CHAPTER 5

MEASURING EXPOSURE TO EXCHANGE RATE FLUCTUATIONS

LEARNING OBJECTIVES:
The specific objectives of this chapter are to:
• 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, and
• explain how translation exposure can be measured.
Exchange rate risk can be broadly defined as the risk that a
company’s performance will be affected by exchange rate
movements.
Multinational corporations (MNCs) closely monitor their
operations to determine how they are exposed to various
forms of exchange rate risk.
Financial managers must understand how to measure the
exposure of their MNCs to exchange rate fluctuations so that
they can determine whether and how to protect their
companies from such exposure.
IS EXCHANGE RATE RISK RELEVANT?
Some have argued that exchange rate risk is irrelevant. These
contentions, in turn, have resulted in counter arguments, as
summarized here.
Purchasing power parity argument
One argument for exchange rate irrelevance is that,
according to purchasing power parity (PPP) theory,
exchange rate movements are just a response to
differentials in price changes between countries.
Therefore, the exchange rate effect is offset by the
change in prices.
Example:
Hokkaido Ltd of Japan denominates its exports to Europe in
Euros. If the euro weakens by 3% due to purchasing power
parity that implies that European inflation is about 3% higher
than Japanese inflation. If European competitors raise their
prices in line with European inflation, Hokkaido can increase its
euro prices by 3% without losing any customers. Thus, the
increase in its price of 3% offsets the 3% reduction in the value
of the euro.
PPP does not necessarily hold, however, so the
exchange rate will not necessarily change in
accordance with the inflation differential between the
two countries.
Since a perfect offsetting effect is unlikely, the firm’s
competitive capabilities may indeed be influenced by
exchange rate movements.
Even if PPP did hold over a very long period of time,
this would not comfort managers of MNCs that are
focusing on the next quarter or year.
The investor hedge argument
A second argument for exchange rate irrelevance is
that investors in MNCs can hedge exchange rate risk
on their own. Therefore, companies need not
concern themselves with currency risk.
The investor hedge argument assumes that investors
have sufficient information on corporate exposure to
exchange rate fluctuations as well as the capabilities
to correctly insulate their individual exposure.
To the extent that investors prefer that corporations
perform the hedging for them, exchange rate
exposure is relevant to corporations.
An MNC may be able to hedge at a lower cost than
individual investors. In addition, it has more
information about its exposure and can more
effectively hedge its exposure.
Currency diversification argument
Another argument is that if an MNC is well
diversified across numerous countries, its value
will not be affected by exchange rate movements
because of offsetting effects.
Correlations between currencies can be high and
complete offsetting impossible.
Stakeholder diversification argument
Some critics also argue that if stakeholders (such as
creditors or shareholders) are well diversified, they
will be somewhat insulated against losses
experienced by an MNC due to exchange rate risk.
The exact nature of the currency risk of MNCs’ is
not disclosed so protection can only be
approximate.
TYPES OF EXPOSURE
Exchange rates cannot be forecasted with perfect
accuracy, but the firm can at least measure its exposure
to exchange rate fluctuations.
If the firm is highly exposed to exchange rate
fluctuations, it can consider techniques to reduce its
exposure.
Exposure to exchange rate fluctuations comes in
three forms:
 Transaction exposure
 Economic exposure
 Translation exposure.
Each type of exposure will be discussed as follows:
TRANSACTION EXPOSURE
The value of a firm’s cash inflows received in
various currencies will be affected by the respective
exchange rates of these currencies when they are
converted typically into the home currency.
Similarly, the value of a firm’s cash outflows in
various currencies will be dependent on the
respective exchange rates of these currencies.
The degree to which the value of future cash
transactions can be affected by exchange rate
fluctuations is referred to as transaction exposure.
Transaction exposure can have a substantial impact on
a firm’s earnings. It is not unusual for a currency to
change by as much as 10% in a given year. If an
exporter denominates its exports in a foreign currency,
a 10% decline in that currency will reduce the dollar
value of its receivables by 10%. This effect could
possibly eliminate any profits from exporting.
