Lecture 6 Flashcards
How can economic exposure impact firms? (2)
- Changes in exchange rates:
○ Affects both international and domestic firms. This is because of an alteration of their competitive position and therefore their operating cash flows.
○ May alter the home currency values of a firms assets and liabilities for an MNC.
Define and compare the difference between currency risk and currency exposure:
- Currency risk- represents random changes in exchange rates.
- Currency exposure- measures “what is at risk”
How can you measure currency risk?
- Sensitivity of the future home currency values of the firms asserts and liabilities to random changes in exchange rates.
- Sensitivity of the firms future operating cash flows to random changes in exchange rates.
Provide the 2 channels of economic exposure:
Exchange rate fluctuations:
- Asset exposure
○ Home currency value of assets and liabilities
- Operating exposure
○ Future operating cash flows
Results in: Firm value
How can you measure Asset Exposure? (US firm with assets in Britain example)
P = a + b x S + e
Where:
P = SxP, where P = Asset price in local currency (in this case P* = GBP, P = USD)
a = regression constant
b = regression coefficient to measure the sentivity of the $ value of the asset (P) to the exchange rate (S)
S = Dollar/pound exchange rate
e = Random error term with mean 0.
How do you measure the exposure coefficient, b?
b = Cov(P,S) / Var(S)
Where:
Cov(P,S) is the covariance between the dollar value of the asset and the exchange rate
Var(S) is the variance of the exchange rate
Provide the formula for Cov(P,S):
Sum { q[i] ( P[i] - P[x] ) ( S[i] - S[x] ) }
P[x] = Sum { q[i] x P[i] }
S[x] = Sum { q[i] x S[i] }
q[i] = probability of the state of the world i
Provide the formula for Var(S)
Sum { q[i] (S[i] - S[x])^2
S[x] = Sum { q[i] x S[i] }
q[i] = probability of the state of the world i
What is the formula for the variability of the dollar value asset?
The variability of the dollar value asset can be decomposed into 2 components:
- Exchange rate-related variability
- Residual variability
Var(P) = b^2 var(S) + Var( e )
Define operating exposure:
The extent to which the firms operating cash flows will be affected by the effect of random changes in the exchange rates on the firm’s competitive position.
- Many cases occur where the operating exposure accounts for a larger portion of the firm’s total exposure than contractual exposure.
How can operating exposure be determined?
Operating exposure cannot be determined from the firms accounting statements, unlike transaction exposure. However, operating exposure can be determined by:
- The structure of the markets in which the firm sources its inputs, such as labor and materials, and selling its products.
- The firms ability to mitigate the effect of exchange rate changes by adjusting its markets, product mix, and sourcing.
Why do firms hedge operating exposure? Name the 5 types:
Hedging operating exposure allows firms to stabilize cash flows in the face of fluctuating exchange rates.
These are the 5 strategies of hedging operating exposure:
1. Selecting low-cost production sites.
2. Flexible sourcing policy
3. Diversification of the market
4. Product differentiation and R&D efforts
5. Financial hedging
Describe how firms hedge operating exposure through Selecting Low-Cost Production Sites: (2)
When firms expect domestic currency to become strong (or is strong), a firm may choose to locate production facilities in a foreign country where costs are low.
Low costs may be due to undervalued currency, or underpriced factors of production.
Firms may choose to establish and maintain production facilities in multiple countries to deal with the effect of exchange rate changes. (I.E. Nissan manufactures in US, UK, Mexico, and Japan)
Describe how firms hedge operating exposure through Flexible Sourcing Policy:
Even if manufacturing facilities for a firm is located in the domestic country, it can make a significant impact to decrease the effect of the exchange rate changes by “sourcing” from where input costs are low.
It is strategy for managing operating exposure that involves sourcing from areas where input costs are low.
Describe how firms hedge operating exposure through Diversification of the Market
Diversifying the market for the firms products is another way to managing exchange exposure. Expansion into a new business in a foreign country can reduce the impact of exchange rate changes, however it should be justified in its own right, not solely as a solution to currency exposure.
The idea is if the exchange rate in one country goes down, the business operations in another country can balance it out if that exchange rate goes up.
Describe how firms hedge operating exposure through R&D Efforts and Product Differentiation:
Investments into research and development can allow the firm to strengthen its competitive position in the face of adverse exchange rate movements.
Successful R&D should (2):
- Cut costs and enhance productivity
Introduce new and unique products for which competitors offer no close substitutes.
Describe how firms hedge operating exposure through Financial Hedging:
Financial hedging can be used to stabilize the firms cash flows.
This would refer to hedging exchange risk exposure through financial contracts such as currency forward and options contracts.
If operational hedges, which involve redeployment of resources are costly or impractical, financial contracts can provide the firm with a flexible and economical way of dealing with exchange exposure.
Define translation exposure
This is the effect of an unanticipated change in the exchange rates on the consolidated financial reports of an MNC.
What are the 4 translation methods:
- Current/non-current method
- Monetary/non-monetary method
- Temporal method
- Current rate method
Describe the current/non-current method
The idea that current assets and liabilities are converted at the current exchange rate, while non-current assets and liabilities are translated at the historical exchange rates.
This was accepted in the US between 1930-1975
Describe the monetary/non-monetary method
The idea that monetary balance sheet accounts (e.g. accounts receivable) are translated at the current exchange rate, while the non-monetary balance sheet accounts (stockholders equity) are converted at the historical exchange rate.
Describe the Temporal Method
The idea that current and non-current monetary accounts as well as accounts that are carried on the books at current value are converted at the current exchange rate, while accounts carried on the books at historical costs are translated at the historical exchange rate.
Describe the Current Rate method
The idea that all balance sheet accounts are translated at the current exchange rate except stockholder’s equity, which is translated at the exchange rate on the date of issuance.
Functional vs Reporting Currency (FASB 52 / ASC 830) (2)
The method of translation prescribed by FASB 52 depends upon the functional currency used by the foreign subsidiary whose statements are to be translated.
- Functional Currency - is the currency of the primary economic environment in which the entity operates.
- Reporting Currency - the currency in which the MNC prepares its consolidated financial statements.
Describe the FASB 52 / ASB 830 Translation Process (2)
- Determine win which currency the foreign entity keeps its books.
a. If the local currency in which the foreign entity keeps its books is not the functional currency, remeasurement into the functional currency is required—> This can be accomplished with the Temporal method. - The foreign entity’s functional currency is not the same as the parent’s currency, the foreign entity’s books are translated using the current rate method.
What are the 2 methods are hedging translation exposure:
- Balance sheet hedge
- Derivatives hedge
Describe the balance sheet hedge for translation exposure:
Important to note: Translation exposure is currency specific, not entity specific.
A balance sheet hedge is intended to reduce translation exposure of an MNC by eliminating the mismatch of exposed net assets (and exposed net liabilities) denominated in the same currency.
However, this may create transaction exposure.
Describe a derivatives hedger
- A derivative product, such as a forward contract, can be used as an attempt to hedge.
○ A derivatives hedge to control translation exposure involves speculation about foreign exchange rates.
