Chapter 10 - Measuring Exposure to Exchange Rate Fluctuations Flashcards
Chapter Objectives:
Discuss the relevance of an M N C’s exposure to exchange rate risk.
Explain how transaction exposure can be measured.
Explain how economic exposure can be measured.
Explain how translation exposure can be measured.
Relevance of Exchange Rate Risk
When an M N C is exposed to exchange rate risk, its cash flows could be adversely affected by exchange rate movements and in turn affect firm performance and value.
By reducing exchange rate exposure, M N C’s may stabilize their earnings and cash flows. This can
–>. reduce the risk that the M N C’s stock valuation may decline.
–>. improve the ability to repay debts in long-run – enable the firm to borrow at lower cost.
In general, the assumptions used to argue for exchange rate irrelevance are not realistic.
Response from M N Cs:
Many financial reports of M N Cs acknowledge how their cash flows can be adversely affected by exchange rate movements. Examples are provided here:
In general, we are a net receiver of currencies other than the U.S. dollar. Accordingly, changes in exchange rates, and in particular a strengthening of the U.S. dollar, will negatively affect our revenue and other operating results as expressed in U.S. dollars.
— Facebook
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.
–> By Pepsi Co
Exhibit 10.1 Is Exchange Rate Risk Relevant for M N Cs? ARGUMENT FOR WHY EXCHANGE RAT RISK IS IRRELEVANT FOR M N CS
An M N C with cash flows in numerous currencies should not be affected by exchange rate risk if the adverse effects due to some currency movements are offset by the favorable effects of other currency movements.
If stakeholders (such as stockholders or creditors) have stakes in a well-diversified portfolio of M N Cs, then their portfolio’s value might be insulated if the adverse effects of exchange rates on some M N Cs are offset by favorable effects of exchange rates on other M N Cs. If these stakeholders can insulate their portfolios from exchange rate effects, then M N Cs should not worry about exchange rate risk.
Investors who invest in M N Cs can hedge exchange rate risk on their own. If they believe that the investments in U.S.-based M N Cs would be adversely affected when foreign currencies weaken against the dollar, they could take their own positions in currency derivatives that would increase in value if foreign currencies weaken against the dollar. Thus, if investors can hedge the exposure of their investments to exchange rate risk on their own, the M N Cs may not need to worry about exchange rate risk.
Exhibit 10.1 Is Exchange Rate Risk Relevant for M N Cs? ARGUMENT FOR WHY EXCHANGE RAT RISK IS RELEVANT FOR M N CS
Exchange rate effects on an M N C will not be offsetting, because the exchange rate movements of many currencies against the dollar go in the same direction over a specific period of time. Therefore, an M N C cannot ignore exchange rate risk, even when it has cash flows in numerous currencies.
Many M N Cs are similarly affected by exchange rate movements, so it would be difficult for stakeholders to create a diversified portfolio of M N Cs that will be fully insulated from exchange rate movements. Because stakeholders cannot diversify away the exposure of their portfolios to exchange rate risk, M N Cs should be concerned about their exposure to exchange rate risk.
Investors who invest in M N Cs do not have complete information on each M N C’s exposure to exchange rate fluctuations, so they may not have the ability to hedge the exposure of their individual investments to exchange rate risk. M N Cs are better informed about their own exposure to exchange rate risk and should have more expertise in managing that risk. Thus, investors should benefit if M N Cs manage their own exchange rate risk.
Transaction Exposure
Definition: Sensitivity of the firm’s contractual transactions in foreign currencies to exchange rate movements.
The exchange rate movements of the currencies the MNC will need or receive in the near future for international transactions could adversely affect its dollar cash flows.
The greater the uncertainty surrounding the future exchange rate of the currency, the greater is Seahawk’s transaction exposure (potential adverse effects of its international transactions that could be caused by the future exchange rate movements).
–> After estimating net dollar cash flows per currency for an upcoming period (such as the next quarter), an MNC can assess the degree of transaction exposure of its portfolio of currencies.
–> To measure that exposure, the MNC can determine the dollar value of the portfolio at the end of the quarter for the last several quarters, and then estimate the standard deviation of the quarterly percentage changes in the portfolio’s value.
-If a currency portfolio has a relatively high standard deviation, its value may be more volatile over time, suggesting that it is more susceptible to a pronounced reduction in value over the next quarter.
Exhibit 10.2 Amount of Dollars Needed to Obtain Imports (transaction value = 1 million euros)
Exhibit 10.3 Consolidated Net Cash Flow Assessment of Miami Co.
