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8/13/2019 IFM_CH 10 - IIFT
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Measuring Exposure ToExchange Rate Fluctuations
10
Chapter
South-Western/Thomson Learning 2006
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Chapter Objectives
To discuss the relevance of an
MNCs exposure to exchange rate risk;
To explain how transaction exposure canbe measured;
To explain how economic exposure can be
measured; and To explain how translation exposure can
be measured.
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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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Is Exchange Rate Risk Relevant?
The Investor Hedge Argum ent
MNC shareholders can hedge against
exchange rate fluctuations on their own.
The investors have complete information on
corporate exposure. They have the
capabilities to correctly and efficientlyinsulate 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.
Is Exchange Rate Risk Relevant?
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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.
Many MNCs are similarly affected byexchange rate movements.
Is Exchange Rate Risk Relevant?
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Response from MNCs
Many MNCs have attempted to stabilize
their earnings with hedging strategiesbecause they believe exchange rate risk is
relevant.
Is Exchange Rate Risk Relevant?
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Types of Exposure
Although exchange rates cannot beforecasted with perfect accuracy, firms
can at least measure their exposure to
exchange rate fluctuations.
Exposure to exchange rate fluctuationscomes in three forms:
Transaction exposure Economic exposure
Translation exposure
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Transaction Exposure
The degree to which the value of futurecash transactions can be affected by
exchange rate fluctuations is referred to
as transaction exposure.
To measure transaction exposure: estimate the net cash inflows or outflows
in each currency, and measure the potential impact of the
exposure to those currencies.
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MNCs can usually anticipate foreign cashflows for an upcoming short-term period
with reasonable accuracy.
After the consolidated net currency flowsfor the entire MNC has been determined,
each net flow is converted into a point
estimate (or range) of a chosen currency.
The exposure for each currency can thenbe assessed using the same measure.
Estimating Net Currency Flows
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Measuring the Potential Impact
An MNCs exposure can be measured byconsidering the proportion of each
currency together with the currencys
variability and the correlations among the
movements of the currencies.
For a two-currency portfolio,
xyyxyxyyxxp CORRwwww 2
2222
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Measuring the Potential Impact
The standard deviationstatistic measurescurrency variability.
Correlation coefficientsindicate the degreeto which two currencies move in relation to
each other. CoefficientPerfect positive correlation 1.00
No correlation 0.00Perfect negative correlation 1.00
Both variability and correlations varyamong currencies and over time.
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Impact of Cash Flow and Correlation Conditionson an MNCs Exposure
+Q +Q Negative Low
+Q Q Slightly positive Moderate
+Q +Q Highly positive High
MNCsExposure
Expected Net Cash FlowCurrencyx Currencyy
Correlation betweenCurrencies xand y
+Q +Q Slightly positive Moderate
+Q Q Highly positive Low
+Q Q Negative High
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Movements of Major Currencies against the Dollar
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The value-at-risk (VAR) methodmakes useof currency volatility and correlations to
determine the potential maximum one-day
loss on the value of an MNCs positions.
For foreign currency x, the maximum one-day loss = E(e
x) z[P] x
E(ex) = expected % in xfor the next dayz[P] = if u ~ N(0,1), Prob (u < z[P]) = P
for 95% confidence level, z[.95] = 1.65
x = standard deviation of the daily % in x
Transaction Exposure
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The VAR method can also be used toassess exposure to multiple currencies
and over longer time horizons.
Maximum one-month loss of currencyportfolio p= E(e
p) z[P] p
E(ep) = expected % in pover the next month
z[P] = if u ~ N(0,1), Prob (u < z[P]) = Pfor 95% confidence level, z[.95] = 1.65
p = standard deviation of the monthly %
in portfolio p
Transaction Exposure
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Economic Exposure
Economic exposurerefers to the degree towhich a firms present value of future cash
flows can be influenced by exchange rate
fluctuations.
Some of these affected cash flows do notrequire currency conversion.
Even a purely domestic firm may beaffected by economic exposure if it faces
foreign competition in its local markets.
8/13/2019 IFM_CH 10 - IIFT
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Economic Exposure to Exchange Rate Fluctuations
Firms exports denominated Decrease Increase
in foreign currency
Interest owed on foreign funds Decrease Increaseborrowed
Transactions that Influencethe Firms Cash Inflows
Local CurrencyAppreciates
Local CurrencyDepreciates
Local sales (relative to foreign Decrease Increasecompetition in local markets)
Firms exports denominated Decrease Increasein local currency
Interest received from foreign Decrease Increaseinvestments
Firms imported supplies No change No changedenominated in local currency
Transactions that Influencethe Firms Cash Inflows
Firms imported supplies Decrease Increasedenominated in foreign currency
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Economic exposure can be measured byassessing the sensitivity of the firms
earnings to exchange rates.
This involves reviewing how the earnings
forecast in the firms income statement
changes in response to alternative
exchange rate scenarios. In general, firms with more foreign costs
than revenues tend to be unfavorably
affected by stronger foreign currencies.
Economic Exposure
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Economic exposure can also be measuredby assessing the sensitivity of the firms
cash flows to exchange rates through
regression analysis.
For a single foreign currency:
Economic Exposure
PCFt= a0+ a1et+ t
PCFt = % in inflation-adjusted cash flowsmeasured in the firms home currencyover period t
et = % in the exchange rate over period t
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Does Translation Exposure Matter?
Cash Flow Perspect ive
The translation of financial statements for
consolidated reporting purposes does not byitself affect an MNCs cash flows.
However, a weak spot rate today may result
in a weak exchange rate forecast (and hence
a weak expected cash flow) for the point inthe future when subsidiary earnings are to be
remitted.
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Does Translation Exposure Matter?
Stock Price Perspect ive
Since an MNCs translation exposure affects
its consolidated earnings and many investorstend to use earnings when valuing firms, the
MNCs valuation may be affected.
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An MNCs degree of translation exposureis dependent on:
the proportion of its business conducted byforeign subsidiaries,
the locations of its foreign subsidiaries,
and
the accounting methods that it uses.
Translation Exposure
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In the 20002001 period, the weakness ofthe euro caused several U.S.-based MNCs
to report lower earnings than what they
had expected.
In 2002 and 2003, however, the eurostrengthened, and the consolidated
income statements of these U.S.-basedMNCs improved.
Translation Exposure