Transcript Chapter 10

10
Chapter
Measuring Exposure To
Exchange Rate Fluctuations
See c10.xls for spreadsheets to
accompany this chapter.
South-Western/Thomson Learning © 2003
Chapter Objectives
• To discuss the relevance of an
MNC’s exposure to exchange rate risk;
• To explain how transaction exposure can
be measured;
• To explain how economic exposure can be
measured; and
• To explain how translation exposure can
be measured.
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Is Exchange Rate Risk Relevant?
Purchasing Power Parity Argument
 Exchange rate movements will be matched
by price movements.
 PPP does not necessarily hold.
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Is Exchange Rate Risk Relevant?
The Investor Hedge Argument
 MNC shareholders can hedge against
exchange rate fluctuations on their own.
 The investors may not have complete
information on corporate exposure. They
may not have the capabilities to correctly
insulate their individual exposure too.
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Is Exchange Rate Risk Relevant?
Currency Diversification Argument
 An MNC that is well diversified should not
be affected by exchange rate movements
because of offsetting effects.
 This is a naive presumption.
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Is Exchange Rate Risk Relevant?
Stakeholder Diversification Argument
 Well diversified stakeholders will be
somewhat insulated against losses
experienced by an MNC due to exchange
rate risk.
 MNCs may be affected in the same way
because of exchange rate risk.
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Is Exchange Rate Risk Relevant?
Response from MNCs
• Many MNCs have attempted to stabilize
their earnings with hedging strategies,
which confirms the view that exchange
rate risk is relevant.
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Online Application
• For current and historic exchange rates,
as well as implied currency volatilities,
visit http://www.ny.frb.org/pihome/statistics/.
11/30/01
Implied Vols 1 Week 1 Month 2 Month 3 Month 6 Month 12 Month 2 Year 3 Year
EUR
10.9
9.9
10.9
11.2
11.7
11.9
11.9
11.8
JPY
9.1
8.9
9.5
9.9
10.4
10.6
10.7
10.7
CHF
11.2
10.3
11.2
11.5
11.9
12.1
12.0
12.0
GBP
9.0
8.1
8.8
9.1
9.4
9.5
9.6
9.7
CAD
6.2
5.9
6.0
6.1
6.1
6.1
6.2
6.1
AUD
10.4
10.3
11.0
11.4
11.8
12.0
12.0
12.0
GBPEUR
8.1
6.9
7.4
7.7
8.4
8.7
8.6
8.5
EURJPY
9.3
9.0
9.7
10.3
10.8
11.3
11.4
11.4
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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
¤ Economic exposure
¤ Translation exposure
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Transaction Exposure
• The degree to which the value of future
cash transactions can be affected by
exchange rate fluctuations is referred to
as transaction exposure.
• To measure transaction exposure:
 project the net amount of inflows or
outflows in each foreign currency, and
 determine the overall risk of exposure to
those currencies.
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Transaction Exposure
• 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 either a
point estimate or a range of a chosen
currency, so as to standardize the
exposure assessment for each currency.
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Transaction Exposure
• An MNC’s overall exposure can be
assessed by considering each currency
position together with the currency’s
variability and the correlations among the
currencies.
• The standard deviation statistic on
historical data serves as one measure of
currency variability. Note that currency
variability levels may change over time.
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Transaction Exposure
Standard Deviations of Exchange Rate Movements
Based on Monthly Data
Currency
British pound
Canadian dollar
Indian rupee
Japanese yen
New Zealand dollar
Swedish krona
Swiss franc
Singapore dollar
1981-1993
1994-1998
0.0309
0.0100
0.0219
0.0279
0.0289
0.0287
0.0330
0.0111
0.0148
0.0110
0.0168
0.0298
0.0190
0.0195
0.0246
0.0174
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Transaction Exposure
• The correlations among currency
movements can be measured by their
correlation coefficients, which indicate the
degree to which two currencies move in
relation to each other.
perfect positive correlation
no correlation
perfect negative correlation
coefficient
1.00
0.00
-1.00
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Transaction Exposure
Correlations Among Exchange Rate Movements
£
British
pound (£)
1.00
Canadian
dollar (Can$)
.18
Japanese
yen (¥)
.45
New Zealand
dollar (NZ$)
.39
Swedish
krona (Sk)
.62
Swiss franc
(SwF)
.63
Can$
¥
NZ$
Sk
SwF
1.00
.06
1.00
.20
.33
1.00
.16
.46
.33
1.00
.12
.61
.37
.70
1.00
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Transaction Exposure
• The point in considering correlations is to
detect positions that could somewhat
offset each other.
• For example, if currencies X and Y are
highly correlated, the exposures of a net X
inflow and a net Y outflow will offset each
other to a certain degree.
• Note that the corrrelations among
currencies may change over time.
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Movements of Selected Currencies
Against the Dollar
$ per unit
1.40
1.20
$/10 Indian rupees
1.00
$/Canadian$
$/100 ¥
0.80
0.60
0.40
0.20
$/Singapore$ $/5 Swedish krona
$/Chinese yuan
0.00
1981
1986
1991
1996
2001
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Transaction Exposure
• A related method, the value-at-risk (VAR)
method, incorporates currency volatility
and correlations to determine the potential
maximum one-day loss.
• Historical data is used to determine the
potential one-day decline in a particular
currency. This decline is then applied to
the net cash flows in that currency.
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Economic Exposure
• Economic exposure refers to the degree to
which a firm’s present value of future cash
flows can be influenced by exchange rate
fluctuations.
• Cash flows that do not require conversion
of currencies do not reflect transaction
exposure. Yet, these cash flows may also
be influenced significantly by exchange
rate movements.
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Economic Exposure
Transactions that
Influence the Firm’s
Cash Inflows
Impact on Transactions
Local Currency Local Currency
Appreciates
Depreciates
Local sales (relative
Decrease
to foreign competition
in local markets)
Firm’s exports
denominated in local
Decrease
currency
 Firm’s exports
denominated in
Decrease
foreign currency
 Interest received from
Decrease
foreign investments
Transactions reflecting transaction exposure.
Increase
Increase
Increase
Increase
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Economic Exposure
Transactions that
Influence the Firm’s
Cash Outflows
Firm’s imported
supplies denominated
in local currency
 Firm’s imported
supplies denominated
in foreign currency
 Interest owed on
foreign funds
borrowed
Impact on Transactions
Local Currency Local Currency
Appreciates
Depreciates
No Change
No Change
Decrease
Increase
Decrease
Increase
Transactions reflecting transaction exposure.
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Economic Exposure
• Even purely domestic firms may be
affected by economic exposure if there is
foreign competition within the local
markets.
• MNCs are likely to be much more exposed
to exchange rate fluctuations. The impact
varies across MNCs according to their
individual operating characteristics and
net currency positions.
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Economic Exposure
• One measure of economic exposure
involves classifying the firm’s cash flows
into income statement items, and then
reviewing how the earnings forecast in the
income statement changes in response to
alternative exchange rate scenarios.
• In general, firms with more foreign costs
than revenues will be unfavorably affected
by stronger foreign currencies.
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Economic Exposure
• Another method of assessing a firm’s
economic exposure involves applying
regression analysis to historical cash flow
and exchange rate data.
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Economic Exposure
PCFt = a0 + a1et + t
PCFt = % change in inflation-adjusted cash
flows measured in the firm’s home
currency over period t
et = % change in the currency exchange
rate over period t
t = random error term
a0 = intercept
a1 = slope coefficient
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Economic Exposure
• The regression model may be revised to
handle multiple currencies by including
them as additional independent variables,
or by using a currency index (composite).
• By changing the dependent variable, the
impact of exchange rates on the firm’s
value (as measured by its stock price),
earnings, exports, sales, etc. may also be
assessed.
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Translation Exposure
• The exposure of the 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.
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Translation Exposure
Does Translation Exposure Matter?
• Cash Flow Perspective - Translating
financial statements for consolidated
reporting purposes does not by itself
affect an MNC’s cash flows.
• However, a weak foreign currency today
may result in a forecast of a weak
exchange rate at the time subsidiary
earnings are actually remitted.
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Translation Exposure
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.
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Translation Exposure
• In general, translation exposure is relevant
because
some MNC subsidiaries may want to remit
their earnings to their parents now,
the prevailing exchange rates may be used
to forecast the expected cash flows that will
result from future remittances, and
consolidated earnings are used by many
investors to value MNCs.
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Translation Exposure
• An MNC’s degree of translation exposure
is dependent on:
the proportion of its business conducted by
its foreign subsidiaries,
the locations of its foreign subsidiaries, and
the accounting method that it uses.
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Translation Exposure
• According to World Research Advisory
estimates, the translated earnings of U.S.based MNCs in aggregate were reduced
by $20 billion in the third quarter of 1998
alone simply because of the depreciation
of Asian currencies against the dollar.
• In 2000, the weakness of the euro also
caused several U.S.-based MNCs to report
lower earnings than expected.
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Online Application
• The annual reports for many MNCs may be
found at http://www.reportgallery.com.
Review some annual reports and see if
you can find any comments that describe
the MNCs’ transaction, economic, or
translation exposures.
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Impact of Exchange Rate Exposure
on an MNC’s Value
Transaction Exposure
Economic Exposure
m

