Lecture Objectives

• Discuss the relevance of an MNC’s exposure to exchange rate risk.

• Explain how transaction exposure can be measured.
• Explain how economic exposure can be measured.
• Explain how translation exposure can be measured.

Lecture 7
Measuring Exposure to Exchange
Rate Fluctuations

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Relevance of Exchange Rate Risk (1 of 2) Relevance of Exchange Rate Risk (2 of 2)

• When an MNC is exposed to exchange rate risk, its cash flows could be Response from MNCs
adversely affected by exchange rate movements. Many financial reports of MNCs acknowledge how their cash flows can be adversely affected
• By reducing exchange rate exposure, MNC’s may able to stabilize their by exchange rate movements. Examples are provided here:
earnings and cash flows. This can reduce the risk that the MNC’s stock In general, we are a net receiver of currencies other than the U.S. dollar. Accordingly,
valuation may decline. changes in exchange rates, and in particular a strengthening of the U.S. dollar, will
negatively affect our revenue and other operating results as expressed in U.S. dollars.
• In general, the assumptions used to argue for exchange rate irrelevance are
— Facebook
not realistic.
Because we manufacture and sell products in a number of countries throughout the world,
we are exposed to the impact on revenues and expenses of movements in currency
exchange rates.
— Proctor & Gamble Co.
Increased volatility in foreign exchange rates … may have an adverse impact on our
business results and financial condition.
—PepsiCo
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Exhibit 10.1 Is Exchange Rate Risk Relevant for MNCs? Transaction Exposure (1 of 7)
ARGUMENT FOR WHY EXCHANGE RAT RISK IS IRRELEVANT ARGUMENT FOR WHY EXCHANGE RATE RISK IS
FOR MNCS RELEVANT FOR MNCS Definition: Sensitivity of the firm’s contractual transactions in foreign currencies
An MNC with cash flows in numerous currencies should not be Exchange rate effects on an MNC will not be offsetting, because to exchange rate movements.
affected by exchange rate risk if the adverse effects due to some the exchange rate movements of many currencies against the
currency movements are offset by the favorable effects of other dollar go in the same direction over a specific period of time. Assessing transaction exposure:
currency movements. Therefore, an MNC cannot ignore exchange rate risk, even
when it has cash flows in numerous currencies. Estimating net cash flows in each currency (See Exhibits 10.2 & 10.3)
If stakeholders (such as stockholders or creditors) have stakes in a Many MNCs are similarly affected by exchange rate movements,
well-diversified portfolio of MNCs, then their portfolio's value might so it would be difficult for stakeholders to create a diversified Transaction Exposure of an MNC’s Portfolio
be insulated if the adverse effects of exchange rates on some MN portfolio of MNCs that will be fully insulated from exchange rate
Cs are offset by favorable effects of exchange rates on other MN movements. Because stakeholders cannot diversify away the Measure potential impact of the currency exposure
Cs. If these stakeholders can insulate their portfolios from exposure of their portfolios to exchange rate risk, MNCs should
exchange rate effects, then MNCs should not worry about be concerned about their exposure to exchange rate risk.
exchange rate risk.  p  Wx2 x2  Wy2 y2  2WxWy  x  y CORRxy
Investors who invest in MNCs can hedge exchange rate risk on Investors who invest in MNCs do not have complete information
their own. If they believe that the investments in U.S.-based MNCs on each MNC's exposure to exchange rate fluctuations, so they
would be adversely affected when foreign currencies weaken may not have the ability to hedge the exposure of their individual W = proportion of portfolio value in currency x or y
against the dollar, they could take their own positions in currency investments to exchange rate risk. MNCs are better informed
derivatives that would increase in value if foreign currencies about their own exposure to exchange rate risk and should have σ = standard deviation of percentage changes in currency x or y
weaken against the dollar. Thus, if investors can hedge the more expertise in managing that risk. Thus, investors should
exposure of their investments to exchange rate risk on their own,
the MNCs may not need to worry about exchange rate risk.
benefit if MNCs manage their own exchange rate risk. CORR = correlation coefficient of percentage changes in currencies x and y
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Exhibit 10.2 Amount of Dollars Needed to Obtain Exhibit 10.3 Consolidated Net Cash Flow
Imports (transaction value = 1 million euros) Assessment of Miami Co.
(1) (2) (3) (4) (5) (6)
EXPECTED
EXCHANGE NET INFLOW OR
RATE AT OUTFLOW AS
TOTAL TOTAL NET INFLOW END OF MEASURED IN
CURRENCY INFLOW OUTFLOW OR OUTFLOW QUARTER U.S. DOLLARS
British pound £17,000,000 £7,000,000 +£10,000,000 $1.50 +$15,000,000
Canadian dollar C$12,000,000 C$2,000,000 +C$10,000,000 $.80 +$8,000,000
Swedish krona SK20,000,000 SK120,000,000 −SK100,000,000 $.15 −$15,000,000
Mexican peso MXP90,000,000 MXP10,000,000 +MXP80,000,000 $.10 +$8,000,000

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Transaction Exposure (2 of 7) Transaction Exposure (3 of 7)
Exposure of an MNC’s Portfolio (continued) Exposure of an MNC’s Portfolio (continued)
• Measurement of currency volatility • Applying currency correlations to net cash flows
o The standard deviation statistic measures the degree of movement for each o If an MNC has positive net cash flows in various currencies that are highly
currency. In any given period, some currencies clearly fluctuate much more than correlated, it may be exposed to exchange rate risk. However, many MNCs have
others. some negative net cash flow positions in some currencies to complement their
positive net cash flows in other currencies.
• Currency volatility over time
o The volatility of a currency may not remain consistent from one time period to
another. An MNC can identify currencies whose values are most likely to be
stable or highly volatile in the future.