To assess transaction exposure, an MNC needs to: (1)
estimate its net cash flows in each currency, and (2)
measure the potential impact of the currency exposure.
Estimating ‘net’ cash flows in each currency
MNCs tend to focus on transaction exposure over
an upcoming short-term period (such as the next
month or the next quarter) for which they can
anticipate foreign currency cash flows with
reasonable accuracy.
Since MNCs commonly have foreign subsidiaries
spread around the world, they need information
system that can track their currency positions.
To measure its transaction exposure, an MNC needs to
project the consolidated net amount in currency inflows
or outflows for all its subsidiaries, categorized by
currency.
One foreign subsidiary may have inflows of a foreign
currency while another has outflows of that same
currency. In that case, the MNC’s net cash flows of that
currency overall may be negligible.
If most of the MNC’s subsidiaries have future
inflows in another currency, however, the net cash
flows in that currency could be substantial.
Estimating the consolidated net cash flows per
currency is a useful first step when assessing an
MNC’s exposure because it helps to determine the
MNC’s overall position in each currency.
Example: Youth plc, a UK company, conducts its
international business in four currencies. Its objective
is first to measure its exposure in each currency in the
next quarter and then estimate its consolidated cash
flows for one quarter ahead, as shown below.
For example, Youth expects Swiss franc inflows of 12,
000,000 SFr and outflows of 2,000,000 SFr over the
next quarter. Thus, Youth expects net inflows of 10,
000,000 SFr.
Given an expected exchange rate of £0.44 to the Swiss franc at the
end of the quarter, it can convert the expected net inflow of Swiss
francs into an expected net inflow of £4,400,000 (estimated as 10,
000,000 SFr x £0.44).
The same process is used to determine the net cash flows of each of
the other three currencies. Notice the expected net cash flows in
three of the currencies are positive, while the net cash flows in
Japanese yen are negative (reflecting cash outflows).
Thus, Youth will be favorably affected by the appreciation of the euro,
US dollar, and Swiss franc. Conversely, it will be adversely affected by
the appreciation of the yen.
EXAMPLE
Consolidated net cash flows assessment of YOUTH PLC
Currency Total Inflow total outflow Net inflow/outflow Expected rate Net in/outflow
Euros 17m 7m 10m £0.68 £6.8 m
Swiss francs 12m 2m 10m £0.44 £4.4 m
Japanese yen 200 m 900m -700m £0.005 - £3.5 m
US dollars 10m 7m 3m £0.55 £1.65m
Measuring the potential impact of the currency
exposure
The net cash flows of an MNC can be viewed as streams of cash
flows in differing currencies. Their value converted into the
home currency will vary due to both business risk and exchange
rate risk. The currency values over time are bound to be
correlated to some degree. If there is inflation in the UK, for
instance, the pound will depreciate against all currencies, not
just one currency.
Business risk may also be correlated between different
countries; recession can affect economic areas made up of
many countries. A successful new drug, for instance, will be
effective in a range of markets in different countries. Here we
look just at currency exposure and assume that the cash flow in
the foreign currency is known, and it is only the exchange rate
that is uncertain. A company needs to be able to assess its
overall exposure to exchange rate variation.
To do this it needs to be able to combine the individual estimates of
variation due to exchange rate changes. One way of combining the risk from
different sources to achieve an overall estimate is to see the returns as a
portfolio of cash flows and use the model to assess the overall portfolio risk
of the cash flows. Thus, the standard deviation in terms of the converted
value of the foreign cash flows is used rather than a percentage.
So, absolute cash flows are used rather than percentages and weights.
Combining the variability of cash flows originating from two different
currencies can be achieved as follows:
FORMULA: Refer to page 342 in the text book.
Measurement of currency variability.
The standard deviation statistic measures the degree of movement
for each currency. In any given period, some currencies clearly
fluctuate much more than others. The exact causes of fluctuation
and hence standard deviation in a currency are not well
understood. Where countries trade extensively with each other,
the standard deviation tends to be lower, though other factors may
intervene. Also, where there are stable economies, variation in the
value of the currency tends to be lower.
Measurement of currency correlations .

