Foreign Exchange Exposure

What is it and How it Affects the

Multinational Firm?
What is Foreign Exchange Exposure?
Simply put, foreign exchange exposure is the
risk associated with activities that involve a
global firm in currencies other than its home
currency.
Essentially, it is the risk that a foreign currency
may move in a direction which is financially
detrimental to the global firm.
Given our observed potential for adverse
exchange rate movements, firms must:
Assess and Manage their foreign exchange
exposures.

Does Foreign Exchange Exposure Matter?
What do Global Firms Say
Nike: Our international operations and sources of supply
are subject to the usual risks of doing business abroad,
such as possible revaluation of currencies (2005).
Starbucks: In fiscal 2004, international company revenue
[in US dollars] increased 32%, [in part] because of the
weakening U.S. dollar against both the Canadian dollar
and the British pound. (2005).
McDonalds: In 2000, the weak euro, British pound and
Australian dollar had a negative impact upon reported
*US dollar+ results. (2000).

4
FX Exposure and the Valuation of a
MNC





where E(CF$,t) represents expected cash flows to be
received at the end of period t,
n represents the number of periods into the future in which
cash flows are received, and
k represents the required rate of return by investors.

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Impact of Foreign Exchange Exposure






where CFj,t represents the amount of cash flow denominated in a
particular foreign currency j at the end of period t,

Sj,t represents the exchange rate at which the foreign currency
(measured in dollars per unit of the foreign currency) can be
converted to dollars at the end of period t.



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Global Companies and FX Exposure
What are the specific risks to a global firm from
foreign exchange exposure?
Cash inflows and outflows, as measured in home
currency equivalents, associated with foreign operations
can be adversely affected.
Revenues (profits) and Costs
Settlement value of foreign currency denominated
contracts, in home currency equivalents, can be
adversely affected.
For Example: Loans in foreign currencies.
The global competitive position of the firm can be
affected by adverse changes in exchange rates.
Influence on required return.
End Result: The value (market price) of the firm can be
adversely affected.
Types of Foreign Exchange Exposure
There are three distinct types of foreign exchange
exposures that global firms may face as a result of their
international activities.
These foreign exchange exposures are:
Transaction exposure
Any MNC engaged in current transactions involving foreign
currencies.
Economic exposure
Results for future and unknown transactions in foreign currencies
resulting from a MNC long term involvement in a particular
market.
Translation exposure (sometimes called accounting
exposure).
Important for MNCs with a physical presence in a foreign country.
We will develop each of these in the slides which
follow.
Transaction Exposure
Transaction Exposure: Results from a firm
taking on fixed cash flow foreign currency
denominated contractual agreements.
Examples of translation exposure:
An Account Receivable denominate in a foreign
currency.
A maturing financial asset (e.g., a bond) denominated
in a foreign currency.
An Account Payable denominate in a foreign currency.
A maturing financial liability (e.g., a loan) denominated
in a foreign currency.



Economic Exposure
Economic Exposure: Results from the physical entry
(and on-going presence) of a global firm into a foreign
market.
This is a long term foreign exchange exposure resulting from a
previous FDI location decision.
Over time, the firm will acquire foreign currency
denominated assets and liabilities in the foreign
country.
The firm will also have operating income and operating
costs in the foreign country.
Economic exposure impacts the firm through contracts and
transactions which have yet to occur, but will, in the future,
because of the firms location.
These are really future transaction exposures which
are unknown today.
Economic exposure can have profound impacts on a global firms
competitive position and on the market value of that firm.

Operating exposure
(Revenues and Costs)

The Two Channels of Economic Exposure
MNCs
Competitive
Position and Value
Impact on the home
currency value of
foreign assets and
liabilities
Impact on home
currency amount of
future operating
cash flows
Exchange
Rate
Fluctuations
Foreign currency
denominated asset
& liability exposure
Translation Exposure
Translation Exposure: Results from the need of
a global firm to consolidated its financial
statements to include results from foreign
operations.
Consolidation involves translating subsidiary
financial statements from local currencies (in the
foreign markets where the firm is located) to the
home currency of the firm (i.e., the parent).
Consolidation can result in either translation gains
or translation losses.
These are essentially the accounting systems attempt
to measure foreign exchange ex post exposure.
Assessing Foreign Exchange Exposure
All global firms are faced with the need to analyze their
foreign exchange exposures.
In some cases, the analysis of foreign exchange exposure is
fairly straight forward and known.
For example: Transaction exposure.
There is a fixed (and thus known) contractual obligation
(in some foreign currency) .
While in other cases, the analysis of the foreign exchange
exposure is complex and less certain.
For example: Economic exposure
There is great uncertainty as to what the firms
exposures will look like over the long term.
Specifically when they will take place and what the
amounts will be.

Using a Hedge to Deal with Exposures
In using a hedge, a firm establishes a situation opposite
to its initial foreign exchange exposure.
A firm with a long position: i.e., it expects to receive
foreign currency in the future, will:
Offset that position with a short position (i.e., a
payment in the future) in the same currency.
A firm with a short position: i.e., it expects to pay foreign
currency in the future, will:
Offset that position with a long position in the same
currency.
In essence, the firm is covering (offsetting) the original
foreign exchange position.
Since the firm has two opposite foreign exchange
positions, they will cancel each other out.
To Hedge or Not to Hedge?
What are some of the factors that would influence a global
firms decision to hedge its exposures?
Perhaps the firms assessment of the future strength or weakness
of the foreign currency it is exposed in.
This involves forecasting and how comfortable the firm is with the
results of the forecast.
For example; If the firm has a long position in what they think will be a
strong currency they may decide not to hedge, or do a partial hedge.
Under these assumptions, a firm might accept an open position.
On the other hand, firms may decide not have any currency
exposures and simply focus on their core business.
Does Starbucks want to sell coffee overseas or speculate on
currency moves?
Obviously, this is different from a company managing a hedge fund, or
a currency trading floor?
Hedging Strategies
It appears that most MNC firms (except for those
involved in currency-trading) would prefer to hedge
their foreign exchange exposures.
But, how can firms hedge?
(1) Financial Contracts
Forward contracts (also futures contracts)
Options contracts (puts and calls)
Borrowing or investing in local markets.
(2) Operational Techniques
Geographic diversification (spreading the risk)