10 Measuring Exposure to Exchange Rate Fluctuations
Chapter Objectives
▪ Discuss the relevance of an MNC’s exposure 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.
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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:
Exposure of an MNC’s portfolio
Measure potential impact of the currency exposure
W1 and o1 and W2 and o2
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 = correlation coefficient of percentage changes in currencies x and y
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Exhibit 10.7 Impact of Cash Flow and Correlation
Conditions on an MNC’s Exposure
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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.
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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Cash inflows will increase
Foreign importers will import less
Cash outflows will decrease
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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
Var:
Expected percentage change minus (1.65*standard deviation)
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