INTL303chpt10exchgnrateexposure

8/3/2019 INTL303chpt10exchgnrateexposure

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Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson


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Measuring Exposure to Exchange

Rate Fluctuations

Chapter 10


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Overview

Present the relevance of an MNCs

exchange rate exposure

Explain measurement of transactionexposure

Explain how economic exposure is

measured

Explain measurement of translationexposure


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Exchange Rate Risk

definition

the risk that a companys performance

will be effected by exchange ratemovements


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Relevance of Exchange Rate Risk

Arguments against relevance

some people say that a firms exposure to

exchange rate risk is not relevant one argument for irrelevance is that ,

according to purchasing power parity

(PPP) theory, exchange rate movementsshould be matched by price movements

argues that similar costs exist across countries


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according to purchasing power parity

(PPP) theory, a lower dollar means imports are more

expensive

but a lower dollar also means inflation ishigh so domestic stuff cost more to make


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re: purchasing power parity (PPP) theory,

PPP does not hold true in real life

the exchange rate does not change inaccordance with the inflation difference

between the two countries


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Arguments supporting relevance

hedging reduces volatility of MNC

operations creditors may prefer that the firms to which

they lend maintain low exposure toexchange rate risk

creditors are usually the banks and they areserving their own interests since the thingscompanies will do to reduce exchange rate riskwill involve using the services of banks


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Arguments supporting relevance

volatile foreign earnings can also cause

more volatile growth which is costly

hedging can reduce the volatility of cash

flows cause the firms payments andreceipts are not forced to fluctuate inaccordance with the currency movements

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Chpt 10 is about measuring exchange rate

exposure

Chpt 11 is about using techniques to reduceexchange rate exposure


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Before knowing what techniques to useto reduce exchange rate exposure, we

first of all have to measure it to see if itis of any consequence


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Transaction Exposure

The degree to which transactionscan be effected by exchange ratefluctuations is transaction exposure


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TWO steps are involved in measuringtransaction exposure

1. Determine the projected net amount ofinflows and outflows in each foreigncurrency

2. Determine the overall risk of exposureto those currencies

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Affects exposure to net cash flow

consolidates subsidiaries cash in/outflows

e.g., minimal exposure in Mexican peso ifSubsidiary A has net inflow of PS9,000,000

Subsidiary B has net outflow of PS8,700,000

MNC net flow = PS300,000


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Exposure to currency variability

MNC develops range of projected

exchange rates for the end of the specifiedperiod

standard deviation may be helpful

variability changes over time

S


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Currency correlation

pattern of movement between twocurrencies

affects net exposure for MNC

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Currency correlation, example

German mark and Swiss franc increase in value MNC X has net inflow exposure from Germany

MNC Y has net outflow exposure in Germany with similarsized inflow exposure from Switzerland

DM and SF have a correlation of 94 percent

Net transaction exposures MNC X maintains currency risk exposure

MNC Y has offsetting DM and SF exposure

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Steps to assess transaction exposure

assess MNCs position in each currency

estimate how an exposure in a currencyaffects the MNC

use standard deviations and correlations

assess the net effect of currencyexposures

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Economic Exposure

Currency fluctuations affect more thancurrency transactions

e.g., an increase in inflation in France may:

1. lower value of outflow from France

(transaction exposure)2. increase subsidiarys French sales

3. raise financing cost in France

Measures how greatly an MNCs present value of future

cash flows is affected by exchange rate fluctuations

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Economic Exposure

Impact of local currency depreciation

inflows of local currency

Variable affecting MNCs

local currency inflows

Impact of local

currency depreciation

Local sales(relative to foreign competition)

Increase

MNCs exports

(valued in local currency)

Increase

MNCs exports(valued in foreign currency)

Increase

or No change

Interest from foreign

investment

Increase

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Economic Exposure

Impact of local currency depreciation

outflows of local currency

Variable affecting MNCslocal currency outflows

Impact of localcurrency depreciation

Imported supplies(denominated in local currency)

No change

Imported supplies

(valued in foreign currency)

Increase

Interest owed on foreign

funds borrowed

Increase

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Economic Exposure

Indirect exposure

impact from currency revaluation

e.g., exporters may increase prices tocompensate for devaluation of home currency

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Economic Exposure

Exposure of domestic firms

impacted by foreign competition and

financial markets

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Economic Exposure

Exposure of domestic firms

impacted by foreign competition and financial

markets Exposure of MNCs

face exposure on domestic and foreign soils

Jan-May 1993:13% appreciation of Japanese yen

against $US many US firms increase US market share

Japanese firms often priced out of the US market

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Economic Exposure:

MeasurementAssess sensitivity of earnings to

exchange rate fluctuations

sort income statement items by currency project future values from estimated rates

conduct sensitivity analysis on estimates

A firm is relatively insulated from exchange rate movements

if costs and revenues are affected by similar magnitudes.

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Translation Exposure

Affects value of assets, liabilities and

earningsArgument for relevance to MNC

affects financial statements (MNC

performance) reflects an earlier trend in opinions

Measures impact that exchange rate fluctuations haveupon an MNCs consolidated financial statement

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Affects value of assets, liabilities and earnings

Argument for relevance to MNC affects financial statements (MNC performance)

reflects an earlier trend in opinions

Argument for irrelevance to MNC does not affect cash flows weak foreign currency may be retained or invested

in foreign country

Measures impact that exchange rate fluctuations haveupon an MNCs consolidated financial statement

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DeterminantsLevel of foreign involvement by foreign

subsidiaries

a greater exposure exists when:a larger contribution is made offshore

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DeterminantsLocations of foreign subsidiaries

affects currencies used in initial

measurements

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DeterminantsAccounting methods

affect how and what financial numbers are

reported

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Summary

Exchange rate exposure may affectfinancing costs

volatile cash flow from exchange ratechanges increases risk

Transaction exposure

reflects the exposure of an MNCs futurecash transactions to exchange ratemovements

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Slid d l d b J ff M d ith dditi d h t b Ti Ri h d

Summary

Economic exposure

measures the direct and indirect risks to

cash flows from exchange rate movementsTranslation exposure

focuses on consolidated financial

statements

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INTL303chpt10exchgnrateexposure