Chapter 10
Measuring Foreign Exchange Exposure
10A. 1
Exchange Rate Exposure
Businesses generally face foreign exchange
exposure when they deal with currencies that are
based on the flexible or floating exchange rate
systems.
Exchange rate exposure arises when firms have net
cash flows (inflows – outflows) in currencies that
fluctuate in value.
Before deciding on exposure management, firms
need to first quantify (measure) that exposure.
10A. 2
Is Exchange Rate Risk Relevant?
Purchasing Power Parity Argument
. Exchange rate movements will be matched by price
movements.
Investor Hedge Argument
. Shareholders can hedge against exchange rate fluctuations
on their own
Currency Diversification Argument
. A well-diversified MNC should not be affected because of
offsetting currency exposures will stabilize corporate cash
flows
10A. 3
Is Exchange Rate Risk Relevant?
Response from MNCs
• MNCs generally attempt to stabilize their earnings
in domestic currency terms with hedging
strategies because they believe exchange rate
risk is real and relevant.
10A. 4
Types of Exposure
• 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
• Operating exposure
• Translation exposure
10A. 5
Transaction Exposure
• The degree to which the value of future short-
term cash transactions (e.g., A/P and A/R in
foreign currencies) can be affected by
exchange rate fluctuations is referred to as
transaction exposure.
• To measure transaction exposure:
estimate the net cash inflow or outflow in each
currency, and
measure the potential impact of that exposure to
currency value changes.
10A. 6
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.
10A. 7
Measuring the Potential Impact
• An MNC’s exposure can be measured by
considering the proportion (weight) of each
currency together with the currency’s variability
and correlation with the movements of the other
currencies.
• For a two-currency portfolio,
σ p = w x2σ x2 + w 2yσ 2y + 2 w x w yσ xσ y CORR xy
10A. 8
Measuring the Potential Impact
• The standard deviation statistic measures currency
variability (fluctuation).
• 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.
10A. 9
Correlations Among
Exchange Rate Movements
British Canadian Japanese Swedish
Pound Dollar Euro Yen Krona
British
Pound 1.00
Canadian
Dollar .35 1.00
Euro .91 .48 1.00
Japanese
Yen .71 .12 .67 1.00
Swedish
Krona .83 .57 .92 .64 1.00
10A. 10
Impact of Cash Flow and Correlation Conditions
on an MNC’s Exposure
10A. 11
Economic Exposure
• Economic exposure refers to the degree to
which a firm’s present value of future long
term cash flows can be influenced by
exchange rate fluctuations.
• Some of these affected cash flows do not
require currency conversion.
• Even a purely domestic firm like Shiner may
be affected by economic exposure if it faces
foreign competition in its local markets.
10A. 12
Economic Exposure to Exchange Rate
Fluctuations
Activities that reflect transaction exposure
10A. 13
Economic Exposure
• Economic exposure can be measured by
assessing the sensitivity of the firm’s earnings
to exchange rates.
• This involves reviewing how the earnings forecast in
the firm’s income statement changes in response to
alternative exchange rate scenarios.
• In general, firms with more foreign costs than
revenues tend to be unfavorably affected by
stronger foreign currencies.
10A. 14
Operating Exposure
• 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 + µt
PCFt = % ∆ in inflation-adjusted cash flows
measured in the firm’s home currency
over period t
et = % ∆ in the exchange rate over period t
10A. 15
Economic Exposure
• 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.
10A. 16
Translation Exposure
• The exposure of an 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.
10A. 17
Does Translation Exposure Matter?
Cash Flow Perspective
The translation of financial statements for
consolidated reporting purposes does not by itself
affect an MNC’s cash flows.
However, a weak spot rate today may result in a
weak exchange rate forecast (and hence a weak
expected cash flow) for the future when subsidiary
earnings are to be remitted.
10A. 18
Does Translation Exposure Matter?
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.
10A. 19
Translation Exposure
• An MNC’s degree of translation exposure is
dependent on:
the proportion of its business conducted by foreign
subsidiaries,
the locations of its foreign subsidiaries, and
the accounting methods that it uses.
10A. 20
