 To discuss the relevance of an

MNC’s exposure to exchange rate risk;

 To explain how transaction exposure can be

measured;
 To explain how economic exposure can be

measured; and
 To explain how translation exposure can be

measured.

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 Exchange rate risk can be broadly defined as
the risk that a company’s performance will be
affected by exchange rate movements.
 Since exchange rate movements can affect a

multinational corporation’s (MNC’s) cash

flow, they can affect an MNC’s performance
and value
 Financial managers must understand how to

measure the exposure of their MNCs to

exchange rate fluctuations so that they can
determine whether and how to protect their
operations from that exposure sbk.fin444
Purchasing Power Parity Argument
 Exchange rate movements will be matched by price
movements.
 PPP does not necessarily hold.

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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.

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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.

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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.

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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.

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 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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 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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 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.

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 An MNC’s overall exposure can be assessed
by considering each currency position
together with the currency’s 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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sbk.fin444
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 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 1.00
no correlation 0.00
perfect negative correlation -1.00

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 The dollar net cash flows of an MNC are
generated from a portfolio of currencies. The
exposure of the portfolio of currencies can be
measured by the standard deviation of the
portfolio, which indicates how the portfolio’s
value may deviate from what is expected.

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sbk.fin444
 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.

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sbk.fin444
 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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 Economic exposure refers to the degree to
which a firm’s 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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sbk.fin444
 Transactions that Impact on Transactions
Influence the Firm’s Local Currency Local Currency
Cash Inflows Appreciates Depreciates
Local sales (relative
to foreign competition Decrease Increase
in local markets)
Firm’s exports
denominated in local Decrease Increase
currency
 Firm’s exports
denominated in Decrease Increase
foreign currency
 Interest received from
foreign investments Decrease Increase
Transactions reflecting transaction exposure. sbk.fin444
 Transactions that Impact on Transactions
Influence the Firm’s Local Currency Local Currency
Cash Outflows Appreciates Depreciates
Firm’s imported
supplies denominated No Change No Change
in local currency
 Firm’s imported
supplies denominated Decrease Increase
in foreign currency
 Interest owed on
foreign funds Decrease Increase
borrowed

Transactions reflecting transaction exposure. sbk.fin444

 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 characteristics and net currency
positions.

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 Measuring economic exposure:
 Sensitivity Analysis: One measure of economic
exposure involves classifying the firm’s 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.
 In general, firms with more foreign costs than
revenues will be unfavorably affected by
stronger foreign currencies.

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 Another method of assessing a firm’s
economic exposure involves applying
regression analysis to historical cash flow and
exchange rate data.

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 PCFt = a0 + a1et + t
PCFt = % change in inflation-
adjusted cash flows measured in the
firm’s home currency over period t
et = % change in the currency
exchange rate over period t
t = random error term
a0 = intercept
a1 = slope coefficient

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 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 firm’s value

(as measured by its stock price), earnings,
exports, sales, etc. may also be assessed.

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 The exposure of the MNC’s 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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Does Translation Exposure Matter?
 Cash Flow Perspective - Translating financial

statements for consolidated reporting

purposes does not by itself affect an MNC’s
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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Does Translation Exposure Matter?
 Stock Price Perspective - Since an MNC’s
translation exposure affects its
consolidated earnings and many investors
tend to use earnings when valuing firms,
the MNC’s valuation may be affected.

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 In general, translation exposure is relevant
because
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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 An MNC’s 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.(FASB 52)

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 Transaction Exposure
Economic Exposure

m 
n 

E  CFj , t   E ER j , t   
 j 1 
Value =   
t =1   1  k  t

 
E (CFj,t ) = expected cash flows in
currency j to be received by the U.S. parent at
the end of period t
E (ERj,t ) = expected exchange rate at
which currency j can be converted to dollars at
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