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Managing Economic Exposure PDF

This document discusses how multinational companies can manage economic and translation exposure from currency exchange rate fluctuations. It defines economic exposure as the impact of exchange rates on a firm's future cash flows. MNCs can assess economic exposure through income statement analysis under different exchange rate scenarios and reduce exposure by restructuring operations. Translation exposure results from converting subsidiary financial statements to the parent company's reporting currency. The document provides an example of how an MNC can hedge translation exposure through currency forwards to influence reported consolidated earnings. It also notes limitations to hedging translation exposure.

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Nilesh Mandlik
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© © All Rights Reserved
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Download as PDF, TXT or read online on Scribd
570 views

Managing Economic Exposure PDF

This document discusses how multinational companies can manage economic and translation exposure from currency exchange rate fluctuations. It defines economic exposure as the impact of exchange rates on a firm's future cash flows. MNCs can assess economic exposure through income statement analysis under different exchange rate scenarios and reduce exposure by restructuring operations. Translation exposure results from converting subsidiary financial statements to the parent company's reporting currency. The document provides an example of how an MNC can hedge translation exposure through currency forwards to influence reported consolidated earnings. It also notes limitations to hedging translation exposure.

Uploaded by

Nilesh Mandlik
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
You are on page 1/ 24

12

Chapter

Managing Economic Exposure


And Translation Exposure

J. Gaspar: Adapted from Jeff Madura, International Financial Management

12. 1

Chapter Objectives

To explain how an MNCs economic exposure can


be managed/hedged; and

To explain how an MNCs translation exposure


can be managed/hedged.

12. 2

Economic Exposure
Economic exposure refers to the impact
exchange rate fluctuations can have on a firms
Present Value of future cash flows.

Recall that corporate cash flows can be affected


by exchange rate movements in ways not directly
associated with foreign transactions, i.e., a purely
domestic firm that faces international competition.

12. 3

Economic Exposure
The economic impact of currency exchange rates on
us is complex because such changes are often
linked to variability in real growth, inflation, interest
rates, governmental actions, and other factors.
These changes, if material, can cause us to adjust
our financing and operating strategies.
PepsiCo

12. 4

Income Statement Analysis to


Assess Economic Exposure
MNCs can determine the impact of FX exposure
by assessing the sensitivity of their cash inflows
and outflows to various possible exchange rate
scenarios.

The MNC can then minimize its FX exposure by


restructuring its operations to reduce its net
exchange-rate-sensitive cash flows.

Use spreadsheets to facilitate analysis.


12. 5

Base Case: Impact of Exchange Rate Movements on


Earnings of Madison, Inc. (In Millions)

12. 6

Managing
Madison Inc.s Economic Exposure
Madison Inc.s Net FX Exposure: C$206 m outflow
Madisons earnings before taxes is inversely
related to the Canadian dollars strength, since the
higher expenses more than offset the higher
revenue when the Canadian dollar strengthens.

Madison may reduce its exposure by increasing


Canadian sales, reducing orders of Canadian
materials, and borrowing less in Canadian dollars.

12. 7

How to Minimize Economic


Exposure
Restructuring can reduce economic exposure by
shifting the sources of costs or revenue to other
locations in order to match cash inflows and
outflows in foreign currencies.

The new structure is then evaluated by assessing


how the revised cash flows are sensitive to
various possible exchange rate scenarios.

12. 8

Impact of Possible Exchange Rate Movements on


Earnings: Before and After Corporate Restructuring
(in Millions)

12. 9

Economic Exposure Based on the Original


and Proposed Operating Structures

12. 10

Crucial Issues Involved in the


Restructuring Decisions
Restructuring operations is a long-term solution to
reducing economic exposure. It is a much more
complex task than hedging any foreign currency
transaction.

MNCs must be very confident about the long-term


potential benefits before they proceed to
restructure their operations, because of the high
reversal costs.

12. 11

Strategies for Restructuring


Restructuring may involve:
increasing/reducing sales in new or existing foreign

markets,
increasing/reducing dependency on foreign suppliers,
establishing/eliminating production facilities in foreign

markets, and/or
increasing/reducing the level of debt denominated in

foreign currencies.

12. 12

12. 13

A Case Study in
Hedging Economic Exposure
Savor Co., a U.S. firm, has three independent
units that conduct business in the Eurozone. It is
concerned about its exposure to the euro.

To determine whether it is exposed and the source


of the exposure, Savor applies a series of
regression analysis to its cash flows and the
euros movements.