We need to convert the net inflow or outflow into the same currency (USD) to determine dollar value of exposure to each currency. For GBP: GBP 10mil *$1.5/GBP=$15mil
Note: the expected net cash flows in three of the currencies are positive but that the net cash flows in the Swedish krona are negative (reflecting cash outflows). Thus, Miami would be favorably affected by appreciation of the British pound, Canadian dollar, and Mexican peso against the dollar over the next quarter. Conversely, it would be adversely affected by appreciation of the Swedish krona against the dollar over the next quarter.
Transaction Exposure: Transaction Exposure of an M N C’s Portfolio
Measure potential impact of the currency exposure
Formula–>
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
–> This equation shows that the volatility of an MNC’s currency portfolio is positively related to each individual currency’s volatility and positively related to the correlation between currencies. Thus, the MNC’s two-currency portfolio is subject to a higher degree of transaction exposure when each currency is very volatile and when the movements of the two currencies against the dollar are highly correlated.
–> The volatility of a portfolio containing more than two currencies is more difficult to estimate. Nevertheless, it is also positively related to the volatility of each individual currency, and to the degree of correlation between each pair of currencies in the portfolio.
Measurement of currency volatility
–> The standard deviation statistic measures the degree of movement for each currency. In any given period, some currencies clearly fluctuate much more than others.
–> The volatility depends on the time horizon. The longer time horizon, the more volatile. For example, a currency is more volatile on quarterly basis than daily basis
Currency volatility over time
–> The volatility of a currency may not remain consistent from one time period to another. An M N C can identify currencies whose values are most likely to be stable or highly volatile in the future.
- Currencies of developed countries are less volatile.
- Currencies of developing countries are more volatile.
Measurement of currency correlations:
–> The correlations coefficients indicate the degree to which two currencies move in relation to each other.
–> A negative correlation coefficient suggests an inverse relationship between the exchange rate movements of two currencies.
–> Because currency correlations change over time, previous correlations are not perfect predictors of future correlations. Nevertheless, some general relationships tend to hold over time.
–> The correlation coefficient between a given pair of currencies can vary with the time horizon assessed. In general, correlation coefficients are lower when using a daily time horizon to measure the percentage changes in the currency values against the dollar over time than when using a quarterly time horizon.Most MNCs are more concerned about their exchange exposure over the next few months or quarters than over the next few days.
Applying currency correlations to net cash flows
–> If an M N C has positive net cash flows in various currencies that are highly correlated, it may be exposed to exchange rate risk. If the values of these currencies move in the same direction, and by similar degrees, they could all depreciate against the dollar in the quarter without any offsetting effects.
–> However, many M N Cs have some negative net cash flow positions in some currencies to complement their positive net cash flows in other currencies. An MNC’s transaction exposure is reduced if its negative net cash flow currencies are highly correlated with its positive net cash flow currencies.
-While depreciation of currencies has an adverse effect on the positive net cash flows (the inflows will convert to fewer dollars), it will favorably affect the negative net cash flow positions because the MNC will need fewer dollars to obtain these currencies. -Conversely, whereas currency appreciation would adversely affect the MNC’s negative net cash flows (more dollars would be needed to obtain those currencies), it would favorably affect the MNC’s positive net cash flows (the inflows will convert to more dollars).
Exhibit 10.4 Impact of Cash Flow and Correlation Conditions on an M N C’s Exposure over the Next Period
IF THE M N C’S EXPECTED CASH FLOW SITUATION IS:
- Equal amounts of net inflows in two currencies; AND IF THE CURRENCIES ARE Highly correlated, THEN THE M N C’S EXPOSURE IS RELATIVELY: High
- Equal amounts of net inflows in two currencies; AND IF THE CURRENCIES ARE Slightly positively correlated, THEN THE M N C’S EXPOSURE IS RELATIVELY: Moderate
- Equal amounts of net inflows in two currencies; AND IF THE CURRENCIES ARE Negatively correlated, THEN THE M N C’S EXPOSURE IS RELATIVELY: Low
- A net inflow in one currency and a net outflow of about the same amount in another currency; AND IF THE CURRENCIES ARE Highly correlated, THEN THE M N C’S EXPOSURE IS RELATIVELY: Low
- A net inflow in one currency and a net outflow of about the same amount in another currency; AND IF THE CURRENCIES ARE Slightly positively correlated Negatively correlated, THEN THE M N C’S EXPOSURE IS RELATIVELY: Moderate
- A net inflow in one currency and a net outflow of about the same amount in another currency; AND IF THE CURRENCIES ARE Negatively correlated , THEN THE M N C’S EXPOSURE IS RELATIVELY: High
Transaction Exposure Based on Value at Risk (V a R)
Transaction Exposure Based on Value at Risk (V a R)
–> A related method for assessing exposure is the value-at-risk (VaR) method, which can estimate the maximum possible loss on the value of currency positions that are exposed to exchange rate movements.
