Chapter 4

Measuring Exposure To Exchange Rate Fluctuations

Objectives
This chapter distinguishes among three forms by which MNCs are exposed to exchange rate risk: (1) transaction exposure, (2) economic exposure, and (3) translation exposure. Each firm differs in degree of exposure. A firm should be able to measure its degree of each type of exposure as described in this chapter. Then, it can decide how to cover that exposure using methods described in the following two chapters. The specific objectives are to:
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Objectives
discuss the relevance of an MNCs 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.
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Is Exchange Rate Risk Relevant?

Purchasing Power Parity Argument
Exchange rate movements will be matched by

price movements.
PPP does not necessarily hold.

Is Exchange Rate Risk Relevant?

The Investor Hedge Argument
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 correctly

insulate their individual exposure too.

Is Exchange Rate Risk Relevant?

Currency Diversification Argument
An MNC that is well diversified should not

be affected by exchange rate movements because of offsetting effects.

This is a naive presumption.

Is Exchange Rate Risk Relevant?

Stakeholder Diversification Argument
Well diversified stakeholders will be

somewhat insulated against losses experienced by an MNC due to exchange rate risk.
MNCs may be affected in the same

way because of exchange rate risk.

Is Exchange Rate Risk Relevant?

Response from MNCs Many MNCs have attempted to stabilize their earnings with hedging strategies, which confirms the view that exchange rate risk is relevant.

Types of Exposure
Although exchange rates cannot be forecasted with perfect accuracy, firms can at least measure their exposure to exchange 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 to as transaction 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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Transaction Exposure
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. (Example)
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Transaction Exposure
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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Transaction Exposure
The correlations among currency movements can be measured by their correlation coefficients, which indicate the degree to which two currencies move in relation to each other. coefficient
perfect positive correlation no correlation perfect negative correlation 1.00 0.00 -1.00

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Transaction Exposure
The point in considering correlations is to detect positions that could somewhat offset each other. For example, if currency 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 correlations among currencies may change over time.

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Transaction Exposure
A related method, the value-at-risk (VAR) method, incorporates currency volatility and correlations to determine the potential maximum 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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Transaction Exposure
Example: Pitt, Inc., a U.S.-based MNC, typically has receivables in Japanese yen. It first determines the maximum potential one-day decline in the yen that would be likely using a recent historical period such as 90 days. Pitt then applies that potential decline to its receivables to determine the potential loss in the dollar value of its receivables if that decline in the yen does occur.
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Transaction Exposure
If Pitt has other positions in yen ( such as a Japanese subsidiary), it will also determine the potential reduction in value of those positions due to a maximum one-day decline In the yens value. By aggregating these effects, Pitt can determine how its value could be affected by a maximum one-day loss in the value of the yen. By repeating this process, the company can determine how its value could be affected by a maximum loss in the yen over a different time horizon, such as a 7-day or 30-day horizon.
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Transaction Exposure
If MNCs are exposed to more than one currency, they may apply the VAR method to a currency portfolio.

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Economic Exposure
Economic exposure refers to the degree to which a firms present value of future cash flows can be influenced by exchange rate 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
Even purely domestic firms may be affected by economic exposure if there is foreign competition within the local markets. MNCs are likely to be much more exposed to exchange rate fluctuations. The impact varies across MNCs according to their individual operating 20 characteristics and net currency positions.

Economic Exposure
One measure of economic exposure involves classifying the firms cash flows into income statement items, and then reviewing how the earnings forecast in the income statement changes in response to alternative exchange rate scenarios.
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Economic Exposure
Example:
Madison, Inc., is a U.S.-based MNC that conduct a portion of its business in Canada. Its U.S. sales are denominated in U.S. dollars, while its Canadian sales are denominated in Canadian dollars. Its pro forma income statement for next year is shown in the following exhibit. The income statement items are segmented into those for the United States and for Canada. Assume that Madison desires to assess how its income statement items would be affected by three possible exchange rates scenarios for the Canadian dollar over the period of concern: (1) $.75, (2)$.80, (3) $.85. These scenarios are separately analyzed in the exhibit.

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Economic Exposure
Impact of Possible Exchange Rate Movements on Earnings of Madison, Inc. (in Millions)
Exchange C$ = $.75 Sales: (1) U.S. $300.00 (2) Canadian C$4 = 3.00 (3) Total $303.00 Cost of goods sold: (4) U.S. $ 50.00 (5) Canadian C$200 = 150.00 (6) Total $200.00 (7) Gross Profit $103.00 Operating expenses: (8) U.S.: Fixed $ 30.00 (9) U.S. Variable(10% of total sales) 30.30 (10) Total 60.30 (11) EBIT $ 42.70 Interest expense: (12) U.S. $ 3.00 (13) Canadian C$ 10 = 7.50 (14) Total $ 10.50 (15) EBT $ 32.20 Rate Scenario C$ = $.80 C$ = $.85 $307.00 C$4 = 3.40 $310.40 $50.00 C$200 = 170.00 $220.00 $ 90.40 $ 30.00 31.04 61.04 $ 29.36 3.00 C$ 10 = 8.50 $ 11.50 $ 17.86 $ $304.00 C$4 = 3.20 $307.20 $ 50.00 C$200= 160.00 $210.00 $ 97.20 $ 30.00 30.72 60.72 $ 36.48 3.00 C$10 = 8.00 $ 11.00 $ 25.48 $

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Economic Exposure
Conclusion: Madison, Inc., would be adversely affected by a strong Canadian dollar. *In general, firms with more foreign costs than revenues will be unfavorably affected by stronger foreign currencies.