E CFj , t  E ER j , t 
n 
 j 1

Value =  

t
1  k 
t =1 



E (CFj,t ) = expected cash flows in currency j to be received
by the U.S. parent at the end of period t
E (ERj,t ) = expected exchange rate at which currency j can
be converted to dollars at the end of period t
k
= weighted average cost of capital of the parent
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Chapter Review
• Is Exchange Rate Risk Relevant?
¤
¤
¤
¤
¤
Purchasing Power Parity Argument
The Investor Hedge Argument
Currency Diversification Argument
Stakeholder Diversification Argument
Response from MNCs
• Types of Exposure
¤
Transaction, Economic, and Translation
Exposures
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Chapter Review
• Transaction Exposure
¤
¤
¤
¤
Transaction Exposure to “Net” Cash Flows
Transaction Exposure Based on Currency
Variability
Transaction Exposure Based on Currency
Correlations
Transaction Exposure Based on Value-atRisk
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Chapter Review
• Economic Exposure
¤
¤
¤
Economic Exposure to Local Currency
Appreciation & Depreciation
Economic Exposure of Domestic Firms &
MNCs
Measuring Economic Exposure
- Sensitivity of Earnings & Cash Flows to
Exchange Rates
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Chapter Review
• Translation Exposure
¤
¤
¤
Does Translation Exposure Matter?
- Cash Flow Perspective
- Stock Price Perspective
Determinants of Translation Exposure
Examples of Translation Exposure
• Impact of Exchange Rate Exposure on an
MNC’s Value
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