–> Factors that affect the maximum periodic loss:
1. Expected percentage change in the currency rate for the next day
2. Confidence level used: a higher confidence level leads to greater max expected loss.
3. Standard deviation of the daily percentage changes in the currency
95% confidence level: Maximum periodic loss=〖𝐸(𝑒〗_𝑡)−1.65∗𝜎_𝑐
97.5% confidence level: Maximum periodic loss=〖𝐸(𝑒〗_𝑡)−1.96∗𝜎_𝑐
–> E(et): expected percentage change of the currency
–> 𝜎_𝑐: standard deviation of exchange rate movements of the currency
–> The formula above also applies to currency portfolios
Limitations of V a R:
–> The VaR method presumes that the distribution of exchange rate movements is normal. If the distribution of exchange rate movements is not normal, the estimate of the maximum expected loss is subject to error.
–> The V a R method assumes that the volatility (standard deviation) of exchange rate movements is stable over time. If exchange rate movements are less volatile in the past than in the future, the estimated maximum expected loss derived from the V a R method will be underestimated.
Transaction Exposure Based on Value at Risk (V a R) (continued)
Applying V a R to Transaction Exposure of a Portfolio
What’s the max one-quarter loss of currency portfolio at 95% confidence level? Assuming an expected percentage change ofpercentfor the currency portfolio
Economic Exposure
Definition: The overall sensitivity of a firm’s cash flows to exchange rate movements is economic exposure, sometimes referred to as operating exposure. It’s a broader concept than transaction exposure. Transaction exposure can be thought of as a subset of economic exposure.
–>transaction exposure focuses on the impact of exchange rate movements on an MNC’s contractual international transactions
–> economic exposure encompasses all of the ways that an MNC’s cash flows can be affected by exchange rate movements.
Exposure to Foreign Currency Depreciation (Exhibit 10.5)
Depreciation in the firm’s foreign 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 Foreign Currency Appreciation
Appreciation in the firm’s foreign currency causes an increase in both cash inflows and outflows.
Measuring Economic Exposure
–> Economic exposure by determining how its cash flows in the following period (such as the following quarter) would be affected by possible exchange rate scenarios.
–> M N C can apply the following regression model to its quarterly cash flow and exchange rate data:
Use of regression analysis:
PCFt= a0+a1et + ut
where
PCFt = percentage change in inflation-adjusted cash flows measured in home currency
et = percentage change in direct exchange rate
μt = random error term
a0 = intercept
a1 = slope coefficient
Exhibit 10.5 Economic Exposure of a U.S. Firm to Exchange Rate Fluctuations–> SOURCES OF U.S. FIRM’S DOLLAR CASH INFLOWS: Local sales in the U.S. (relative to foreign competition in local markets. Local customers will be able to obtain foreign substitute products cheaply if the foreign currency depreciates.)
IMPACT OF FOREIGN CURRENCY DEPRECIATION ON U.S. FIRM’S DOLLAR CASH FLOWS: Decrease
IMPACT OF FOREIGN CURRENCY APPRECIATION ON U.S. FIRM’S DOLLAR CASH FLOWS: Increase
Exhibit 10.5 Economic Exposure of a U.S. Firm to Exchange Rate Fluctuations–> SOURCES OF U.S. FIRM’S DOLLAR CASH INFLOWS: Firm‘s exports denominated in dollars (foreign demand may change)
IMPACT OF FOREIGN CURRENCY DEPRECIATION ON U.S. FIRM’S DOLLAR CASH FLOWS: Decrease
IMPACT OF FOREIGN CURRENCY APPRECIATION ON U.S. FIRM’S DOLLAR CASH FLOWS: Increase
Exhibit 10.5 Economic Exposure of a U.S. Firm to Exchange Rate Fluctuations–> SOURCES OF U.S. FIRM’S DOLLAR CASH INFLOWS:Firm’s exports denominated in foreign currency (conversion from foreign currency to USD)
IMPACT OF FOREIGN CURRENCY DEPRECIATION ON U.S. FIRM’S DOLLAR CASH FLOWS: Decrease
IMPACT OF FOREIGN CURRENCY APPRECIATION ON U.S. FIRM’S DOLLAR CASH FLOWS: Increase