The correlation coefficient measures the degree to which two

currencies move in relation to each other. As noted in an earlier
chapter a correlation is the same as a covariance except that a
correlation is mapped on to a scale of -1.0 through to +1.0. The
extreme case is perfect positive correlation, which is represented
by a correlation coefficient equal to 1.00.
In such cases when the change in one currency is a
little above its mean, the change in the other
currency is also a little above its mean. When one
currency change is very much below its mean, the
change in the other currency is also very much below
its mean.
Correlations can also be negative, reflecting an inverse
relationship between individual movements, the extreme case
being -1.00. When the change in one currency is a little above its
mean, the change in the other currency is a little below its mean.
Here they move in opposite directions and offset each other.
Negative correlations are obviously useful in reducing risk; but so
are poor correlations instead of high correlations.
ECONOMIC EXPOSURE
The degree to which a firm’s present value of future cash flows
can be influenced by exchange rate fluctuations is referred to as
economic exposure to exchange rates.
All types of anticipated future transactions that cause
transaction exposure also cause economic exposure because
these transactions represent cash flows that can be influenced
by exchange rate fluctuations.
Thus, economic exposure is the general term for the financial
effects of exchange rates, it includes transaction exposure and
indirect effects on revenues and costs.
Example
Intel invoices about 65% of its chip exports in US dollars.
Although Intel is not subject to transaction exposure for its
dollar-denominated exports, it is subject to economic exposure.
If the euro weakens against the dollar, the European importers
of those chips from Intel will need more euros to pay for them.
These importers are subject to transaction exposure and
economic exposure. As their costs of importing the chips
increase in response to the weak euro, they may decide
to purchase chips from European manufacturers instead.
Consequently, Intel’s cash flows from its exports will be
reduced, even though these exports are invoiced in
dollars.
TRANSLATION EXPOSURE
An MNC creates its financial statements by consolidating all of
its individual subsidiaries’ financial statements. A subsidiary’s
financial statement is normally measured in its local currency.
To be consolidated, each subsidiary’s financial statement must
be translated into the currency of the MNC’s parent.
Since exchange rates change over time, the translation of the
subsidiary’s financial statement into a different currency is
affected by exchange rate movements. 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.
Determinants of translation exposure
Some MNCs are subject to a greater degree of translation
exposure than others.
An MNC’s degree of translation exposure is dependent on the
following:
• The proportion of its business conducted by foreign
subsidiaries.
• The locations of its foreign subsidiaries, in particular, the
volatility of the currency in relation to the home currency.
• The accounting methods that it uses.
Proportion of its business conducted by foreign subsidiaries.
The greater the percentage of an MNC’s business conducted by its foreign
subsidiaries, the larger the percentage of a given financial statement item
that is susceptible to translation exposure.
Example:
Locus Ltd and Zeuss Ltd each generate about 30% of their sales from
foreign countries. However, Locus Ltd generates all of its international
business by exporting, whereas Zeuss Ltd has a large subsidiary in India
that generates all of its international business. Locus Ltd is not subject to
translation exposure (although it is subject to economic exposure), while
Zeuss has substantial translation exposure.
Locations of foreign subsidiaries.
The locations of the subsidiaries can also influence the degree of translation
exposure because the financial statement items of each subsidiary are
typically measured by the home currency of the subsidiary’s country.
Example:
Zum Ltd (UK) and Canton SA (France) each have one large foreign subsidiary
that generates about 30% of their respective sales. However, Zum Ltd is
subject to a much higher degree of translation exposure because its
subsidiary is based in India, and the rupee’s value is volatile. In contrast,
Canton’s subsidiary is based in Switzerland, and the Swiss franc is very stable
against the euro.
Accounting methods.
An MNC’s degree of translation exposure can be greatly affected by the
accounting procedures it uses to translate when consolidating financial
statement data.
Note: Refer to IAS 21.
IAS 21 prescribes how an entity should: account for foreign currency
transactions; translate financial statements of a foreign operation into the
entity's functional currency; and translate the entity's financial statements
into a presentation currency, if different from the entity's functional currency.
HEDGING TRANSACTION EXPOSURE
There are two categories: financial contracts and operational techniques.
Financial contracts include:
•Forward market hedge
•Money market hedge
•Option market hedge, and
•Swap market hedge
Forward Market Hedge
•Allows a party to buy or sell an asset at a predetermined price
within a specified time in the future.
•Consists of an outright purchase of currency at a forward
exchange rate.
•Executed between banks or between a bank and customer.

