Chapter 10: Measuring Exposure to Exchange Rate Fluctuations Flashcards
Relevance of exchange rate risk
- Cannot ignore even if exposed to many currencies
-Stakeholders cannot diversify exposure of portfolio to exchange rate risk
-MNCs should manage own risk since more informed to exposure
What is transaction exposure?
the sensitivity of the firm’s contractual transactions in foreign currencies to exchange rate movements.
Concern:
Currencies to pay could appreciate
Currencies to receive could depreciate
How to help transaction exposure
MNCs should
1. Estimate expected net CFs (inflow - outflow) for each currency over next quarter
2. Assess its exposure to all currencies as a portfolio over next quarter
3. Next determine degree of transaction exposure for its portfolio of currencies
○ Determine dollar value of each of last several quarters
○ Estimate std dev of quarterly % changes (higher = more risk)
net CF * expected rate = change
Measuring currency volatility
The standard deviation statistic measures the degree of movement for each currency.
The volatility of a currency may not remain consistent from one time period to another.
Currency correlations
- The correlations coefficients indicate the degree to which two currencies move in relation to each other.
○ Perfectly correlated = 1
○ Negative correlated = inverse
If CF __, and Currency ___ correlated then exposure is
Equal net inflows of each currency:
High corr = high exposure
Sligtly pos corr = moderate exposure
Negative corr = low exposure
Net inflow in 1 currency and net outflow about same in other currency:
High corr = low exposure
Sligtly pos corr = moderate exposure
Negative corr = high exposure
What does the Value at Risk (VaR) measure?
A: VaR measures the maximum potential loss a firm might experience on its foreign exchange positions over a 1-day period due to exchange rate movements
What are the limitations of the VaR method?
VaR assumes normal distribution of exchange rate movements and stable volatility over time, which may lead to inaccurate loss estimates if these assumptions are incorrect.
What is economic exposure?
Economic exposure refers to the sensitivity of a firm’s cash flows to long-term exchange rate movements, impacting overall business operations. (operational exposure)
Depreciation in the firm’s foreign currency causes
a reduction in both cash inflows and outflows.
How is economic exposure measured?
Economic exposure is measured by analyzing how cash flows would be affected by potential exchange rate scenarios using sensitivity or regression analysis.
Sensitivity - if varies depending on scenario then high exposure (if similar then low)
What is translation exposure?
Translation exposure is the degree to which a firm’s consolidated financial statements are impacted by exchange rate fluctuations when converting foreign currency financials into the reporting currency.
What factors affect translation exposure?
Factors include the proportion of business from foreign subsidiaries, the locations of those subsidiaries, and accounting methods (such as FASB 52 guidelines).
How can translation exposure impact an MNC’s stock price?
Translation exposure affects consolidated earnings, which can influence the valuation of the MNC, thereby impacting its stock price.
