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International Financial Management 10th Edition by Jeff Madura 1 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 10 Measuring Exposure to Exchange Rate Fluctuations Chapter Objectives This chapter will: A. Discuss the relevance of an MNC’s exposure to exchange rate risk B. Explain how transaction exposure can be measured C. Explain how economic exposure can be measured D. Explain how translation exposure can be measured 2 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Relevance of Exchange Rate Risk 1. Investor Hedge Argument: exchange rate risk is irrelevant because investors can hedge exchange rate risk on their own. 2. Currency Diversification Argument: if U.S.-based MNC is well diversified across numerous currencies, its value will not be affected by exchange rate risk 3. Stakeholder Diversification Argument: if stakeholders are well diversified, they will be somewhat insulated against losses due to MNC exchange rate risk. 3 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Forms of Exchange Rate Exposure 1. Transaction exposure 2. Economic exposure 3. Translation exposure 4 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Transaction Exposure 1. Definition: sensitivity of the firm’s contractual transactions in foreign currencies to exchange rate movements. 2. To assess transaction exposure, the MNC must: a. Estimate net cash flows in each currency b. Measure potential impact of the currency exposure p Wx2 x2 Wy2 y2 2WxWy x y CORRxy W proportionof portfoliovaluein currency xor y σ standarddeviationof percentagechangesin currency xor y CORR correlation coefficient of percentagechangesin currenciesx and y 5 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Exposure of an MNC’s Portfolio Affected by: 1. 2. 3. 4. 5. 6 Measurement of currency variability Currency variability over time Measurement of currency correlations Applying currency correlations to net cash flows Currency correlations over time © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Transaction Exposure Based on Value at Risk (VaR) 1. Measures the potential maximum 1-day loss on the value of positions of an MNC that is exposed to exchange rate movements. 2. Factors that affect the maximum 1-day loss: a. Expected percentage change in the currency rate for the next day b. Confidence level used c. Standard deviation of the daily percentage changes in the currency 7 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Using Value at Risk 1. 2. 3. 4. Applying VaR to longer time horizons Applying VaR to transaction exposure of a portfolio Estimating VaR with an electronic spreadsheet Limitations of VaR a. Presumes that the distribution of exchange rate movements is normal b. Assumes that the volatility of exchange rate movements is stable over time 8 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Economic Exposure 1. Definition: The sensitivity of the firm’s cash flows to exchange rate movements, sometimes referred to as operating exposure. 2. Economic exposure arises from: a. Exposure to local currency appreciation b. Exposure to local currency depreciation 9 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Measuring Economic Exposure 1. Use of sensitivity analysis 2. Use of regression analysis PCFt a0 a1et t where PCFt percentagechangein inflation- adjusted cash flows measuredin homecurrency et percentagechangein direct exchangerate t randomerror term a0 intercept a1 slope coefficient 10 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Translation Exposure 1. Definition: The exposure of the MNC’s consolidated financial statements to exchange rate fluctuations. 2. Does translation exposure matter? a. Cash flow perspective b. Stock price perspective 3. Determinants of translation exposure: a. The proportion of business conducted by foreign subsidiaries b. The locations of foreign subsidiaries c. The accounting methods used 11 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.