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Economic Exposure
Another method of assessing a firms economic exposure involves applying regression analysis to historical cash flow and exchange rate data.

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Economic Exposure
PCFt = a0 + a1et + t
PCFt = % change in inflation-adjusted cash flows measured in the firms home currency over period t = % change in the currency exchange rate over period t = random error term = intercept = slope coefficient
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et

t
a0 a1

Economic Exposure
The regression model may be revised to handle multiple currencies by including them as additional independent variables, or by using a currency index (composite). By changing the dependent variable, the impact of exchange rates on the firms value (as measured by its stock price), earnings, exports, sales, etc. may also be assessed.

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Translation Exposure
The exposure of the MNCs consolidated financial statements to exchange rate fluctuations is known as translation exposure. In particular, subsidiary earnings translated into the reporting currency on the consolidated income statement are subject to changing exchange rates.
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Translation Exposure
Does Translation Exposure Matter? Cash Flow Perspective * Translating financial statements for consolidated reporting purposes does not by itself affect an MNCs cash flows. * However, a weak foreign currency today may result in a forecast of a weak exchange rate at the time subsidiary earnings are actually remitted.
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Translation Exposure
Does Translation Exposure Matter? Stock Price Perspective - Since an MNCs translation exposure affects its consolidated earnings and many investors tend to use earnings when valuing firms, the MNCs valuation may be affected.
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Translation Exposure
In general, translation relevant because exposure is

some MNC subsidiaries may want to remit

their 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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Translation Exposure
An MNCs degree of translation exposure is dependent on:
the proportion of its business conducted by

its foreign subsidiaries, The locations of its foreign subsidiaries, and the accounting method that it uses.

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Questions and Applications

1. Your employer, a large MNC, has asked you to assess its transaction exposure. Its projected cash flows are as follows for the next year:
Currency Total inflow Total outflow Current Exchange Rate in U.S. Dollars

Danish (DK) 50,000,000 krone British ( ) 2,000,000 pound

40,000,000

$.15

1,000,000

$1.50

Assume that the movements in the Danish krone and the pound are highly correlated . Provide your assessment as to your firms degree of transaction exposure (as to whether the exposure is high or low). Substantiate your answer.

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Questions and Applications

2. Fisher Inc., Export products from Florida to Europe. It obtains its supplies and borrows funds locally. How would appreciation of the euro likely affect its net cash flows? Why? 3. Walt Disney World build an amusement park in France that opened in 1992. How do you think this project has affected Disneys overall economic exposure to exchange rate movements? Explain.

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Questions and Applications

4. Lubbock, Inc., produces furniture and has no international business. Its major competitors import most of their furniture from Brazil and then sell it out of retail stores in the United States. How will Lubbock be affected if Brazils currency (the real ) strengthens over time?

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Questions and Applications

5. Cieplak, Inc., is a U.S.-based MNC that has expanded into Asia. Its U.S. parent exports to some Asian countries, with its exports denominated in the Asian currencies. It also has a large subsidiary in Malaysia that serves that market. Offer at least two reasons related to exposure to exchange rates why Cieplaks earnings were reduced during the Asian Crisis.

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Questions and Applications

6. Vegas Corp. is a U.S. Firm that exports most of its products to Canada. It historically invoiced its products in Canadian dollars to accommodate the importers. However, it was adversely affected when the Canadian dollar weakened against the U.S. dollar. Since Vegas did not hedge, its Canadian dollar receivables were converted into a relatively small amount of U.S. dollars. After a few more year of continual concern about possible exchange rate movements, Vegas called
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Questions and Applications

its customers and requested that they pay for future orders with U.S. dollars instead of Canadian dollars. At this time, the Canadian dollar was valued at $.81. The customers decided to oblige, since the number of Canadian dollars to be converted into U.S. dollars when importing the goods from Vegas was still slightly smaller than the number of Canadian dollars that would be needed to buy the product from a Canadian manufacturer. Based on this situation, has transaction exposure changed for Vegas Corp.? Has economic exposure changed? Explain.
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Questions and Applications

7. Decko Co. is a U.S. firm with a Chinese subsidiary that produces cell phones in China and sells them in Japan. This subsidiary pays its wages and its rent in Chinese yuan. The cell phones sold to Japan are denominated in Japanese yen. Assume that Decko Co. expects that the Chinese yuan will continue to be stable against the dollar. The subsidiarys main goal is to generate profits for itself and it reinvests the profits. It does not plan to remit any funds to the U.S. parent.

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Questions and Applications

a. Assume that the Japanese yen strengthens against the U.S. dollar over time. How would this be expected to affect the profits earned by the Chinese subsidiary? b. If Decko Co. had established its subsidiary in Tokyo, Japan instead of China, would its subsidiarys profits be more exposed or less exposed to exchange rate risk? c. Why do you think that Decko Co. established the subsidiary in China instead of Japan? Assume no major country risk barriers. d. If the Chinese subsidiary needs to borrow money to finance its expansion and wants to reduce its exchange rate risk, should it borrow U.S. dollars, Chinese yuan, or Japanese yen?

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