Measuring Exposure to exchange rate fluctuations Flashcards
Give some arguments for the relevance of exchange rate risk for MNCs
The Investor Hedge Argument: exchange rate
risk is irrelevant because investors can hedge
exchange rate risk on their own.
Currency Diversification Argument: if U.S.-
based MNC is well diversified across numerous
currencies, its value will not be affected by
exchange rate risk because of offsetting effects
Stakeholder Diversification Argument: if
stakeholders are well diversified, they will be
somewhat insulated against losses due to MNC
exchange rate risk
Why are MNCs in particular exposed to exchange rate risk?
Because they could 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.
Give three forms of exchange rate exposure faced by MNCs
Transaction exposure
Economic exposure
Translation exposure
Define transaction exposure
Sensitivity of the firm’s contractual transactions in foreign currencies to exchange rate movements
How can one measure the exposure of an MNCs portfolio to transaction exposure?
The standard deviation statistic measures the degree of movement for each currency. In any given period, some currencies clearly fluctuate much more than others - meausre of current volatility.
The volatility of a currency may not remain consistent from one time period to another.
The correlations coefficients indicate the degree to which two currencies move in relation to each other.
How do I calculate the Standard deviation fo portfolio of currencies?
Sqrt(weight of portfolio x * SD x+ weight of portfolio y * SD y+ 2 Weight x* Weight y* SD X SD Y CORRxy)
Why can MNC not use past correlations to predict future values
Because currency correlations change over time, an MNC cannot use previous correlations to predict future correlations with perfect accuracy.
If MNCs expected cash flow situation is to be equal amounts of net inflows in two currencies and the currencies are high correlated: what exposure does the MNC have relatively?
High
If MNCs expected cash flow situation is to be equal amounts of net inflows in two currencies and the currencies are slightly positively correlated: what exposure does the MNC have relatively?
Moderate
If MNCs expected cash flow situation is to be equal amounts of net inflows in two currencies and the currencies are negatively correlated: what exposure does the MNC have relatively?
low
If MNCs expected cash flow situation is to be net inflows in one currency and net outflow of same amount in another and the currencies are slightly positively correlated: what exposure does the MNC have relatively?
Moderate
If MNCs expected cash flow situation is to be net inflows in one currency and net outflow of same amount in another and the currencies are negatively correlated: what exposure does the MNC have relatively?
High
What is VaR?
Measures the potential maximum 1-day loss on the value of positions of an MNC that is exposed to exchange rate movements.
=Expected(exchange rate change) - 1.65xSD daily changes
What factors affect the maximum 1 day loss? - VaR
Expected percentage change in the currency rate for the next day
Confidence level used
Standard deviation of the daily percentage changes in the currency
If we use a 97.5% confidence interval instead of 95% what does the lower boundary change to?
A higher confidence level would lead to a
greater maximum 1-day loss other things being
equal. If it was 97.5% instead of 95%, then the
lower boundary would be 1.96 standard
deviations from the expected Δ% in the peso
How can we apply VaR to Longer time horizons?
The standard deviation should be estimated over the time horizon in which the maximum loss is to be measured. Same formula can be applied.
How can we apply VaR to a portfolio of currencies?
When considering multiple currencies, software
packages can be used to perform the computations.
How can one estimate VaR with an electronic spreadsheet?
Obtain the series of exchange rates for all relevant dates for each currency in columns.
▪ Compute the percentage changes per period (from one date to the next) for each exchange rate.
▪ Estimate the standard deviation of the column of percentage changes for each exchange rate.
In a separate column, compute the periodic percentage change in the portfolio value by applying weights to the individual currency returns.
Determine the standard deviation of the column of percentage changes in the portfolio value.
What are the limitations of VaR basis for transaction exposure
If the distribution of exchange rate movements is not normal, the estimate of the maximum expected loss is subject to error. - Probably are not normal. Needs fatter tails.
The VaR 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 VaR method will be underestimated.
VaR is not likely to accurately predict exposures in markets that exhibit sudden fundamental changes or shifts in market conditions
What are some things to note when considering transaction exposure that can sometimes lead to errors in estimations?
If unusual events are not present in the data set, you might be missing extreme positive or
negative possibilities that might have a massive
impact on risk
Tails of the distribution are in fact fatter than generally supposed, because extreme things hit us more often than we anticipate
Define economic exposure
he sensitivity of the firm’s cash flows to
exchange rate movements, sometimes referred to as operating exposure - domestic firms are affected also
Explain the exposure a firm has to Local currency appreciation/depreciation
Appreciation in the firm’s local currency causes a reduction in both cash inflows and outflows. Impact on a firm’s net cash flows will depend on whether the inflow transactions are affected more or less than the outflow transactions.
Depreciation of the firm’s local currency causes an increase in both cash inflows and outflows
Give an example of how a company can have economic exposure but not transaction exposure
Company invoicing to european companies any purchases in dollars - no transaction exposure. However If euro weakens against the dollar, then European importers would need more euros to pay for them and so might decide to purchase imports from European manufacturers instead - economic exposure as US companies cash flows would decline.
