finc3240 international finance chapter 10 measuring exposure to exchange rate fluctuations

FINC3240FINC3240International FinanceInternational Finance

Chapter 10 Chapter 10

Measuring Exposure to Measuring Exposure to Exchange Rate FluctuationsExchange Rate Fluctuations

Types of ExposureTypes of Exposure

Three exposures from Exchange Three exposures from Exchange Rate Rate Risk:Risk:

a. Transaction exposurea. Transaction exposure

b. Economic exposureb. Economic exposure

c. Translation exposurec. Translation exposure

Transaction Exposure Transaction Exposure

The sensitivity of the firm’s contractual The sensitivity of the firm’s contractual transactions in foreign currencies to transactions in foreign currencies to exchange rate movements.exchange rate movements.

e.g. an US exporter denominates its exports in e.g. an US exporter denominates its exports in euro. A 10% percent decline in that currency will euro. A 10% percent decline in that currency will reduce the dollar value of its receivables by 10%. reduce the dollar value of its receivables by 10%. This effect could possibly eliminate any profit This effect could possibly eliminate any profit from the exports.from the exports.

Transaction ExposureTransaction Exposure

MNC may have multiple foreign subsidiaries MNC may have multiple foreign subsidiaries spread around the work, it needs to project the spread around the work, it needs to project the consolidated net amount in currency inflows or consolidated net amount in currency inflows or outflows for all its subsidiaries, categorized by outflows for all its subsidiaries, categorized by currency. Aggregate inflows and outflows of a currency. Aggregate inflows and outflows of a foreign currency may offset and therefore the net foreign currency may offset and therefore the net cash flows of that currency overall may be cash flows of that currency overall may be negligible. negligible.

Example: Miami Co. on page 314Example: Miami Co. on page 314

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Exhibit 10.2 Consolidated Net Cash Flow Assessment of Miami Co.


Exhibit 10.3 Estimating the Range of Net Inflows or Outflows for Miami Co.


Currency volatility (standard deviation)Currency volatility (standard deviation)

28

164001119

16)59(,4)57(

0)55(,0)55(,1)54(

1)54(,1)54(,9)52(

58

97554442

9,7,5,5,4,4,4,2

22

222

222


8

Exhibit 10.4 Standard Deviation of Exchange Rate Movements (based on quarterly exchange rates, 2005–2008)


Currency correlations Currency correlations If a MNC has positive (or negative) net cash flows If a MNC has positive (or negative) net cash flows in various currencies that are highly positively in various currencies that are highly positively correlated, it may be exposed to a high level of correlated, it may be exposed to a high level of exchange rate risk. Because these currencies exchange rate risk. Because these currencies move in the same direction and by similar move in the same direction and by similar degrees, without any offsetting effects. degrees, without any offsetting effects.

What if the correlations are negatively correlated?What if the correlations are negatively correlated?

Example: on page 318. Miami Co. again.Example: on page 318. Miami Co. again.


10

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

Assessing Transaction Assessing Transaction Exposure - VaRExposure - VaR

It measures the potential maximum 1-day loss on It measures the potential maximum 1-day loss on the value of currency positionsthe value of currency positions

Max 1-day loss Max 1-day loss

=Expected % change in exchange rate – (z-score of =Expected % change in exchange rate – (z-score of confidence level) x (s.d. of daily % change)confidence level) x (s.d. of daily % change)

z-score (Standard Deviations) p-value (Probability) Confidence level

< -1.65 or > +1.65 < 0.10 90%

< -1.96 or > +1.96 < 0.05 95%

< -2.58 or > +2.58 < 0.01 99%

VaR applicationVaR application

Example: Celia Co. on page 319Example: Celia Co. on page 319

Economic ExposureEconomic ExposureThe sensitivity of the firm’s cash flows to The sensitivity of the firm’s cash flows to exchange rate movements is referred to as exchange rate movements is referred to as economic exposure. Transaction exposure is a economic exposure. Transaction exposure is a subset of economic exposure.subset of economic exposure.

