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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 10

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

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Overview
Present

the relevance of an MNCs exchange rate exposure Explain measurement of transaction exposure Explain how economic exposure is measured Explain measurement of translation exposure
Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson

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

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

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Relevance of Exchange Rate Risk

Arguments

against relevance

some people say that a firms 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

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

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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

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

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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

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

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

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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 firms payments and receipts are not forced to fluctuate in accordance with the currency movements
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Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson

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Chpt 10 is about measuring exchange rate exposure

Chpt 11 is about using techniques to reduce exchange rate exposure

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

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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

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

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Transaction Exposure

The

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

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

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

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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

MNC net flow = PS300,000

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

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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

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

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Transaction Exposure
Currency

correlation

pattern of movement between two currencies affects net exposure for MNC

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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

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

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Transaction Exposure
Steps

to assess transaction exposure

assess MNCs 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

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

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Economic Exposure
Measures how greatly an MNCs present value of future cash flows is affected by exchange rate fluctuations
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 subsidiarys French sales 3. raise financing cost in France
Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson

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Economic Exposure
Impact

of local currency depreciation

inflows of local currency

Variable affecting MNCs Impact of local local currency inflows currency depreciation Local sales Increase
(relative to foreign competition)

MNCs exports
(valued in local currency)

Increase Increase or No change Increase

MNCs exports
(valued in foreign currency)

Interest from foreign investment

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

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Economic Exposure
Impact

of local currency depreciation

outflows of local currency

Variable affecting MNCs Impact of local local currency outflows currency depreciation Imported supplies No change
(denominated in local currency)

Imported supplies
(valued in foreign currency)

Increase Increase

Interest owed on foreign funds borrowed

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

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Economic Exposure
Indirect
e.g.,

exposure

impact from currency revaluation

exporters may increase prices to compensate for devaluation of home currency

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

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Economic Exposure
Exposure

of domestic firms

impacted by foreign competition and financial markets

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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

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

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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

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

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

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Translation Exposure
Measures impact that exchange rate fluctuations have upon an MNCs consolidated financial statement
Affects

value of assets, liabilities and earnings Argument for relevance to MNC

affects financial statements (MNC performance) reflects an earlier trend in opinions

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

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Translation Exposure
Measures impact that exchange rate fluctuations have upon an MNCs consolidated financial statement

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

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

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Translation Exposure Determinants

Level

of foreign involvement by foreign subsidiaries

a greater exposure exists when:
a

larger contribution is made offshore

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

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Translation Exposure Determinants

Locations

of foreign subsidiaries

affects currencies used in initial measurements

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

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Translation Exposure Determinants

Accounting

methods

affect how and what financial numbers are reported

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

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Summary
Exchange

rate exposure may affect financing costs

volatile cash flow from exchange rate changes increases risk

Transaction

exposure

reflects the exposure of an MNCs future cash transactions to exchange rate movements
Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson

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Summary
Economic

exposure

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

exposure

focuses on consolidated financial statements

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