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7/23/2019 International Finance Slides
1/26
Measuring Exposure ToExchange Rate Fluctuations
10
Chapter
South-Western/Thomson Learning 2003
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A10 - 2
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 may not have complete
information on corporate exposure. They
may not have the capabilities to correctlyinsulate their individual exposure too.
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A10 - 4
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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A10 - 5
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.
Is Exchange Rate Risk Relevant?
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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.
Is Exchange Rate Risk 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.
Transaction Exposure
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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.
Transaction Exposure
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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
Transaction Exposure
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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.
Transaction Exposure
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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.
Transaction Exposure
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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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Translation Exposure
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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Translation Exposure
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.
Translation Exposure
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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.
Translation Exposure
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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.
Translation Exposure