• Measurement of currency correlations

o The correlations coefficients indicate the degree to which two currencies move
in relation to each other.
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Exhibit 10.4 Impact of Cash Flow and Correlation Transaction Exposure (4 of 7)

Conditions on an MNC’s Exposure over the Next Period
Transaction Exposure Based on Value at Risk (VaR)
THEN THE MNC'S
IF THE MNC’S EXPECTED CASH FLOW AND IF THE EXPOSURE IS
• Measures the potential maximum 1-day loss on the value of positions of an
SITUATION IS CURRENCIES ARE RELATIVELY MNC that is exposed to exchange rate movements.
Equal amounts of net inflows in two currencies Highly correlated High • Factors that affect the maximum 1-day loss:
Equal amounts of net inflows in two currencies Slightly positively Moderate o Expected percentage change in the currency rate for the next day
correlated
Equal amounts of net inflows in two currencies Negatively correlated Low
o Confidence level used
A net inflow in one currency and a net outflow of Highly correlated Low o Standard deviation of the daily percentage changes in the currency
about the same amount in another currency
A net inflow in one currency and a net outflow of Slightly positively Moderate
about the same amount in another currency correlated
A net inflow in one currency and a net outflow of Negatively correlated High
about the same amount in another currency

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Transaction Exposure (5 of 7) Transaction Exposure (6 of 7)
Transaction Exposure Based on Value at Risk (VaR) (continued) Transaction Exposure Based on Value at Risk (VaR) (continued)
• Applying VaR to Transaction Exposure of a Portfolio • Estimating VaR with an Electronic Spreadsheet
Since MNCs are commonly exposed to more than one currency, they may apply the VaR o Obtain the series of exchange rates for all relevant dates for each currency of
method to a currency portfolio. When considering multiple currencies, software packages can concern and list each currency in its own column.
be used to perform the computations. Portfolio’s standard deviation is estimated to be:
o Compute the percentage changes per period (from one date to the next) for each
 p  WA2 A2  WB2 B2  2WAWB A BCORR exchange rate in a column.

Where
o Estimate the standard deviation of the column of percentage changes for each
exchange rate.
WA = proportion of total portfolio value represented by Currency A
o In a separate column, compute the periodic percentage change in the portfolio
WB = proportion of total portfolio value represented by Currency B
value by applying weights to the individual currency returns.
σA = standard deviation of quarterly percentage changes in Currency A
o Use a compute statement to determine the standard deviation of the column of
σA = standard deviation of quarterly percentage changes in the value of Currency B percentage changes in the portfolio value.
CORR = correlation coefficient of quarterly percentage changes between Currency A and
Currency B
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Transaction Exposure (7 of 7) Economic Exposure (1 of 2)

Transaction Exposure Based on Value at Risk (VaR) (continued) Definition: The sensitivity of the firm’s cash flows to exchange rate movements,
• Limitations of VaR sometimes referred to as operating exposure.
o If the distribution of exchange rate movements is not normal, the estimate of the Exposure to Foreign Currency Depreciation (Exhibit 10.5)
maximum expected loss is subject to error. Depreciation in the firm’s foreign currency causes a reduction in both cash inflows
o The VaR method assumes that the volatility (standard deviation) of exchange and outflows. The impact on a firm’s net cash flows will depend on whether the
rate movements is stable over time. If exchange rate movements are less volatile inflow transactions are affected more or less than the outflow transactions.
in the past than in the future, the estimated maximum expected loss derived from Exposure to Foreign Currency Appreciation
the VaR method will be underestimated.
Appreciation in the firm’s foreign currency causes an increase in both cash inflows
and outflows.
Measuring Economic Exposure
Economic exposure by determining how its cash flows in the following period (such
as the following quarter) would be affected by possible exchange rate scenarios.
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Exhibit 10.5 Economic Exposure of a U.S. Firm to Economic Exposure (2 of 2)
Exchange Rate Fluctuations
IMPACT OF FOREIGN IMPACT OF FOREIGN
Measuring Economic Exposure (Continued)
CURRENCY DEPRECIATION ON CURRENCY APPRECIATION • Use of regression analysis
SOURCES OF U.S. FIRM'S DOLLAR CASH U.S. FIRM'S DOLLAR CASH ON U.S. FIRM'S DOLLAR
FLOWS FLOWS CASH FLOWS MNC can apply the following regression model to its quarterly cash flow and
Local sales (relative to foreign competition in local Decrease Increase exchange rate data:
markets)
Firm's exports denominated in dollars Decrease Increase PCFt  a0  a1et  t
Firm's exports denominated in foreign currency Decrease Increase
where
Interest received from foreign investments Decrease Increase
PCFt = percentage change in inflation-adjusted cash flows measured in home
SOURCES OF DOLLAR CASH OUTFLOWS currency
Firm's imported supplies denominated in dollars No change No change
et = percentage change in direct exchange rate
Firm's imported supplies denominated in foreign Decrease Increase
currency μt = random error term
Interest owed on foreign funds borrowed Decrease Increase a0 = intercept
a1 = slope coefficient
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Exhibit 10.6 Estimated Sales and Expenses for Exhibit 10.7 Impact of Possible Exchange Rates on Cash
Madison’s U.S. and Canadian Business Segments Flows of Madison Co. (millions of currency units)
(millions of currency units)
U.S. BUSINESS CANADIAN BUSINESS
Sales $320 C$4
Cost of materials $50 C$200
Operating expenses $60 —
Interest expenses $3 C$10
Cash flows $207 −C$206

