Measuring Exposure To

Exchange Rate Fluctuations

Chapter Objectives
To discuss the relevance of an
MNCs 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.
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.
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.
Is Exchange Rate Risk Relevant?
For current and historic exchange rates,
as well as implied currency volatilities,
visit http://www.ny.frb.org/pihome/statistics/.
Online Application
11/30/01
Implied Vols 1 Week 1 Month 2 Month 3 Month 6 Month 12 Month 2 Year 3 Year
EUR 10.9 9.9 10.9 11.2 11.7 11.9 11.9 11.8
JPY 9.1 8.9 9.5 9.9 10.4 10.6 10.7 10.7
CHF 11.2 10.3 11.2 11.5 11.9 12.1 12.0 12.0
GBP 9.0 8.1 8.8 9.1 9.4 9.5 9.6 9.7
CAD 6.2 5.9 6.0 6.1 6.1 6.1 6.2 6.1
AUD 10.4 10.3 11.0 11.4 11.8 12.0 12.0 12.0
GBPEUR 8.1 6.9 7.4 7.7 8.4 8.7 8.6 8.5
EURJPY 9.3 9.0 9.7 10.3 10.8 11.3 11.4 11.4

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
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.
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
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
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
Transaction Exposure
Standard Deviations of Exchange Rate Movements
Based on Monthly Data
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
Transaction Exposure
Can$ NZ$ Sk SwF
British
pound () 1.00
Canadian
dollar (Can$) .18 1.00
Japanese
yen () .45 .06 1.00
New Zealand
dollar (NZ$) .39 .20 .33 1.00
Swedish
krona (Sk) .62 .16 .46 .33 1.00
Swiss franc
(SwF) .63 .12 .61 .37 .70 1.00
Transaction Exposure
Correlations Among Exchange Rate Movements
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
Movements of Selected Currencies
Against the Dollar
0.00
0.20
0.40
0.60
0.80
1.00
1.20
1.40
1981 1986 1991 1996 2001
$/100
$/10 Indian rupees
$/Chinese yuan
$/5 Swedish krona
$/Canadian$
$/Singapore$
$

p
e
r

u
n
i
t

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.
Transaction Exposure
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.
Economic Exposure
Transactions that
Influence the Firms
Cash Inflows

Local Currency
Appreciates

Local Currency
Depreciates
Local sales (relative
to foreign competition
in local markets)
Firms exports
denominated in local
currency
Firms exports
denominated in
foreign currency
Interest received from
foreign investments

Decrease


Decrease


Decrease


Decrease

Increase


Increase


Increase


Increase

Impact on Transactions

Transactions reflecting transaction exposure.
Economic Exposure
Transactions that
Influence the Firms
Cash Outflows

Local Currency
Appreciates

Local Currency
Depreciates

Impact on Transactions

Transactions reflecting transaction exposure.
Firms imported
supplies denominated
in local currency
Firms imported
supplies denominated
in foreign currency
Interest owed on
foreign funds
borrowed

No Change


Decrease


Decrease

No Change


Increase


Increase
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.
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.
In general, firms with more foreign costs
than revenues will be unfavorably affected
by stronger foreign currencies.
Economic Exposure
Another method of assessing a firms
economic exposure involves applying
regression analysis to historical cash flow
and exchange rate data.
Economic Exposure
PCF
t
= a
0
+ a
1
e
t
+
t

PCF
t
= % change in inflation-adjusted cash
flows measured in the firms home
currency over period t
e
t
= % change in the currency exchange
rate over period t

t
= random error term
a
0
= intercept
a
1
= slope coefficient
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.
Economic Exposure
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.
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.
Translation Exposure
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.
Does Translation Exposure Matter?
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.
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.
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.
Translation Exposure
The annual reports for many MNCs may be
found at http://www.reportgallery.com.
Review some annual reports and see if
you can find any comments that describe
the MNCs transaction, economic, or
translation exposures.
Online Application
Impact of Exchange Rate Exposure
on an MNCs Value
( ) ( ) | |
( )

=
n
t
t
m
j
t j t j
k
1 =
1
, ,
1
ER E CF E
= Value
E (CF
j,t
) = expected cash flows in currency j to be received
by the U.S. parent at the end of period t
E (ER
j,t
) = expected exchange rate at which currency j can
be converted to dollars at the end of period t
k = weighted average cost of capital of the parent
Transaction Exposure
Economic Exposure
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
Chapter Review
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
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
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
MNCs Value