10
Chapter
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 their individual
exposure too.
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.
Response from MNCs
Many MNCs have attempted to stabilize their
earnings with hedging strategies, which confirms
the view that exchange rate risk is relevant.
Although exchange rates cannot be forecasted
with perfect accuracy, firms can at least measure
their exposure to exchange rate fluctuations.
Exposure to exchange rate fluctuations comes in
three forms:
Transaction exposure
Economic exposure
Translation 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:
project the net amount of inflows or outflows in each
foreign currency, and
determine the overall risk of exposure to those
currencies.
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 either a point estimate or a
range of a chosen currency, so as to standardize
the exposure assessment for each currency.
An MNC’s overall exposure can be assessed by
considering each currency position together with
the currency’s variability and the correlations
among the currencies.
The standard deviation statistic on historical data
serves as one measure of currency variability.
Note that currency variability levels may change
over time.
The correlations among currency movements can
be measured by their correlation coefficients,
which 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
Standard Deviations of Exchange Rate Movements
Based on Monthly Data
Currency 1981-1993 1994-1998
British pound 0.0309 0.0148
Canadian dollar 0.0100 0.0110
Indian rupee 0.0219 0.0168
Japanese yen 0.0279 0.0298
New Zealand dollar 0.0289 0.0190
Swedish krona 0.0287 0.0195
Swiss franc 0.0330 0.0246
Singapore dollar 0.0111 0.0174
Correlations Among Exchange Rate Movements
£ Can$ ¥ NZ$ Sk SwF
British
pound (£) 1.00
Canadian
dollar (Can$) .18 1.00
Japanese
yen (¥) .45 .06 1.00
New Zealand
dollar (NZ$) .39 .20 .33 1.00
Swedish
krona (Sk) .62 .16 .46 .33 1.00
Swiss franc
(SwF) .63 .12 .61 .37 .70 1.00
The point in considering correlations is to detect
positions that could somewhat offset each other.
For example, if currencies X and Y are highly
correlated, the exposures of a net X inflow and a
net Y outflow will offset each other to a certain
degree.
Note that the correlations among currencies may
change over time.
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 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.
Transactions that Impact on Transactions
Influence the Firm’s Local Currency Local Currency
Cash Inflows Appreciates Depreciates
Local sales (relative to
foreign competition in Decrease Increase
local markets)
Firm’s exports
denominated in local Decrease Increase
currency
Firm’s exports
denominated in foreign Decrease Increase
currency
Interest received from
foreign investments Decrease Increase
Transactions reflecting transaction exposure.
Transactions that Impact on Transactions
Influence the Firm’s Local Currency Local Currency
Cash Outflows Appreciates Depreciates
Firm’s imported
supplies denominated No Change No Change
in local currency
Firm’s imported
supplies denominated Decrease Increase
in foreign currency
Interest owed on
foreign funds Decrease Increase
borrowed
Transactions reflecting transaction exposure.
Even purely domestic firms may be affected by
economic exposure if there is foreign competition
within the local markets.
MNCs are likely to be much more exposed to
exchange rate fluctuations. The impact varies
across MNCs according to their individual
operating characteristics and net currency
positions.
One measure of economic exposure involves
classifying the firm’s cash flows into income
statement items, and then reviewing how the
earnings forecast in the income statement changes
in response to alternative exchange rate scenarios.
In general, firms with more foreign costs than
revenues will be unfavorably affected by stronger
foreign currencies.
Another method of assessing a firm’s economic
exposure involves applying regression analysis to
historical cash flow and exchange rate data.
PCFt = a0 + a1et + t
PCFt = % change in inflation-adjusted
cash flows measured in the firm’s home
currency over period t
et = % change in the currency exchange
rate over period t
t= random error term
a0= intercept
a1= slope coefficient
The regression model may be revised to handle
multiple currencies by including them as
additional independent variables, or by using a
currency index (composite).
By changing the dependent variable, the impact
of exchange rates on the firm’s value (as
measured by its stock price), earnings, exports,
sales, etc. may also be assessed.
The exposure of the MNC’s consolidated
financial statements to exchange rate fluctuations
is known as translation exposure.
In particular, subsidiary earnings translated into
the reporting currency on the consolidated
income statement are subject to changing
exchange rates.
Does Translation Exposure Matter?
Cash Flow Perspective - Translating financial
statements for consolidated reporting purposes
does not by itself affect an MNC’s cash flows.
Does Translation Exposure Matter?
However, a weak foreign currency today may
result in a forecast of a weak exchange rate at the
time subsidiary earnings are actually remitted.
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.
In general, translation exposure is relevant
because
some MNC subsidiaries may want to remit their
earnings to their parents now,
the prevailing exchange rates may be used to forecast
the expected cash flows that will result from future
remittances, and
consolidated earnings are used by many investors to
value MNCs.
An MNC’s degree of translation exposure is
dependent on:
the proportion of its business conducted by its
foreign subsidiaries,
the locations of its foreign subsidiaries, and
the accounting method that it uses.
According to World Research Advisory estimates,
the translated earnings of U.S.-based MNCs in
aggregate were reduced by $20 billion in the third
quarter of 1998 alone simply because of the
depreciation of Asian currencies against the
dollar.
In 2000, the weakness of the euro also caused
several U.S.-based MNCs to report lower
earnings than expected.
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