International Financial Management

12th Edition
by Jeff Madura

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10 Measuring Exposure to Exchange Rate 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 extremely volatile.

§ Which operational activities or cashflows of MNCs are

related to exchange rate risk?

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Relevance of Exchange Rate Risk

§ Exchange rates are extremely 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.
(Exhibit 10.1)

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

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Relevance of Exchange Rate Risk

The Investor Hedge Argument: exchange rate risk is

irrelevant because investors can hedge exchange rate risk
on their own.
Currency Diversification Argument: if U.S.-based MNC
is well diversified across numerous currencies, its value
will not be affected by exchange rate risk
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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 Relevance of Exchange Rate Risk

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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Relevance of Exchange Rate Risk

Response from MNCs (cont.)

§ Forms of Exchange Rate Exposure
§ Transaction exposure
§ Economic exposure
§ Translation exposure

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 Transaction Exposure

Definition: sensitivity of the firm’s contractual transactions in

foreign currencies to exchange rate movements.
Assessing transaction exposure:
Estimating net cash flows in each currency (See Exhibits
10.2 & 10.3)
Exposure of an MNC’s portfolio
Measure potential impact of the currency exposure
s p = Wx2s x2 + Wy2s y2 + 2WxWys xs y CORRxy
W = proportion of portfolio value in currency x or y
σ = standard deviation of percentage changes in currency x or y
CORR = correlation coefficient 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

Exposure of an MNC’s Portfolio (cont.)

§ 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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 Transaction Exposure

Exposure of an MNC’s Portfolio (cont.)

§ 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, 2007–2012

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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

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

Transaction Exposure Based on Value at Risk (VaR) (cont.)

§ 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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Transaction Exposure

Transaction Exposure Based on Value at Risk (VaR) (cont.)

§ Estimating VaR with an Electronic Spreadsheet (Exhibit 10.8)
§ Obtain the series of exchange rates for all relevant dates for each
currency of concern and list each currency in its own column.
§ Compute the percentage changes per period (from one date to the
next) for each exchange rate in a column.
§ Estimate the standard deviation of the column of percentage
changes for each exchange rate.
§ In a separate column, compute the periodic percentage change in
the portfolio value by applying weights to the individual currency
returns.
§ 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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Transaction Exposure

Transaction Exposure Based on Value at Risk (VaR) (cont.)

§ Limitations of VaR

§ If the distribution of exchange rate movements is not normal,

the estimate of the maximum expected loss is subject to error.

§ 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)
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
Economic Exposure of Domestic Firms
§ even purely domestic firms are affected by economic exposure.
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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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Economic Exposure

Measuring Economic Exposure

§ Using 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 + µt
where
PCFt = percentage change in inflation - adjusted
cash flows measured in home currency
et = percentage change in direct exchange rate
µt = random error term
a0 = intercept
a1 = slope coefficient
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 Exhibit 10.11 Estimated Sales and Expenses for Madison’s
U.S. and Canadian Business Segments (millions of currency units)

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Exhibit 10.12 Impact of Possible Exchange Rates on

Cash Flows of Madison Co. (millions of currency units)

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 Translation Exposure

Definition: The exposure of the MNC’s consolidated

financial statements to exchange rate fluctuations.
Determinants of translation exposure:
§ Proportion of business 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.
§ Locations of foreign subsidiaries: Location can also
influence the degree of translation exposure because the
financial statement items of each subsidiary are typically
measured by the respective subsidiary’s home currency.

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Translation Exposure

Determinants of translation exposure (cont.)

§ Accounting Methods: MNC translation exposure is affected
by accounting procedures, many of which are based on FASB
52
§ The functional currency of an entity is the currency of the
economic environment in which the entity operates.
§ 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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 Translation Exposure

Determinants of translation exposure (cont.)

§ Accounting Methods (cont.)
§ 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.
§ 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.

§ 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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Translation Exposure

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)
§ Signals that complement translation effects: exchange rate
conditions that cause a translation effect can also signal changes
in expected cash flows in future years. Such changes could also
influence the stock price.
§ Exposure of managerial compensation to translation effects:
Since an MNC’s stock may be subject to translation effects and
since managerial compensation is often tied to the MNC’s stock
price, it follows that managerial compensation is affected by
translation effects.

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 Exhibit 10.13 How Translation Exposure Can Affect the
MNC’s Stock Price

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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 recognize the
relevance of exchange rate risk, and may benefit from hedging
their exposure.
§ Transaction exposure is the exposure of an MNC’s
contractual 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 volatility 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.
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 SUMMARY (Cont.)

§ 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 how their earnings could be affected by the
potential exchange rate movements of each currency.

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