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Translation Exposure (1 of 4) Translation Exposure (2 of 4)
Definition: The exposure of the MNC’s consolidated financial statements to Determinants of translation exposure (continued)
exchange rate fluctuations. • Accounting Methods: MNC translation exposure is affected by accounting
Determinants of translation exposure: procedures, many of which are based on FASB 52
• Proportion of business by foreign subsidiaries: The greater the o The functional currency of an entity is the currency of the economic environment
percentage of an MNC’s business conducted by its foreign subsidiaries, the in which the entity operates.
larger the percentage of a given financial statement item that is susceptible o The current exchange rate of the reporting date is used to translate the assets
to translation exposure. and liabilities of a foreign entity from its functional currency into the reporting
• Locations of foreign subsidiaries: Location can also influence the degree currency.
of translation exposure because the financial statement items of each
subsidiary are typically measured by the respective subsidiary’s home
currency.

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Translation Exposure (3 of 4) Translation Exposure (4 of 4)

Determinants of translation exposure (continued) Exposure of an MNC’s Stock Price to Translation Effects
• Accounting Methods (continued) • Because an MNC’s translation exposure affects its consolidated earnings, it
o The weighted average exchange rate over the relevant period is used to translate can affect the MNC’s valuation. (Exhibit 10.8)
revenue, expenses, and gains and losses of a foreign entity from its functional • Signals that complement translation effects: Exchange rate conditions
currency into the reporting currency. that cause a translation effect can also signal changes in expected cash
o Translated income gains or losses due to changes in foreign currency values are flows in future years. Such changes could also influence the stock price.
not recognized in current net income but are reported as a second component of • Exposure of managerial compensation to translation effects: Since an
stockholder’s equity; an exception to this rule is a foreign entity located in a
country with high inflation.
MNC’s stock may be subject to translation effects and since managerial
compensation is often tied to the MNC’s stock price, it follows that
o Realized income gains or losses due to foreign currency transactions are managerial compensation is affected by translation effects.
recorded in current net income, although there are some exceptions.

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Exhibit 10.8 How Translation Exposure Can Affect Summary (1 of 3)
the M N C’s Stock Price
• Exchange rate movements can affect an MNC’s cash flows and therefore
EARNINGS PER SHARE can affect its performance and value. MNCs with less risk can obtain funds at
(EPS), COMPUTED AS PREVAILING lower financing costs. Because they may experience more volatile cash flows
CONSOLIDATED PRICE- due to exchange rate movements, exchange rate risk can also affect their
EARNINGS DIVIDED BY EARNINGS VALUATION OF PROVIDENCE financing costs. Thus MNCs frequently attempt to measure their exposure to
CONSOLIDATED 10 MILLION SHARES (P/E) RATIO IN CO. STOCK [EPS BASED ON exchange rate risk (as explained in this chapter), so that they can decide
YEAR EARNINGS OUTSTANDING THE INDUSTRY PREVAILING P/E RATIO × EPS]
whether and how to hedge that risk (as explained in the next two chapters).
1 $17,000,000 $1.70 20 $1.70 × 20 = $34
2 $15,000,000 $1.50 20 $1.50 × 20 = $30

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Summary (2 of 3) Summary (3 of 3)
• Transaction exposure is the exposure of an MNC’s contractual transactions • Economic exposure is any exposure of an MNC’s cash flows (direct or
to exchange rate movements. MNCs can measure their transaction exposure indirect) to exchange rate movements. MNCs can attempt to measure their
by determining their future payables and receivables positions in various economic exposure by determining the extent to which their cash flows will
currencies, along with the volatility levels and correlations of these be affected by their exposure to each foreign currency.
currencies. From this information, they can assess how their revenue and • Translation exposure is the exposure of an MNC’s consolidated financial
costs may change in response to various exchange rate scenarios. statements to exchange rate movements. To measure translation exposure,
MNCs can forecast their earnings in each foreign currency and then
determine how their earnings could be affected by the potential exchange
rate movements of each currency.

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