International Finance Slides

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Measuring Exposure ToExchange Rate Fluctuations

10

Chapter

South-Western/Thomson Learning 2003


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Is Exchange Rate Risk Relevant?

Purchasing Power Par i ty Argument

Exchange rate movements will be matched

by price movements.

PPP does not necessarily hold.


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The Investor Hedge Argum ent

MNC shareholders can hedge against

exchange rate fluctuations on their own.

The investors may not have complete

information on corporate exposure. They

may not have the capabilities to correctlyinsulate their individual exposure too.


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Currency Divers i ficat ion A rgum ent

An MNC that is well diversified should not

be affected by exchange rate movementsbecause of offsetting effects.

This is a naive presumption.



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Stakeho lder Diversi f icat ion Argument

Well diversified stakeholders will be

somewhat insulated against lossesexperienced by an MNC due to exchange

rate risk.

MNCs may be affected in the same waybecause of exchange rate risk.



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Response from MNCs

Many MNCs have attempted to stabilize

their earnings with hedging strategies,which confirms the view that exchange

rate risk is relevant.



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Types of Exposure

Although exchange rates cannot be

forecasted with perfect accuracy, firms

can at least measure their exposure toexchange rate fluctuations.

Exposure to exchange rate fluctuations

comes in three forms:

Transaction exposure

Economic exposure

Translation exposure


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Transaction Exposure

The degree to which the value of future

cash transactions can be affected by

exchange rate fluctuations is referred toas t ransact ion exposure.

To measure transaction exposure:

project the net amount of inflows or

outflows in each foreign currency, and

determine the overall risk of exposure to

those currencies.


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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 either a

point estimate or a range of a chosen

currency, so as to standardize the

exposure assessment for each currency.



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An MNCs overall exposure can be

assessed by considering each currency

position together with the currencys

variability and the correlations among the

currencies.

The standard deviation statistic on

historical data serves as one measure of

currency variability. Note that currency

variability levels may change over time.



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The correlations among currency

movements can be measured by their

co rrelation coeff ic ients, which indicate thedegree to which two currencies move in

relation to each other.

coefficient

perfect positive correlation 1.00

no correlation 0.00

perfect negative correlation -1.00



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The point in considering correlations is to

detect positions that could somewhat

offset each other. For example, if currencies X and Y are

highly correlated, the exposures of a net X

inflow and a net Y outflow will offset each

other to a certain degree.

Note that the corrrelations among

currencies may change over time.



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A related method, the value-at-r is k (VAR)

method, incorporates currency volatility

and correlations to determine the potentialmaximum one-day loss.

Historical data is used to determine the

potential one-day decline in a particular

currency. This decline is then applied to

the net cash flows in that currency.



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Economic Exposure

Econom ic exposurerefers to the degree to

which a firms present value of future

cash flows can be influenced by exchangerate fluctuations.

Cash flows that do not require conversion

of currencies do not reflect transaction

exposure. Yet, these cash flows may also

be influenced significantly by exchange

rate movements.


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Economic Exposure

Transactions thatInfluence the Firms

Cash InflowsLocal Currency

AppreciatesLocal Currency

Depreciates

Local sales (relative

to foreign competitionin local markets)

Firms exportsdenominated in localcurrency

Firms exportsdenominated inforeign currency

Interest received fromforeign investments

Decrease

Decrease

Decrease

Decrease

Increase

Increase

Increase

Increase

Impact on Transactions

Transact ions ref lect ing transact ion expos ure.


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Economic Exposure

Transactions thatInfluence the Firms

Cash OutflowsLocal Currency

AppreciatesLocal Currency

Depreciates

Impact on Transactions

Transact ions ref lect ing transact ion expos ure.

Firms importedsupplies denominated

in local currency

Firms importedsupplies denominated

in foreign currencyInterest owed onforeign fundsborrowed

No Change

Decrease

Decrease

No Change

Increase

Increase


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Even purely domestic firms may be

affected by economic exposure if there is

foreign competition within the localmarkets.

MNCs are likely to be much more exposed

to exchange rate fluctuations. The impact

varies across MNCs according to their

individual operating characteristics and

net currency positions.

Economic Exposure


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One measure of economic exposure

involves classifying the firms cash flows

into income statement items, and thenreviewing how the earnings forecast in the

income statement changes in response to

alternative exchange rate scenarios.

In general, firms with more foreign costs

than revenues will be unfavorably affected

by stronger foreign currencies.

Economic Exposure


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Another method of assessing a firms

economic exposure involves applying

regression analysis to historical cash flowand exchange rate data.

Economic Exposure


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PCFt= a0 + a1et+ tPCFt = % change in inflation-adjusted cash

flows measured in the firms homecurrency over period t

et = % change in the currency exchange

rate over period t

t = random error term

a0 = intercept

a1 = slope coefficient

Economic Exposure


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Translation Exposure

The exposure of the MNCs consolidated

financial statements to exchange rate

fluctuations is known as t ranslat ionexposure.

In particular, subsidiary earnings

translated into the reporting currency on

the consolidated income statement are

subject to changing exchange rates.


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Does Trans lat ion Exposu re Matter?

Cash Flow Perspect ive- Translating

financial statements for consolidatedreporting purposes does not by itself

affect an MNCs cash flows.

However, a weak foreign currency todaymay result in a forecast of a weak

exchange rate at the time subsidiary

earnings are actually remitted.


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Stock Price Perspect ive- Since an MNCs

translation exposure affects itsconsolidated earnings and many investors

tend to use earnings when valuing firms,

the MNCs valuation may be affected.

Does Trans lat ion Exposu re Matter?


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In general, translation exposure is relevant

because

some MNC subsidiaries may want to remittheir earnings to their parents now,

the prevailing exchange rates may be used

to forecast the expected cash flows that will

result from future remittances, and

consolidated earnings are used by many

investors to value MNCs.



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An MNCs degree of translation exposure

is dependent on:

the proportion of its business conducted byits foreign subsidiaries,

the locations of its foreign subsidiaries, and

the accounting method that it uses.



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According to World Research Advisory

estimates, the translated earnings of U.S.-

based MNCs in aggregate were reducedby $20 billion in the third quarter of 1998

alone simply because of the depreciation

of Asian currencies against the dollar.

In 2000, the weakness of the euro also

caused several U.S.-based MNCs to report

lower earnings than expected.


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