Managing Economic Exposure And Translation Exposure 12 Chapter Managing Economic Exposure And Translation Exposure

Chapter Objectives To explain how an MNC’s economic exposure can be hedged; and To explain how an MNC’s translation exposure can be hedged.

Economic Exposure Economic exposure refers to the impact exchange rate fluctuations can have on a firm’s future cash flows. Recall that corporate cash flows can be affected by exchange rate movements in ways not directly associated with foreign transactions.

Economic Exposure The economic impact of currency exchange rates on us is complex because such changes are often linked to variability in real growth, inflation, interest rates, governmental actions, and other factors. These changes, if material, can cause us to adjust our financing and operating strategies. PepsiCo

Use of the Income Statement to Assess Economic Exposure An MNC can determine its exposure by assessing the sensitivity of its cash inflows and outflows to various possible exchange rate scenarios. The MNC can then reduce its exposure by restructuring its operations to balance its exchange-rate-sensitive cash flows. Note that computer spreadsheets are often used to expedite the analysis.

How Restructuring Can Reduce Economic Exposure Restructuring to reduce economic exposure involves shifting the sources of costs or revenue to other locations in order to match cash inflows and outflows in foreign currencies. The proposed structure is then evaluated by assessing the sensitivity of its cash inflows and outflows to various possible exchange rate scenarios.

Example from ch 10 – Mannerton plc Mannerton plc sells to the UK and Europe A strong € increases UK sales somewhat due to increased competitiveness European sales are assumed to be constant at €40 and European costs are much higher (about € 200) Mannerton therefore lose money if the € appreciates BE 408 - International Finance

Impact of exchange rate movements BE 408 - International Finance

Mannerton plc Mannerton should change its operational structure by increasing European sales and decreasing the share of European costs Increase € sales by 20 by spending £2 on advertising £10 on materials from UK and £1 mill on other exp. Reduce € costs by €100 and increasing £ costs by 50 Increase £ borrowing by £3.5 and reduce £ borrowing by €5 BE 408 - International Finance

Different operational structure BE 408 - International Finance

Revenue is more stable From the Mannerton example in the text, the original steep slope is replaced through reducing exposure by the dotted lesser slope. It is less risky, fewer losses but fewer gains from exchange rate variation

A Case Study in Hedging Economic Exposure Silverton Co., a U.K. firm, has three independent units that conduct some business in Europe. It is concerned about its exposure to the euro. To determine whether it is exposed and the source of the exposure, Silverton applies a series of regression analysis to its cash flows and the euro’s movements. PCFt = a0 + a1(%∆€)t + µ

Assessment of Silverton’s Cash Flows and the Euro’s Movements

Regression output Unit A BE 408 - International Finance

Regression output Unit B BE 408 - International Finance

Regression output Unit C BE 408 - International Finance

Translation Exposure Translation exposure results when an MNC translates each subsidiary’s financial data to its home currency for consolidated financial reporting. Translation exposure does not directly affect cash flows, but some firms are concerned about it because of its potential impact on reported consolidated earnings.