Money Market Hedge

• Technique to lock in value of a foreign currency transaction.
•Helps a domestic company reduce its exchange rate or
currency risk when conducting foreign business.
Example: US firm has pound payable for imports, the firm
borrows dollars, converts the proceeds into pounds, buys
British Treasury bills and, pays the import bill with the
funds derived from the sale of Treasury bills.
Option Market Hedge
• Contract that gives the buyer the right, but not the
obligation to buy or sell a certain currency at a specified
exchange rate on or before a specified date.
• Premium is paid to the seller.
Swap Market Hedge
• Transaction between two parties exchange an
equivalent amount of money with each other but in
different currencies.

• Are primarily used to hedge potential risks

associated with fluctuations in currency exchange
rates or to obtain lower interest rates on loans in a
foreign currency.
Operational techniques include:
• Currency risk sharing
• Lead/lag strategy
• Exposure-netting

Currency Risk Sharing

Contractual agreement between counter-parties to
a trade or deal to share in any losses due to
currency risk or exchange rate fluctuations.
Leading and Lagging
• Adjustment of the times of payments that are
made in foreign currencies. Leading is the payment
of an obligation before due date while lagging is
delaying the payment of an obligation past due
date.
• Lagging indicators look backwards.
Exposure Netting
• Used mainly by MNCs to reduce the number of
foreign exchange transactions needed to settle
inter-unit transaction.
• Chart out all the payments that units have to
make to one another and work out a solution that
minimizes the number of transactions needed.
MANAGING ECONOMIC EXPOSURE
 Economic exposure is a type of foreign exchange
exposure caused by the effect of unexpected currency
fluctuations on:
 A company’s future cash flows,
 Investments and
 Earnings.
 Economic exposure is also known as operating
exposure.
 Economic exposure is an effect caused on a
company’s cash flows due to unexpected currency
rate fluctuations.
 Economic exposures are long-term in nature and have a
substantial impact on a company’s market value.
 The degree of economic exposure is directly
proportional to currency volatility.
 Economic exposure increases as foreign exchange
volatility increases and decreases as it falls.
Economic exposure is obviously greater for
multinational companies that have numerous subsidiaries
overseas and a huge number of transactions involving
foreign currencies.
There are two types of strategies to manage economic
exposure:
• Operational Strategies, and
• Risk Mitigation Strategies

Operational Strategies
a) Instead of having focus on one or two markets the
company can diversify the production facilities to a number
of markets.
b) Similarly company can also diversify its sales and
marketing related activities to different markets.
c) If the exchange rate fluctuations make the inputs
expensive from one region, companies may have
alternative sources for acquiring inputs.
d) The company can have access to capital markets in a
number of regions. This enables the company to gain
flexibility in raising capital in the market and company may
be able to reduce the cost of raising funds.
Risk Mitigation Strategies
a) A company can manage the economic exposure by
matching its foreign currency inflows and
outflows.

Example: if a company is going to receive inflows in

USD and is looking to raise debt, it should consider
borrowing in USD. In this way the company would be
able to service its debt in USD.
b) The company can enter into an agreement with some
other party in which the parties share the risk arising from
the exchange rate fluctuations. In case of such agreements
the base price of the transaction will be adjusted in case of
currency rate fluctuations.
MANAGING TRANSLATION EXPOSURE
• Firm’s consolidated financial statements can be affected
by changes in exchange rate.
• The assets, liabilities, equities and earnings of a
subsidiary of a multinational company are usually
denominated in the currency of the country it is situated
in.
• If the parent company is situated in a country with a
different currency, the values of the holdings of each
subsidiary need to be converted into the currency of the
home country.
• Also known as “Accounting exposure”.
Example:
An Austrian subsidiary of an American company purchases a
building worth €100,000 on September 1, 2021. On this date, the
euro-dollar exchange rate is €1 = $1.20, so the value of the
building converted into dollars is $120,000. The company decides
to convert all of its foreign holdings into dollars, to present a
consolidated balance sheet on March 31, 2022. On that day, the
exchange rate changes to €1 =$1.15, so the value of the building
falls to $115,000.
Methods of Translation:
• Current/Non-current Method,
• Monetary/Non-monetary Method,
• Current Rate Method, and
• Temporal Method.
CURRENT/NON-CURRENT METHOD
• The value of current assets and liabilities are
converted at the exchange rate that prevails on the
date of the balance sheet.
• Non-current assets and liabilities are converted at a
historical rate.
Assume that the historical exchange rate is €1 = $1.20,
and the current rate is €1 = $1.15.
 Current/Non-current Method
Liabilities Value Value Assets Value Value
in € in $ in € in $
Sundry Creditors Cash in Hand
(Current rate) 1,000 1,150 (current rate) 500 575

