Chapter

10
Measuring Exposure To
Exchange Rate Fluctuations

South-Western/Thomson Learning © 2003

 Chapter Objectives

• 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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Is Exchange Rate Risk Relevant?

Purchasing Power Parity 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 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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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.

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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.

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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.

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 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.

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 Transaction Exposure

• 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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 Transaction Exposure
Standard Deviations of Exchange Rate Movements
Based on Monthly Data
Currency 1981-1993 1994-1998
British pound 0.0309 0.0148
Canadian dollar 0.0100 0.0110
Indian rupee 0.0219 0.0168
Japanese yen 0.0279 0.0298
New Zealand dollar 0.0289 0.0190
Swedish krona 0.0287 0.0195
Swiss franc 0.0330 0.0246
Singapore dollar 0.0111 0.0174

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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 1.00
no correlation 0.00
perfect negative correlation -1.00

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 Transaction Exposure
Correlations Among Exchange Rate Movements
£ Can$ ¥ NZ$ Sk SwF
British
pound (£) 1.00
Canadian
dollar (Can$) .181.00
Japanese
yen (¥) .45.061.00
New Zealand
dollar (NZ$) .39.20 .331.00
Swedish
krona (Sk) .62.16 .46.331.00
Swiss franc
(SwF) .63.12 .61.37 .701.00

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 Transaction Exposure

• The point in considering correlations is to

detect positions that could somewhat offset
each other.
• For example, if 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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 Movements of Selected Currencies
Against the Dollar
1.40
1.20 $/10 Indian rupees
$/100 ¥
1.00 $/Canadian$
$ per unit

0.80
0.60
0.40 $/Singapore$ $/5 Swedish krona
0.20 $/Chinese yuan
0.00
1981 1986 1991 1996 2001

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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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 Economic Exposure

• 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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 Economic Exposure
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. B10 - 19
 Economic Exposure
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. B10 - 20

 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 characteristics and net
currency positions.

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 Economic Exposure

• 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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 Economic Exposure

• 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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Economic Exposure

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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 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 firm’s 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 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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 Translation Exposure

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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 Translation Exposure

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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 Translation Exposure

• 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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 Translation Exposure

• 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.

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 Translation Exposure

• According to World Research Advisory

estimates, the translated earnings of U.S.-
based MNCs in aggregate were reduced by
$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.

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Impact of Exchange Rate Exposure
on an MNC’s Value
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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 Chapter Review

• Is Exchange Rate Risk Relevant?

¤ Purchasing Power Parity Argument
¤ The Investor Hedge Argument
¤ Currency Diversification Argument
¤ Stakeholder Diversification Argument
¤ Response from MNCs
• Types of Exposure
¤ Transaction, Economic, and Translation
Exposures

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 Chapter Review

• Transaction Exposure
¤ Transaction Exposure to “Net” Cash Flows
¤ Transaction Exposure Based on Currency
Variability
¤ Transaction Exposure Based on Currency
Correlations
¤ Transaction Exposure Based on Value-at-
Risk

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 Chapter Review

• Economic Exposure
¤ Economic Exposure to Local Currency
Appreciation & Depreciation
¤ Economic Exposure of Domestic Firms &
MNCs
¤ Measuring Economic Exposure
­ Sensitivity of Earnings & Cash Flows to
Exchange Rates

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 Chapter Review

• Translation Exposure
¤ Does Translation Exposure Matter?
­ Cash Flow Perspective
­ Stock Price Perspective
¤ Determinants of Translation Exposure
¤ Examples of Translation Exposure
• Impact of Exchange Rate Exposure on an
MNC’s Value

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