 is about “measuring” exchange rate exposureexposure

Chpt 11 is about using techniques to reduce Chpt 11 is about using techniques to reduce exchange rate exposureexchange rate exposure

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

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Transaction Exposure

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

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TWO steps are involved in measuring TWO steps are involved in measuring transaction exposuretransaction exposure

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

2. Determine the overall risk of exposure 2. Determine the overall risk of exposure to those currenciesto those currencies

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Affects exposure to net cash flowAffects exposure to net cash flow– consolidates subsidiaries’ cash in/outflowsconsolidates subsidiaries’ cash in/outflows– e.ge.g., minimal exposure in Mexican peso if., minimal exposure in Mexican peso if

Subsidiary A has net inflow of PS9,000,000Subsidiary A has net inflow of PS9,000,000 Subsidiary B has net outflow of PS8,700,000Subsidiary B has net outflow of PS8,700,000

MNC net flow = PS300,000MNC net flow = PS300,000

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Exposure to currency variabilityExposure to currency variability– MNC develops range of projected MNC develops range of projected

exchange rates for the end of the specified exchange rates for the end of the specified periodperiod standard deviation may be helpfulstandard deviation may be helpful variability changes over timevariability changes over time

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Currency correlationCurrency correlation– pattern of movement between two pattern of movement between two

currenciescurrencies– affects net exposure for MNCaffects net exposure for MNC

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Currency correlation, exampleCurrency correlation, example– German mark and Swiss franc increase in German mark and Swiss franc increase in

valuevalue MNC X has net inflow exposure from GermanyMNC X has net inflow exposure from Germany MNC Y has net outflow exposure in Germany MNC Y has net outflow exposure in Germany

with similar sized inflow exposure from with similar sized inflow exposure from SwitzerlandSwitzerland

– DM and SF have a correlation of 94 percentDM and SF have a correlation of 94 percent

– Net transaction exposuresNet transaction exposures MNC X maintains currency risk exposureMNC X maintains currency risk exposure MNC Y has offsetting DM and SF exposureMNC Y has offsetting DM and SF exposure

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Steps to assess transaction exposureSteps to assess transaction exposure– assess MNC’s position in each currencyassess MNC’s position in each currency– estimate how an exposure in a currency estimate how an exposure in a currency

affects the MNCaffects the MNC use standard deviations and correlationsuse standard deviations and correlations

– assess the “net” effect of currency assess the “net” effect of currency exposuresexposures

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Economic Exposure

Currency fluctuations affect more than Currency fluctuations affect more than currency transactionscurrency transactions– e.ge.g., an increase in inflation in France may:., an increase in inflation in France may:

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

2. increase subsidiary’s French sales2. increase subsidiary’s French sales 3. raise financing cost in France3. raise financing cost in France

Measures how greatly an MNC’s present value of future Measures how greatly an MNC’s present value of future cash flows is affected by exchange rate fluctuationscash flows is affected by exchange rate fluctuations

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Economic Exposure Impact of local currency depreciationImpact of local currency depreciation

– inflows of local currencyinflows of local currency

Variable affecting MNC’slocal currency inflows

Impact of localcurrency depreciation

Local sales(relative to foreign competition)

Increase

MNC’s exports(valued in local currency)

Increase

MNC’s exports(valued in foreign currency)

Increaseor No change

Interest from foreigninvestment

Increase

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Economic Exposure

Impact of local currency depreciationImpact of local currency depreciation– outflows of local currencyoutflows of local currency

Variable affecting MNC’slocal currency outflows

Impact of localcurrency depreciation

Imported supplies(denominated in local currency)

No change

Imported supplies(valued in foreign currency)

Increase

Interest owed on foreignfunds borrowed

Increase

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Economic Exposure

Indirect exposureIndirect exposure– impact from currency revaluationimpact from currency revaluation

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

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Economic Exposure

Exposure of domestic firmsExposure of domestic firms– impacted by foreign competition and impacted by foreign competition and

financial markets financial markets

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Economic Exposure

Exposure of domestic firmsExposure of domestic firms– impacted by foreign competition and impacted by foreign competition and

financial markets financial markets Exposure of MNCsExposure of MNCs

– face exposure on domestic and foreign soilsface exposure on domestic and foreign soils– Jan-May 1993:13% appreciation of Jan-May 1993:13% appreciation of

Japanese yen against $USJapanese yen against $US many US firms increase US market sharemany US firms increase US market share Japanese firms often priced out of the US Japanese firms often priced out of the US

marketmarket

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Economic Exposure:Measurement

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

A firm is relatively insulated from exchange rate movements A firm is relatively insulated from exchange rate movements if costs and revenues are affected by similar magnitudes.if costs and revenues are affected by similar magnitudes.

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Translation Exposure

Affects value of assets, liabilities and Affects value of assets, liabilities and earningsearnings

Argument for relevance to MNCArgument for relevance to MNC– affects financial statements (MNC affects financial statements (MNC

performance)performance)– reflects an earlier trend in opinionsreflects an earlier trend in opinions

Measures impact that exchange rate fluctuations haveMeasures impact that exchange rate fluctuations haveupon an MNC’s consolidated financial statement upon an MNC’s consolidated financial statement

LedgerLedger

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Translation Exposure

Affects value of assets, liabilities and Affects value of assets, liabilities and earningsearnings

Argument for relevance to MNCArgument for relevance to MNC– affects financial statements (MNC performance)affects financial statements (MNC performance)– reflects an earlier trend in opinionsreflects an earlier trend in opinions

Argument for irrelevance to MNCArgument for irrelevance to MNC– does not affect cash flowsdoes not affect cash flows– weak foreign currency may be retained or weak foreign currency may be retained or

invested in foreign countryinvested in foreign country

Measures impact that exchange rate fluctuations haveMeasures impact that exchange rate fluctuations haveupon an MNC’s consolidated financial statement upon an MNC’s consolidated financial statement

LedgerLedger

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Translation ExposureDeterminants

Level of foreign involvement by foreign Level of foreign involvement by foreign subsidiariessubsidiaries– a greater exposure exists when:a greater exposure exists when:

a larger contribution is made offshorea larger contribution is made offshore

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Locations of foreign subsidiariesLocations of foreign subsidiaries– affects currencies used in initial affects currencies used in initial

measurementsmeasurements

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Accounting methodsAccounting methods– affect how and what financial numbers are affect how and what financial numbers are

reportedreported

Accounting

Accounting

Accounting

Accounting

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Summary

Exchange rate exposure may affect Exchange rate exposure may affect financing costsfinancing costs– volatile cash flow from exchange rate volatile cash flow from exchange rate

changes increases riskchanges increases risk Transaction exposureTransaction exposure

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

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Summary

Economic exposureEconomic exposure– measures the direct and indirect risks to measures the direct and indirect risks to

cash flows from exchange rate movementscash flows from exchange rate movements Translation exposureTranslation exposure

– focuses on consolidated financial focuses on consolidated financial statementsstatements

Slide 1 of 32 Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson.

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