Exchange Rate Fluctuations CHAPTER 10 Measuring Exposure to Exchange Rate Fluctuations © 2000 South-Western College Publishing 1

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.

Is Exchange Rate Risk Relevant? Purchasing Power Parity Argument: Exchange rate movements will be matched by price movements. PPP does not necessarily hold. 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 themselves too.

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. 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.

Types of Exposure 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. Two steps are involved in measuring transaction exposure: determine the projected net amount of inflows or outflows in each foreign currency, and determine the overall risk of exposure to those currencies.

Transaction Exposure To determine the overall risk, assess the standard deviations and correlations of the currencies, taking into account the size of the MNC’s position in each currency in terms of a standard currency. The standard deviation statistic on historical data measures currency variability. Note that the variability may change over time. Correlation coefficients indicate the degree to which two currencies move in relation to each other. They may change over time too.

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.

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.

Economic Exposure Transactions that Influence the Firm’s Local Currency Inflows Impact of Local Currency Appreciation on Transactions Impact of Local Currency Depreciation on Transactions Local sales (relative to foreign competition in local markets) Firm’s exports denominated in local currency Firm’s exports denominated in foreign currency Interest received from foreign investments Decrease Increase

Economic Exposure Transactions that Influence the Firm’s Local Currency Outflows Impact of Local Currency Appreciation on Transactions Impact of Local Currency Depreciation on Transactions Firm’s imported supplies denominated in local currency Firm’s imported supplies denominated in foreign currency Interest owed on foreign funds borrowed No Change Decrease Increase

Economic Exposure Even purely domestic firms can be affected by economic exposure if there is foreign competition within the local markets. However, their degree of exposure is likely to be much less than for MNCs. One method of measuring economic exposure is by reviewing how the earnings forecast in the income statement changes in response to alternative exchange rate scenarios.

Economic Exposure Another method of assessing a firm’s economic exposure is by applying regression analysis to historical cash flow and exchange rate data as follows: % D in the inflation - % D in the adjusted cash flows exchange measured in the = a0 + a1 x rate of the + m firm’s home currency currency over period t over period t The model can be varied by including more currencies, using an index of currencies, focusing on selected cash flows only, or using the stock price.

Translation Exposure The exposure of the MNC’s consolidated financial statements to exchange rate fluctuations is known as translation exposure. Translation exposure may not be relevant because translating financial statements for consolidated reporting purposes does not affect an MNC’s cash flows. In reality however, translation exposure may affect the stock price of a firm through its impact on consolidated earnings.

Translation Exposure Note that the current translation of earnings may be a useful base to derive the expected future cash flows when earnings are remitted by the foreign subsidiaries to the parent. Translation exposure is dependent on: the degree of foreign involvement by foreign subsidiaries, the locations of foreign subsidiaries, and the accounting methods used.

Translation Exposure According to estimates, the total translated earnings of U.S.-based MNCs were reduced by $20 billion in the third quarter of 1998 alone simply because of the depreciation of Asian currencies against the dollar. In general, translation exposure is more closely monitored when the foreign earnings of the subsidiaries are more likely to be remitted to the parent, because this signals a business operation that is subject to economic exposure.

Impact of Exchange Rate Exposure on an MNC’s Value Transaction exposure Economic exposure 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 the end of period t k = the weighted average cost of capital of the U.S. parent

Chapter Review Is Exchange Rate Risk Relevant? Purchasing Power Parity Argument The Investor Hedge Argument Currency Diversification Argument Stakeholder Diversification Argument Types of Exposure Transaction Exposure Economic Exposure Translation Exposure

Chapter Review Transaction Exposure Transaction Exposure to Net Cash Flows Transaction Exposure Based on Currency Variability & Currency Correlations Transaction Exposure Based on Value-at-Risk Economic Exposure Economic Exposure to Local Currency Appreciation & Depreciation Economic Exposure of Domestic Firms & MNCs Measuring Economic Exposure Sensitivity of Earnings to Exchange Rates Sensitivity of Cash Flows to Exchange Rates

Chapter Review Translation Exposure Does Translation Exposure Matter Determinants of Translation Exposure The Degree of Foreign Involvement by Foreign Subsidiaries The Locations of Foreign Subsidiaries The Accounting Methods Used Impact of Exchange Rate Exposure on an MNC’s Value