e.g. Intel invoices 65% of its chip export in US dollars. It is e.g. Intel invoices 65% of its chip export in US dollars. It is not subject to transaction exposure for its dollar-not subject to transaction exposure for its dollar-denominated exports. However, if the euro weakens denominated exports. However, if the euro weakens against the dollar, the European importers’ costs of against the dollar, the European importers’ costs of importing the chips increases and they may decide to importing the chips increases and they may decide to purchase fewer chips from Intel. Consequently, Intel’s cash purchase fewer chips from Intel. Consequently, Intel’s cash flows from its exports will be reduced, even though these flows from its exports will be reduced, even though these exports are invoiced in dollars.exports are invoiced in dollars.


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Exhibit 10.9 Examples That Subject a Firm to Economic Exposure

Economic ExposureEconomic Exposure

Economic Exposure to Local Currency Economic Exposure to Local Currency AppreciationAppreciation

local sales decreases, because foreign products invoiced local sales decreases, because foreign products invoiced in foreign currency are cheaper.in foreign currency are cheaper.

Export denominated in home currency decreases, because Export denominated in home currency decreases, because foreign importers will need more of their currency to pay foreign importers will need more of their currency to pay for the same products. for the same products.

The cost of imported supplies denominated in foreign The cost of imported supplies denominated in foreign currency decrease. currency decrease.

The cost (in terms of the local currency) of interest to be The cost (in terms of the local currency) of interest to be paid on foreign currencies decreases.paid on foreign currencies decreases.


Economic Exposure to Local Currency Economic Exposure to Local Currency DepreciationDepreciation

local sales increases, because foreign products invoiced in local sales increases, because foreign products invoiced in foreign currency are more expensive.foreign currency are more expensive.

Export denominated in home currency increases, because Export denominated in home currency increases, because foreign importers will need less of their currency to pay for foreign importers will need less of their currency to pay for the same products. the same products.

The cost of imported supplies denominated in foreign The cost of imported supplies denominated in foreign currency increase. currency increase.

The cost (in terms of the local currency) of interest to be The cost (in terms of the local currency) of interest to be paid on foreign currencies increases.paid on foreign currencies increases.


Economic Exposure of Domestic FirmsEconomic Exposure of Domestic Firms

(Example on page 324)(Example on page 324)

e.g. Barrington, Inc. is a US manufacturer of steel that e.g. Barrington, Inc. is a US manufacturer of steel that purchase all its supplies locally and sells all steel locally. It purchase all its supplies locally and sells all steel locally. It is not subject to transaction exposure. It is subject to is not subject to transaction exposure. It is subject to economic exposure because it faces foreign competition. If economic exposure because it faces foreign competition. If the exchange rate of the foreign currency depreciate the exchange rate of the foreign currency depreciate against the dollar, foreign steel will be cheaper. against the dollar, foreign steel will be cheaper. Consequently, demand for Barrington steel will decreases, Consequently, demand for Barrington steel will decreases, and so will its net cash inflows. and so will its net cash inflows.

Measuring Economic ExposureMeasuring Economic Exposure

a. Using Sensitivity Analysisa. Using Sensitivity Analysis

How Sales and expense are affected by various How Sales and expense are affected by various exchange rate scenarios.exchange rate scenarios.

Example: Madison Co. on page 325Example: Madison Co. on page 325


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Exhibit 10.12 Impact of Possible Exchange Rates on Cash Flows of Madison Co. (in Millions)

Measuring Economic ExposureMeasuring Economic Exposure

b. Using Regression Analysisb. Using Regression Analysis

PCF=percentage change in cash flows measured in home currencyPCF=percentage change in cash flows measured in home currency

e= percentage change in the exchange ratee= percentage change in the exchange rate

Translation ExposureTranslation Exposure

A subsidiary’s financial statement is A subsidiary’s financial statement is normally measured in local currency. To normally measured in local currency. To be consolidated, each subsidiary’s be consolidated, each subsidiary’s financial statement must be translated financial statement must be translated into the currency of the MNC’s parent. The into the currency of the MNC’s parent. The exposure of the MNC’s consolidated exposure of the MNC’s consolidated financial statements to exchange rate financial statements to exchange rate fluctuation is translation exposure.fluctuation is translation exposure.

