Measuring Exposure to exchange rate fluctuations

Question 1

Give some arguments for the relevance of exchange rate risk for MNCs

Answer 1

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

Question 2

Why are MNCs in particular exposed to exchange rate risk?

Answer 2

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.

Question 3

Give three forms of exchange rate exposure faced by MNCs

Answer 3

Transaction exposure
Economic exposure
Translation exposure

Question 4

Define transaction exposure

Answer 4

Sensitivity of the firm’s contractual transactions in foreign currencies to exchange rate movements

Question 5

How can one measure the exposure of an MNCs portfolio to transaction exposure?

Answer 5

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.

Question 7

How do I calculate the Standard deviation fo portfolio of currencies?

Answer 7

Sqrt(weight of portfolio x * SD x+ weight of portfolio y * SD y+ 2 Weight x* Weight y* SD X SD Y CORRxy)

Question 8

Why can MNC not use past correlations to predict future values

Answer 8

Because currency correlations change over time, an MNC cannot use previous correlations to predict future correlations with perfect accuracy.

Question 9

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?

Answer 9

High

Question 10

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?

Answer 10

Moderate

Question 11

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?

Answer 11

low

Question 12

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?

Answer 12

Moderate

Question 13

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?

Answer 13

High

Question 14

What is VaR?

Answer 14

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

Question 15

What factors affect the maximum 1 day loss? - VaR

Answer 15

Expected percentage change in the currency rate for the next day
Confidence level used
Standard deviation of the daily percentage changes in the currency

Question 16

If we use a 97.5% confidence interval instead of 95% what does the lower boundary change to?

Answer 16

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

Question 17

How can we apply VaR to Longer time horizons?

Answer 17

The standard deviation should be estimated over the time horizon in which the maximum loss is to be measured. Same formula can be applied.

Question 18

How can we apply VaR to a portfolio of currencies?

Answer 18

When considering multiple currencies, software
packages can be used to perform the computations.

Question 19

How can one estimate VaR with an electronic spreadsheet?

Answer 19

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.

Question 20

What are the limitations of VaR basis for transaction exposure

Answer 20

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

Question 21

What are some things to note when considering transaction exposure that can sometimes lead to errors in estimations?

Answer 21

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

Question 22

Define economic exposure

Answer 22

he sensitivity of the firm’s cash flows to
exchange rate movements, sometimes referred to as operating exposure - domestic firms are affected also

Question 23

Explain the exposure a firm has to Local currency appreciation/depreciation

Answer 23

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

Question 24

Give an example of how a company can have economic exposure but not transaction exposure

Answer 24

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.

Question 25

If local currency appreciates what happens to a firms local current inflows?

Answer 25

Decreases transaction

Question 26

If local currency appreciates what happens to a firms local current outflows?

Answer 26

Firms importing supplies denominated in local currency - wont change
Firms improted supplies denominated in foreign currency : Decreases transaction costs
Interest owed on foreign funds: Decreases transaction costs

Question 27

How can we measure economic expsure

Answer 27

Using sensitivity analysis: Consider how sales and expense categories are affected by various
exchange rate scenarios.
We can use regression analysis also.

Question 28

Define translation exposure

Answer 28

The exposure of the MNC’s consolidated financial statements to exchange rate fluctuations

Question 29

What are the determinants of translation exposure

Answer 29

Proportion of business by foreign subsidiaries:
The more of an MNC’s business conducted by its foreign subsidiaries, the larger the percentage of a given financial statement item that is susceptible to translation exposure.
Locations of foreign subsidiaries: The more stable the foreign currency the smaller the translation exposure
Accounting Methods also MNC translation exposure is affected by accounting procedures, many of which are based on FASB 52

Question 30

Define the functional currency

Answer 30

The functional currency of an entity is the
currency of the economic environment in which
the entity operates.

Question 31

How are assets and liabilities of a foreign entity translated according to FASB statement 52

Answer 31

The current exchange rate as of the reporting
date is used to translate the assets and
liabilities from its functionalcurrency into the reporting currency.
The weighted average exchange rate over the
relevant period is used to translate revenue,
expenses, and gains and losses of a foreign entity into the reporting currency.
Translated income gains or losses are not recognized in current net income but are reported as a second component of stockholder’s equity; except if a foreign entity located in a country with high inflation.
Realized income gains or losses due to foreign
currency transactions are recorded in current net income, although there are some exceptions

Question 32

Explain Exposure of an MNC’s Stock Price to Translation Effects

Answer 32

Because an MNC’s translation exposure affects its consolidated earnings, it can affect the MNC’s
valuation.
Exchange rate conditions that cause a translation effect can also signal changes in expected cash flows in future years. Such changes could also influence the stock price

Question 33

Explain the Exposure of managerial compensation to translation effects:

Answer 33

Since an MNC’s stock may be subject to translation effects and since managerial compensation is often tied to the MNC’s stock price, it follows that managerial compensation is affected by translation effects

Question 34

Summarise info needed to assess and measure transaction exposure

Answer 34

MNCs future payables and receivables
positions in various currencies, along with the
volatility levels and correlations of these currencies