MNC Risk

What is Risk? What are the different kinds of risks? How

do we measure risk? Arguments for hedging.

1. PPP may not hold

2. Currency diversification
3. Stakeholder diversification
 Types of Risk

1. Transaction
2. Economic/Operational
3. Translation
 Measuring risk

- Risk should always be measured on a “net currency”

basis.

Consider a U.S based MNC and its cash flows:

Current
Currency Inflow Outflow Net Rate Net($)

C$ 2M 6M -4M 0.80 -3.2M

DM 10M 12M -2M 0.50 -1M

FF 100M 60M 40M 0.10 +4M
SF 1M 6M -5M 0.60 -3M

Largest position is in FF and the smallest is in DM. Does

this company have transaction or contractual exposure?

Second, which currency provides the largest exposure?

Consider the following ranges of rates:

C$: .79- .81(1.25% change)

DM .48-.52 (4%)
FF .09-.11 (10%)
SF .56-.64 (6.67%)
If we calculate the net position based on the above ranges:

based on C$ range: $3.16M-3.24M

based on Dm range: $960K-1.04M
based on FF range: $3.60-4.4M (800K range)
based on SF range: $2.8-3.2M (400K range)

Which currency has the largest exposure? (FF, why?)

Thus contractual exposure is a function of both the size of
operation as well as the size of FX movement.
 Correlations and FX transaction risk

Your company needs $10M currency X and another $20M

to purchase currency Y. You will receive $30M in Z

Scenario1: Currencies X,Y (with) and Z (against) are

negatively correlated

Impact: Expanded risk profile (higher outflows and lower

inflows)

Scenario2: Currencies X,Y and Z are positively correlated

Impact: more muted risk profile (higher outflows and

inflows)

Strategy: Either restructure the currency flows and or seek

currencies with “favorable” profiles.

For example: could restructure the above to where all three

currencies are payables- if the current correlation profile is
to be maintained.
 Economic Risk

Economic risk is defined as an "operational" risk for

the MNCs as well as domestic firms

For the MNC, it may be a direct result of the rate

movements, and or a byproduct of the rate movement
in other currencies.

For domestic companies, it is always an indirect

impact

In either case, ER can be measured by studying the

"risk" to the operational performance of the MNC
 What are the variables most affected?

- Price

- Units sold or total revenue

- Variables costs such as labor inputs, raw inputs

- Financing costs

- Marketing costs

Any combination of the above variables will have an

impact on the operating performance of the MNC
 What do we look for as being at "risk"?

- Look for the operating cash flows for companies

on an after tax basis

- As CFO change, the PV of the enterprise will also

change.

- Another way to examine is to look at the market

value of the company, tough many variables can
impact this line
 A simple model to determine the relationship
between ER and currency movements

- Determine the CFO for the company; time series

- Determine the weighted average basket of currency

for the company

- Perform as GLS regression, where the cash flow is

dependent upon the movements in the
"independent" basket of currency.

CFO = ai + bi*Currency + eit

 How to manage ER

- Restructure operations: Revenues, costs, financing

- Sources of input

- Product lines- less elastic

- Diversify currency base

 Economic risk in real life

Assume: $/EU = 1.20

Quantity = 10,000 tons of gold

Price/ton = $144
Europeans pay: $144/1.20 = EU120/lton

Total paid: 10,000*120 = EU1.2M = $1.44M

Assume that EU depreciates by 10%; roughly equal to 1.20*0.9 =

$1.08/EU

Assuming the same price, the European price is now: 144/1.08 =

EU 133.33

Case I: Inelastic demand (almost)

Quantity sold = 9500 tons

Revenue = 133.33*9500 = EU1.266M

Base currency revenue: EU1.26M*1.08 = $1.368M

Important points:

1) Demand is almost inelastic, and the “foreign” revenues rise

2) Base revenues still decline as a result of conversion

Lesson: Sometimes, the impact of demand is less important than

the actual conversion.

Economic risk potential: because the revenues (base) lighter, the

impact on CFs will be real.
 Another example

A U.S. based company with businesses interests in Canada.

Canadian sales denominated in C$.

Estimates

U.S. Canada(C$)
Sales $304 4
COGS 50 200
GP $254 ($196)

Fixed expenses 30 0
variable 30.72 0
Total 60.72 0

EBIT $193 ($196)

Interest expense 3 10
EBT $190 ($206)

Forecasted rates Sales

$0.75 $300M
$0.80 $304M
$0.85 $307M
 Example continued

C$=$.75 C$=$.80 C$=$.85

Sales
$ $300 $304 $307
C$ C$=4 $3 C$4 3.2 C$4 3.4
Total $303 $307.2 $310.4

CGS
$ $50 $50 $50
C$ C$200 $150 C$200 $160 C$200 $170
Total $200 $210 $220

Gross profit $103 $97.20 $90.40

Operating expenses
$: fixed $30 $30 $30
$:variable(10% $30.30 $30.72 $31.04
of sales)
Total 60.30 60.72 61.04

EBIT $42.70 $36.48 $29.36

Interest expense
$ $3.0 $3.0 $3.0
C$ C$10 $7.50 $8 $8.50
Total $10.50 $11 $11.50

EBT $32.20 $25.48 $17.86

Why is the variability on EBT so high? What can be done to

remedy this?

Sales and cost in C$ are not consistent!

 Who can have economic exposure?

- Domestic firm
- MNCs

Transactions Impact of LC appreciation Impact of LC depreciation

Inflows
Local sales Decrease Increase
Exports(in LC) Decrease Increase
Exports (in FC) Decrease Increase
Interest received Decrease Increase

Outflows
Imports (in LC) No change No change
Imports (in FC) Decrease Increase
Interest owed Decreased Increase