12. 14

An Analysis of
Savor Co.s Cash Flows and the Euros Movements

12. 15

A Case Study in
Hedging Economic Exposure
Assessment of Savors Exposure:
%TotalCashFlowt = a0 + a1%eurot + t
The slope coefficient, a1, is found by regression
analysis to be positive and statistically significant.
Savor is exposed to the euros movements.

12. 16

A Case Study in
Hedging Economic Exposure
Assessment of Each Units Exposure:
%UnitCashFlowt = a0 + a1%eurot + t

Unit C is exposed to the euros


movements.
12. 17

A Case Study in
Hedging Economic Exposure
Identifying the Source of Unit Cs Exposure:

Savor believes that Unit Cs cash flows are mainly


affected by income statement items.

Savor thus applies regression analysis to each


income statement item, and finds a significant
positive relationship between Unit Cs revenue
and the euros value.
Savors economic exposure could be due to
foreign competition.
12. 18

A Case Study in
Hedging Economic Exposure
Possible Hedging Strategies:

Pricing policy Reduce prices when the euro


depreciates.

Hedging with forward contracts Sell euros


forward to hedge against the adverse effects of a
weak euro.

Purchasing foreign supplies Costs will be


reduced during a weak-euro period.
12. 19

A Case Study in
Hedging Economic Exposure
Possible Hedging Strategies:
Financing with foreign funds Costs will be
reduced during a weak-euro period.

Revising the operations of other units So as to


offset the exposure of Unit C.

12. 20

Hedging Exposure to Fixed Assets


When an MNC has fixed assets (such as buildings
or machinery) in a foreign country, the cash flows
to be received from the sale of these assets is
subject to exchange rate risk.

A sale of fixed assets can be hedged by creating a


liability that matches the expected value of the
assets at the point in the future when they will be
sold.

12. 21

Translation Exposure
Translation exposure results when an MNC
translates each subsidiarys financial data from its
host country (operating) currency to home country
(reporting) currency for consolidated financial
reporting. MNCs like Coca Cola, GE, etc. deal with
over a hundred operating currencies.

Translation exposure does not directly affect cash


flows, but some firms are concerned because of
its potential impact on reported consolidated
earnings.
12. 22

Translation Exposure Management


A simple example of earnings and balance sheet translation
Earnings Translation Management
Columbus, Inc., a US-based MNC has a subsidiary in France that is forecast to have an after tax earnings of 20 million during 2015.
2015 after tax earnings: 20 million Case#1: Repatriate earnings Case of transactions exposure
Case#2: Reinvest earnings in France Case of translation exposure
Exchange rate

Jan 1, 2015
Dec 31, 2015 rate
Ave. 2015
Forward Rate (sell ) quote provided on Jan 1, 2015
$1.30/ spot
$1.40/ spot
$1.35/
$1.50/ (Dec 31, 2015 delivery)
Case#2: Reinvest 20 million earnings in France
Strategy #1: No hedging of translation exposure
Per FASB-52, Translation of 20 French earning to $ (reporting currency) on Dec 31, 2015 = 20 1.35 = $27 million
Earnings after translation = $27 million
Strategy #2: Hedging translation exposure by selling euros forward at a stronger rate than the actual future spot rate of $1.40/
recorded on December 31, 2015.
Profit from executing forward contract
= Sell euros forward buy euros spot on Dec 31, 2015
= 20 million (1.50 1.40) = 20 0.10 = $2 million
Earnings after translation = $27 million + $2*(1-French corporate tax rate) million
Strategy #3: Hedging translation exposure by selling euros forward at a weaker rate than the actual future spot rate (say, $1.36/
instead of the recorded $1.40/ spot rate).
A loss will be incurred while executing the forward contract, since euros will need to be purchased at say, $1.40/ (future spot rate on
December 31, 2015) and the euro sold at a lower forward rate of $1.36/. Loss= 20 million (1.36 1.40) = 20 x -0.04 = -$0.8 mn
Earnings after translation = $27 million (1.35x20) $0.8 million = $26.2 million
Balance Sheet Translation Management
Balance Sheet Translation Exposure relates to consolidation of Balance Sheet items in different currencies to reporting currency and
can be managed by minimizing Net Exposed Assets
Columbus Net exposed assets = Assets Liabilities (i.e., net assets exposed to change in the value of v. $, i.e. from operating
J. Gaspar 5/4/2015
currency to reporting currency).

12. 23

Limitations of
Hedging Translation Exposure
Inaccurate

earnings forecasts

Inadequate

forward contracts for some currencies

Accounting

distortions

Translation gains/losses are based on the average


exchange rate (which is unlikely to be the same as the
forward rate).

Translation losses are also not tax deductible.

12. 24

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