Long-term Debt Sundry Debtors

(Historical rate) 10,000 12,000 (current rate) 1,500 1,725

Capital Buildings
(Historical rate) 50,000 60,000 (Historical rate) 59,000 70,800
MONETARY/NON-MONETARY METHOD
•All monetary accounts are converted at the current rate of
exchange, whereas non-monetary accounts are converted at
historical rate.
• Monetary accounts are those items that represent a fixed
amount of money, either to be received or paid, such as
cash, debtors, creditors and loans.
• Machinery, buildings, and capital are examples of non-
monetary items because their market values can be different
from the values mentioned on the balance sheet.
 Monetary/Non-monetary Method
Liabilities Value Value Assets Value Value
in € in $ in € in $
Sundry Creditors Cash in Hand
(Current rate) 1,000 1,150 (current rate) 500 575
Long-term Debt Sundry Debtors
(Current rate) 10,000 11,500 (current rate) 1,500 1,725
Capital Buildings
(Historical rate) 50,000 60,000 (Historical rate) 59,000 70,800
CURRENT RATE METHOD
•The current rate method is the easiest method, wherein the value of
every item in the balance sheet, except capital, is converted using the
current rate of exchange. The stock of capital is evaluated at the
prevailing rate when the capital was issued.

•All items in income statements are converted at an exchange rate at

their occurrence.
 Current Rate Method
Liabilities Value Value Assets Value Value
in € in $ in € in $
Sundry Creditors Cash in Hand
(Current rate) 1,000 1,150 (current rate) 500 575
Long-term Debt Sundry Debtors
(Current rate) 10,000 11,500 (current rate) 1,500 1,725
Capital Buildings
(Historical rate) 50,000 60,000 (Current rate) 59,000 67,850
TEMPORAL METHOD
•The temporal method is similar to the monetary/non-monetary
method, except in its treatment of inventory.
•The value of inventory is generally converted using the historical
rate, but if the balance sheet records inventory at market value, it
is converted using the current rate of exchange.
•In the example above, if there is an inventory of goods recorded in
the balance sheet at its historical value of say €1,000, its value in
dollars after conversion will be $(1,000 X 1.2) or $1,200.
•However, if the inventory of goods is recorded at the current
market value of, say €1,050, then its value will be $(1,050 X 1.15),
or $1,207.50.
DESIGNING A HEDGING STRATEGY
•Balance sheet Hedge: Hedging translation exposure by
speculating in the forward market in the hope that a
cash profit will be realized to offset the non-cash loss
from translation.

•Monetary balance: Achieved when a firm achieves a

zero-net exposed position under the temporal method.
Derivative Hedge: Derivatives are financial contracts whose
price depends on the value of some underlying asset. The
effectiveness of a derivative hedge is expressed in terms of
its delta, sometimes called the hedge ratio. Hedge ratio is
the comparative value of an open position’s hedge to the
overall position. A hedge ratio of 1, or 100%, means that
the open position has been fully hedged. By contrast, a
hedge ratio of 0, or 0%, means that the open position has
not been hedged in any way.
SUMMARY
MNCs with less risk can obtain funds at lower financing costs.
Since they may experience more volatile cash flows because
of exchange rate movements, exchange rate risk can affect
their financing costs. Thus, MNCs may benefit from hedging
exchange rate risk.
Transaction exposure is the exposure of an MNC’s future cash
transactions to exchange rate movements. MNCs can measure
their transaction exposure by determining their future payables
and receivables positions in various currencies, along with the
variability levels and correlations of these currencies. From this
information, they can assess how their revenue and costs may
change in response to various exchange rate scenarios.
 Economic exposure is any exposure of an MNC’s cash flows
(direct or indirect) to exchange rate movements. MNCs can
attempt to measure their economic exposure by determining the
extent to which their cash flows will be affected by their
exposure to each foreign currency.
Translation exposure is the exposure of an MNC’s consolidated
financial statements to exchange rate movements. To measure
translation exposure, MNCs can forecast their earnings in each
foreign currency and then determine the potential exchange rate
movements of each currency relative to their home currency.