1. Managing Economic Exposure And Translation Exposure12
Chapter
Managing Economic Exposure And Translation Exposure

2. 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.

3. 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.

4. 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

5. 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.

6. 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.

7. 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
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8. Impact of exchange rate movements
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9. 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
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10. Different operational structure
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11. 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

12. 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

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

14. Regression output Unit A
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15. Regression output Unit B
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16. Regression output Unit C
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17. 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.