1. Measuring Exposure to Exchange Rate Fluctuations
C H A P T E R 10
Measuring Exposure to Exchange Rate Fluctuations

2. Chapter Overview A. Is Exchange Rate Risk Relevant?
B. Types of Exposure
C. Transaction Exposure
D. Economic Exposure
E. Translation Exposure

3. Chapter 10 Objectives This chapter will:
A. Discuss the relevance of an MNC’s exposure to exchange rate risk
B. Explain how transaction exposure can be measured
C. Explain how economic exposure can be measured
D. Explain how translation exposure can be measured

4. A. Is Exchange Rate Risk Relevant?
1. Purchasing Power Parity Argument:
XR Risk is irrelevant because
a. according to purchasing power parity (PPP) theory, exchange rate movements are just a response to differentials in price changes between countries
b. Therefore, the exchange rate effect is offset by the change in prices

5. A. Is Exchange Rate Risk Relevant?
2. The Investor Hedge Argument: No!
a. investors in MNCs can hedge exchange rate risk on their own
b. Argument assumes that investors have information on corporate exposure to exchange rate fluctuations
c. Investor prefers company hedge

6. A. Is Exchange Rate Risk Relevant?
3. Currency Diversification Argument
a. If a U.S.-based MNC is well diversified across numerous countries, its value will not be affected by exchange rate movements because of offsetting effects.

7. A. Is Exchange Rate Risk Relevant?
4. Stakeholder Diversification Argument
Some critics also argue that if stakeholders (such as creditors or stockholders) are well diversified, they will be somewhat insulated against losses experienced by an MNC due to exchange rate risk.

8. B. Types of Exposure 1. Three exposures from Exchange Rate Risk:
a. Transaction
b. Economic
c. Translation

9. C. Transaction Exposure
1. Estimating “Net” Cash Flows in Each Currency
2. Measuring the Potential Impact of the Currency Exposure
a. Measurement of Currency Variability
b. Currency Variability over Time
c. Measurement of Currency Correlations
d. Applying Currency Correlations to net Cash Flows
e. Currency Correlations over Time

10. C. Transaction Exposure
3. Assessing Transaction Exposure Based on Value-at-Risk
a. Factors That Affect the Maximum One-day Loss
b. Applying VAR to Longer Time Horizons
c. Applying VAR to Transaction Exposure of a Portfolio
d. Limitations of VAR

11. D. Economic Exposure
1. Economic Exposure to Local Currency Appreciation
2. Economic Exposure to Local Currency Depreciation
3. Economic Exposure of Domestic Firms

12. D. Economic Exposure 4. Measuring Economic Exposure
a. By Using Sensitivity Analysis
b. By Using Regression Analysis

13. E. Translation Exposure
1. Does Translation Exposure Matter?
a. Cash Flow Perspective
b. Stock Price Perspective

14. E. Translation Exposure
2. Determinants of Translation Exposure
a. Proportion of Its Business Conducted by Foreign Subsidiaries
b. Locations of Foreign Subsidiaries
c. Accounting Methods