International Financial Management

by Jeff Madura

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 Measuring Exposure to Exchange Rate
10 Fluctuations
Chapter Objectives

 Discuss the relevance of an MNC’s exposure to

exchange rate risk
 Explain how transaction exposure can be measured
 Explain how economic exposure can be measured
 Explain how translation exposure can be measured

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 Relevance of Exchange Rate Risk

 Exchange rates are very volatile.

 The dollar value of an MNC’s future payables or

receivables in a foreign currency can change substantially
in response to exchange rate movements.

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 Exhibit 10.1 Amount of Dollars Needed to Obtain
Imports (transaction value is 1 million euros)

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 Relevance of Exchange Rate Risk

1. Purchasing Power Parity Argument: Exchange rate

movements will be matched by price movements. PPP does not
necessarily hold.
2. Investor Hedge Argument: exchange rate risk is
irrelevant because investors can hedge exchange rate
risk on their own.
3. Currency Diversification Argument: if U.S.-based
MNC is well diversified across numerous currencies, its
value will not be affected by exchange rate risk
4. Stakeholder Diversification Argument: if
stakeholders are well diversified, they will be somewhat
insulated against losses due to MNC exchange rate risk.
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 Response from MNCs

Many MNCs attempt to stabilize their earnings with

hedging strategies because they believe exchange rate
risk is relevant.
Because we manufacture and sell products in a number of
countries throughout the world, we are exposed to the impact on
revenues and expenses of movements in currency exchange rates.
—Proctor & Gamble Co.

Increased volatility in foreign exchange rates … may have an

adverse impact on our business results and financial condition.
—PepsiCo

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 Forms of Exchange Rate Exposure

1. Transaction exposure
2. Economic exposure
3. Translation exposure

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 Transaction Exposure

 Definition: sensitivity of the firm’s contractual

transactions in foreign currencies to exchange rate
movements.
 To assess transaction exposure, the MNC must:
 Estimate net cash flows in each currency (See Exhibits
10.2 & 10.3)
 Measure potential impact of the currency exposure

 p  Wx2 x2  W y2 y2  2WxWy x y CORRxy

W  proportion of portfolio value in currency x or y
σ  standard deviation of percentage changes in currency x or y
CORR  correlatio n coefficien t of percentage changes in currencies x and y

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 Exhibit 10.2 Consolidated Net Cash Flow Assessment of
Miami Co.

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 Exhibit 10.3 Estimating the Range of Net Inflows or
Outflows for Miami Co.

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 Exposure of an MNC’s Portfolio

 Measurement of currency volatility (Exhibit 10.4)

The standard deviation statistic measures the degree of
movement for each currency. In any given period, some
currencies clearly fluctuate much more than others.
 Currency volatility over time (Exhibit 10.5)
The volatility of a currency may not remain consistent from one
time period to another. An MNC can identify currencies whose
values are most likely to be stable or highly volatile in the future.
 Measurement of currency correlations (Exhibit 10.6)
The correlations coefficients indicate the degree to which two
currencies move in relation to each other.

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 Exposure of an MNC’s Portfolio Affected by:

 Applying currency correlations to net cash flows

(Exhibit 10.7)
If a MNC has positive net cash flows in various currencies that
are highly correlated, it may be exposed to exchange rate risk.
However, many MNCs have some negative net cash flow
positions in some currencies to complement their positive net
cash flows in other currencies.
 Currency correlations over time
Because currency correlations change over time, an MNC
cannot use previous correlations to predict future correlations
with perfect accuracy.

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 Exhibit 10.4 Standard Deviation of Exchange Rate
Movements (based on quarterly exchange rates, 2005–2008)

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 Exhibit 10.5 Shift In Currency Volatility During The
Financial Crisis

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 Exhibit 10.6 Correlations among Movements in Quarterly
Exchange Rates

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 Exhibit 10.7 Impact of Cash Flow and Correlation
Conditions on an MNC’s Exposure

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 Transaction Exposure Based on Value at Risk (VaR)

 Measures the potential maximum 1-day loss on

the value of positions of an MNC that is exposed
to exchange rate movements.
 Factors that affect the maximum 1-day loss:
 Expected percentage change in the currency rate for
the next day
 Confidence level used
 Standard deviation of the daily percentage changes in
the currency

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 Transaction Exposure Based on Value at Risk (VaR)

 Applying VaR to Longer Time Horizons

The standard deviation should be estimated over the time
horizon in which the maximum loss is to be measured.
 Applying VaR to Transaction Exposure of a Portfolio
Since MNCs are commonly exposed to more than one currency, they
may apply the VaR method to a currency portfolio. When considering
multiple currencies, software packages can be used to perform the
computations.

