For use with International Financial Management,
5th edn, ISBN 978-1-4737-7050-8 © Jeff Madura and Roland Fox
For use with International Financial Management,
5th edn, ISBN 978-1-4737-7050-8 © Jeff Madura and Roland Fox
Chapter 10
Measuring Exposure to Exchange
Rate Fluctuations
For use with International Financial Management,
5th edn, ISBN 978-1-4737-7050-8 © Jeff Madura and Roland Fox
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.
For use with International Financial Management,
5th edn, ISBN 978-1-4737-7050-8 © Jeff Madura and Roland Fox
Is Exchange Rate Risk Relevant? (1)
Purchasing Power Parity Argument
Exchange rate movements will be matched by price movements.
PPP does not necessarily hold.
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5th edn, ISBN 978-1-4737-7050-8 © Jeff Madura and Roland Fox
Is Exchange Rate Risk Relevant? (2)
The Investor Hedge Argument
The investors have limited information on corporate exposure. They have
the capabilities to make an approximate estimate of the effect of
exchange rate changes on share value.
MNC shareholders can hedge against such exchange rate fluctuations on
their own
For use with International Financial Management,
5th edn, ISBN 978-1-4737-7050-8 © Jeff Madura and Roland Fox
Is Exchange Rate Risk Relevant? (3)
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; few are that well diversified.
For use with International Financial Management,
5th edn, ISBN 978-1-4737-7050-8 © Jeff Madura and Roland Fox
Is Exchange Rate Risk Relevant? (4)
Stakeholder Diversification Argument
Well-diversified stakeholders will be somewhat insulated against losses
experienced by an MNC caused by exchange rate risk.
Easier for shareholders to diversify investments than MNCs that are
limited by their activities.
But many MNCs are similarly affected by exchange rate movements.
For use with International Financial Management,
5th edn, ISBN 978-1-4737-7050-8 © Jeff Madura and Roland Fox
Is Exchange Rate Risk Relevant? (5)
Response from MNCs
• Many MNCs have attempted to stabilize their earnings with hedging
strategies because they believe exchange rate risk is relevant.
For use with International Financial Management,
5th edn, ISBN 978-1-4737-7050-8 © Jeff Madura and Roland Fox
Types of Exposure
• Although exchange rates cannot be forecast with perfect accuracy, firms
can at least measure their exposure to exchange rate fluctuations.
• Exposure to exchange rate fluctuations comes in three forms:
o transaction exposure
o economic exposure
o translation exposure.
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5th edn, ISBN 978-1-4737-7050-8 © Jeff Madura and Roland Fox
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.
• To measure transaction exposure:
o estimate the net cash inflows or outflows in each currency
o measure the potential impact of the exposure to those currencies.
For use with International Financial Management,
5th edn, ISBN 978-1-4737-7050-8 © Jeff Madura and Roland Fox
Estimating Net Currency Flows
• MNCs can usually anticipate foreign cash flows for an upcoming short-term
period with reasonable accuracy.
• After the consolidated net currency flows for the entire MNC has been
determined, each net flow is converted into a point estimate (or range) of a
chosen currency.
• The exposure for each currency can then be assessed using the same
measure.
For use with International Financial Management,
5th edn, ISBN 978-1-4737-7050-8 © Jeff Madura and Roland Fox
Measuring the Potential Impact (1)
• An MNC’s exposure can be measured by considering the proportion of
each currency together with the currency’s variability and the correlations
among the movements of the currencies.
• For a two-currency portfolio,
σ p w w 2 w x w y x y CORRxy
2
x
2
x
2
y
2
y
For use with International Financial Management,
5th edn, ISBN 978-1-4737-7050-8 © Jeff Madura and Roland Fox
Measuring the Potential Impact (1)
Transaction exposure for more than two cash flows
For use with International Financial Management,
5th edn, ISBN 978-1-4737-7050-8 © Jeff Madura and Roland Fox
Measuring the Potential Impact (2)
• The standard deviation statistic measures currency variability.
• Correlation coefficients indicate the degree to which two currencies move
in relation to each other.
Coefficient
Perfect positive correlation 1.00
No correlation 0.00
Perfect negative correlation –1.00
Both variability and correlations vary among currencies and over time.
For use with International Financial Management,
5th edn, ISBN 978-1-4737-7050-8 © Jeff Madura and Roland Fox
Currencies change in value
Transaction Exposure (1)
• The value-at-risk (VAR) is for example: ‘there is a 5 per cent chance that
monthly losses could be at least £500k’.
• This is the minimum loss in the 5 per cent band, losses could be greater!
But if 500k is already too much we need not worry about greater losses.
• For foreign currency flow x, the one-day loss = E ( ex ) – z[P] x
E(ex) = expected x for the next day
z[P] = if u ~ N(0,1), Prob (u < z[P] ) = P
for 95% confidence level, z[0.95] = 1.65
x = standard deviation of the daily x value
For use with International Financial Management,
5th edn, ISBN 978-1-4737-7050-8 © Jeff Madura and Roland Fox
Transaction Exposure (2)
• The VAR method can also be used to assess exposure to multiple
currencies and over longer time horizons.