Translation ExposureTranslation Exposure

Determinants of Translation ExposureDeterminants of Translation Exposurea. Proportion of its business conducted by a. Proportion of its business conducted by

foreign subsidiariesforeign subsidiariesexample on page 327example on page 327

b. Locations of foreign subsidiariesb. Locations of foreign subsidiariesexample on page 327example on page 327

c. Accounting methodsc. Accounting methods

example on page 327example on page 327

ExampleExample

After chapter 10 question 19.After chapter 10 question 19.

ANSWER: Economic exposure still exists because ANSWER: Economic exposure still exists because a weak euro would encourage Belgian customers a weak euro would encourage Belgian customers to switch to local products.to switch to local products.

Chapter 12 Chapter 12 Managing Economic ExposureManaging Economic Exposure

You may hedge some of transaction You may hedge some of transaction exposure, but you can not eliminate exposure, but you can not eliminate transaction exposure because you cannot transaction exposure because you cannot predict all future transactions. predict all future transactions.

It is difficult to determine exactly how a It is difficult to determine exactly how a specific exchange rate movement will specific exchange rate movement will affect the demand and supply of materials affect the demand and supply of materials and products.and products.

Managing Economic ExposureManaging Economic Exposure

Restructuring operations to reduce Restructuring operations to reduce economic exposure to exchange rate risk, economic exposure to exchange rate risk, that is, shifting the sources of costs or that is, shifting the sources of costs or revenue to other locations in order to revenue to other locations in order to match cash inflows and outflows in foreign match cash inflows and outflows in foreign currencies.currencies.

Examples: Examples:

(1) Madison Co. on page 381; (1) Madison Co. on page 381;

(2) Savor Co. on page 385 and its possible (2) Savor Co. on page 385 and its possible strategies to hedge economics exposure on page strategies to hedge economics exposure on page 387.387.

ExampleExample

Baltimore, Inc is a US based MNC that obtains Baltimore, Inc is a US based MNC that obtains 10% of its supplies from European manufactures. 10% of its supplies from European manufactures. Sixty percent of its revenues are from its exports Sixty percent of its revenues are from its exports to Europe, where its product is invoiced in euro. to Europe, where its product is invoiced in euro. Explain how Baltimore can reduce its economic Explain how Baltimore can reduce its economic exposure to exchange rate risk in the euro.exposure to exchange rate risk in the euro.

ANSWER: Baltimore Inc. could reduce its economic ANSWER: Baltimore Inc. could reduce its economic exposure by shifting some of its U.S. expenses to Europe. exposure by shifting some of its U.S. expenses to Europe. This may involve buying more from Europe, or shifting part This may involve buying more from Europe, or shifting part of its production process to Europe. So that the inflow and of its production process to Europe. So that the inflow and outflow of euro will offset each other.outflow of euro will offset each other.

Discussion in next classDiscussion in next class

What benefits can an auto Co. get for What benefits can an auto Co. get for FDI?FDI?

What is the benefit and cost to the What is the benefit and cost to the local economy?local economy?

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Homework 7Homework 7

Chapter10 Q&A: 6,7,11,12,13.Chapter10 Q&A: 6,7,11,12,13.

Chapter12 Q&A: 2,3.Chapter12 Q&A: 2,3.

finc3240 international finance chapter 10 measuring exposure to exchange rate fluctuations

Documents

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translation exposure

foreign currency

currency inflows

transaction exposure

measuring exposure

economic exposure

types of exposure