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 Estimating VaR with an Electronic Spreadsheet

1. Obtain the series of exchange rates for all relevant dates for
each currency of concern and list each currency in its own
column.
2. Compute the percentage changes per period (from one date to
the next) for each exchange rate in a column.
3. Estimate the standard deviation of the column of percentage
changes for each exchange rate.
4. In a separate column, compute the periodic percentage change
in the portfolio value by applying weights to the individual
currency returns.
5. Use a compute statement to determine the standard deviation
of the column of percentage changes in the portfolio value.

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 Exhibit 10.8 Spreadsheet Analysis Used to Apply
Value-at-Risk

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 Limitations of VaR

1. If the distribution of exchange rate movements is

not normal, the estimate of the maximum expected
loss is subject to error.

2. The VaR method assumes that the volatility

(standard deviation) of exchange rate movements is
stable over time. If exchange rate movements are
less volatile in the past than in the future, the
estimated maximum expected loss derived from the
VaR method will be underestimated.

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 Economic Exposure

 Definition: The sensitivity of the firm’s cash flows to

exchange rate movements, sometimes referred to as
operating exposure. (Exhibits 10.9 & 10.10)
 Economic exposure arises from:
 Exposure to local currency appreciation
Appreciation in the firm’s local currency causes a reduction in
both cash inflows and outflows. The impact on a firm’s net cash
flows will depend on whether the inflow transactions are affected
more or less than the outflow transactions.
 Exposure to local currency depreciation
Depreciation of the firm’s local currency causes an increase in
both cash inflows and outflows.

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 Exhibit 10.9 Examples That Subject a Firm to Economic
Exposure

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 Exhibit 10.10 Economic Exposure to Exchange Rate
Fluctuations

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 Measuring Economic Exposure

 Use of sensitivity analysis (Exhibits 11 & 12)

Consider how sales and expense categories are affected by
various exchange rate scenarios.
 Use of regression analysis
PCFt  a0  a1et  t
where
PCFt  percentage change in inflation - adjusted
cash flows measured in home currency
et  percentage change in direct exchange rate
t  random error term
a0  intercept
a1  slope coefficien t

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 Exhibit 10.11 Estimated Sales and Expenses for Madison’s
U.S. and Canadian Business Segments (in Millions)

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 Exhibit 10.12 Impact of Possible Exchange Rates on
Cash Flows of Madison Co. (in Millions)

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 Translation Exposure

 Definition: The exposure of the MNC’s

consolidated financial statements to exchange
rate fluctuations.
 Determinants of translation exposure:
 The proportion of business conducted by foreign
subsidiaries
 The locations of foreign subsidiaries
 The accounting methods used

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 Accounting Methods

MNC translation exposure is affected by accounting

procedures, many of which are based on FASB 52:
1. The functional currency of an entity is the currency
of the economic environment in which the entity
operates.
2. The current exchange rate as of the reporting date is
used to translate the assets and liabilities of a foreign
entity from its functional currency into the reporting
currency.

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 Accounting Methods

3. The weighted average exchange rate over the relevant period

is used to translate revenue, expenses, and gains and losses of
a foreign entity from its functional currency into the reporting
currency.
4. Translated income gains or losses due to changes in foreign
currency values are not recognized in current net income but
are reported as a second component of stockholder’s equity;
an exception to this rule is a foreign entity located in a country
with high inflation.
5. Realized income gains or losses due to foreign currency
transactions are recorded in current net income, although there
are some exceptions.
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 Exposure of an MNC’s Stock Price to Translation
Effects

Because an MNC’s translation exposure affects its

consolidated earnings, it can affect the MNC’s
valuation.

Exhibit 10.13 How Translation Exposure Can Affect

the MNC’s Stock Price

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Impact of Exchange Rate Exposure on an MNC’s Value

Transaction Exposure
Economic Exposure

m 
n 

E  CFj , t   E ER j , t   
 j 1 
Value =   
t =1   1  k  t

 
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