• Maximum one-month loss of currency portfolio p = E ( ep ) – z[P] p
E(ep) = expected p value over the next month
z[P] = if u ~ N(0,1), Prob (u < z[P] ) = P
for 95% confidence level, z[0.95] = 1.65
p = standard deviation of the monthly portfolio value
For use with International Financial Management,
5th edn, ISBN 978-1-4737-7050-8 © Jeff Madura and Roland Fox
Transaction Exposure (2)
Note:
monthly = daily x
• A useful formula for estimating longer term standard deviation e.g. 1 to 5 years
from short term but relevant data.
If daily = 0.002 estimated monthly = 0.002 x
Where there are approximately 20 trading days in a month.
• The formula assumes a random walk, it is simply the variance covariance matrix for
20 days (instead of currencies) with no covariance – so just the lead diagonal. It
could be days to years and so on.
For use with International Financial Management,
5th edn, ISBN 978-1-4737-7050-8 © Jeff Madura and Roland Fox
Economic Exposure (1)
• Economic exposure refers to the degree to which a firm’s present value of
future cash flows can be influenced by exchange rate fluctuations.
• Even a purely domestic firm may be affected by economic exposure if it
faces foreign competition in its local markets.
For use with International Financial Management,
5th edn, ISBN 978-1-4737-7050-8 © Jeff Madura and Roland Fox
Economic Exposure (2)
• Economic exposure can be measured by assessing the sensitivity of the
firm’s earnings to exchange rates.
o This involves reviewing how the earnings forecast in the firm’s income
statement changes in response to alternative exchange rate scenarios.
For use with International Financial Management,
5th edn, ISBN 978-1-4737-7050-8 © Jeff Madura and Roland Fox
Economic Exposure (3)
• If currency depreciates revenues improve but costs can increase. What
happens to profits?
• Important factors are :
o size of sales and size of costs
o elasticity of demand (the currency is cheaper but how much more will be
purchased?)
o elasticity of supply (cost of supplies increases but can the firm decrease its
foreign supply demand by switching?).
For use with International Financial Management,
5th edn, ISBN 978-1-4737-7050-8 © Jeff Madura and Roland Fox
Economic Exposure (4)
• If currency appreciates revenues worsen but costs can decrease. What
happens to profits?
• Important factors are :
o size of sales and size of costs
o elasticity of demand (the currency is more expensive but how much less will
be purchased?)
o elasticity of supply (cost of supplies decreases but how much can the firm
benefit by switching suppliers to currencies that have depreciated by even
more?).
For use with International Financial Management,
5th edn, ISBN 978-1-4737-7050-8 © Jeff Madura and Roland Fox
Economic Exposure (5)
• Economic exposure can also be measured by assessing the sensitivity of
the firm’s cash flows to exchange rates through regression analysis.
• For a single foreign currency:
PCFt = a0 + a1et + t
PCFt = % in inflation-adjusted cash flows
measured in the firm’s home currency over period t
et = % in the exchange rate over period t
For use with International Financial Management,
5th edn, ISBN 978-1-4737-7050-8 © Jeff Madura and Roland Fox
Economic Exposure (6)
• The model may be revised to handle additional currencies by including
them as additional independent variables.
• By replacing the dependent variable (cash flows), the impact of exchange
rates on the firm’s value (as measured by its stock price), earnings, exports,
sales, etc. may also be assessed.
For use with International Financial Management,
5th edn, ISBN 978-1-4737-7050-8 © Jeff Madura and Roland Fox
Translation Exposure (1)
• The exposure of an MNC’s consolidated financial statements to exchange
rate fluctuations is known as translation exposure.
• Subsidiary earnings translated into the reporting currency on the
consolidated income statement are subject to changing exchange rates.
For use with International Financial Management,
5th edn, ISBN 978-1-4737-7050-8 © Jeff Madura and Roland Fox
Translation Exposure (2)
• In the 2000–2001 period, the weakness of the euro caused several US-
based MNCs to report lower earnings than what they had expected.
• In 2002 and 2003, however, the euro strengthened, and the consolidated
income statements of these US-based MNCs improved.
For use with International Financial Management,
5th edn, ISBN 978-1-4737-7050-8 © Jeff Madura and Roland Fox
Translation Exposure (3)
• An MNC’s degree of translation exposure is dependent on:
o the proportion of its business conducted by foreign subsidiaries
o the locations of its foreign subsidiaries
o the accounting methods that it uses.
For use with International Financial Management,
5th edn, ISBN 978-1-4737-7050-8 © Jeff Madura and Roland Fox
Does Translation Exposure Matter? (4)
Cash Flow Perspective
The translation of financial statements for consolidated reporting purposes does
not by itself affect an MNC’s cash flows.
For that reason, many firms do not hedge against translation exposure.
For use with International Financial Management,
5th edn, ISBN 978-1-4737-7050-8 © Jeff Madura and Roland Fox
Does Translation Exposure Matter? (5)
Stock Price Perspective
Since an MNC’s translation exposure affects its consolidated earnings and many
investors tend to use earnings when valuing firms, the MNC’s valuation may be
affected.
However, an efficient market should be able to separate out the translation
effect and understand that it does not affect their wealth.
For use with International Financial Management,
5th edn, ISBN 978-1-4737-7050-8 © Jeff Madura and Roland Fox