FINC3240 International Finance Chapter 10 Measuring Exposure to Exchange Rate Fluctuations

Types of Exposure Three exposures from Exchange Rate Risk: a. Transaction exposure b. Economic exposure c. Translation exposure

Transaction Exposure The sensitivity of the firm’s contractual transactions in foreign currencies to exchange rate movements. e.g. an US exporter denominates its exports in euro. A 10% percent decline in that currency will reduce the dollar value of its receivables by 10%. This effect could possibly eliminate any profit from the exports.

Transaction Exposure MNC may have multiple foreign subsidiaries spread around the work, it needs to project the consolidated net amount in currency inflows or outflows for all its subsidiaries, categorized by currency. Aggregate inflows and outflows of a foreign currency may offset and therefore the net cash flows of that currency overall may be negligible. Example: Miami Co. on page 314

Exhibit 10.2 Consolidated Net Cash Flow Assessment of Miami Co.

Exhibit 10.3 Estimating the Range of Net Inflows or Outflows for Miami Co.

Transaction Exposure Currency volatility (standard deviation)

Exhibit 10.4 Standard Deviation of Exchange Rate Movements (based on quarterly exchange rates, 2005–2008)

Transaction Exposure Currency correlations If a MNC has positive (or negative) net cash flows in various currencies that are highly positively correlated, it may be exposed to a high level of exchange rate risk. Because these currencies move in the same direction and by similar degrees, without any offsetting effects. What if the correlations are negatively correlated? Example: on page 318. Miami Co. again.

Exhibit 10.6 Correlations among Movements in Quarterly Exchange Rates

Exhibit 10.7 Impact of Cash Flow and Correlation Conditions on an MNC’s Exposure

Assessing Transaction Exposure - VaR It measures the potential maximum 1-day loss on the value of currency positions Max 1-day loss =Expected % change in exchange rate – (z-score of confidence level) x (s.d. of daily % change)

z-score (Standard Deviations) p-value (Probability) Confidence level < -1.65 or > +1.65 < 0.10 90% < -1.96 or > +1.96 < 0.05 95% < -2.58 or > +2.58 < 0.01 99%

VaR application Example: Celia Co. on page 319

Economic Exposure The sensitivity of the firm’s cash flows to exchange rate movements is referred to as economic exposure. Transaction exposure is a subset of economic exposure. e.g. Intel invoices 65% of its chip export in US dollars. It is not subject to transaction exposure for its dollar-denominated exports. However, if the euro weakens against the dollar, the European importers’ costs of importing the chips increases and they may decide to purchase fewer chips from Intel. Consequently, Intel’s cash flows from its exports will be reduced, even though these exports are invoiced in dollars.

Exhibit 10.9 Examples That Subject a Firm to Economic Exposure

Economic Exposure Economic Exposure to Local Currency Appreciation local sales decreases, because foreign products invoiced in foreign currency are cheaper. Export denominated in home currency decreases, because foreign importers will need more of their currency to pay for the same products. The cost of imported supplies denominated in foreign currency decrease. The cost (in terms of the local currency) of interest to be paid on foreign currencies decreases.

Economic Exposure Economic Exposure to Local Currency Depreciation local sales increases, because foreign products invoiced in foreign currency are more expensive. Export denominated in home currency increases, because foreign importers will need less of their currency to pay for the same products. The cost of imported supplies denominated in foreign currency increase. The cost (in terms of the local currency) of interest to be paid on foreign currencies increases.

Economic Exposure Economic Exposure of Domestic Firms (Example on page 324) e.g. Barrington, Inc. is a US manufacturer of steel that purchase all its supplies locally and sells all steel locally. It is not subject to transaction exposure. It is subject to economic exposure because it faces foreign competition. If the exchange rate of the foreign currency depreciate against the dollar, foreign steel will be cheaper. Consequently, demand for Barrington steel will decreases, and so will its net cash inflows.

Measuring Economic Exposure a. Using Sensitivity Analysis How Sales and expense are affected by various exchange rate scenarios. Example: Madison Co. on page 325

Exhibit 10.12 Impact of Possible Exchange Rates on Cash Flows of Madison Co. (in Millions)

Measuring Economic Exposure b. Using Regression Analysis PCF=percentage change in cash flows measured in home currency e= percentage change in the exchange rate

Translation Exposure A subsidiary’s financial statement is normally measured in local currency. To be consolidated, each subsidiary’s financial statement must be translated into the currency of the MNC’s parent. The exposure of the MNC’s consolidated financial statements to exchange rate fluctuation is translation exposure.

Translation Exposure Determinants of Translation Exposure a. Proportion of its business conducted by foreign subsidiaries example on page 327 b. Locations of foreign subsidiaries c. Accounting methods

Example After chapter 10 question 19. ANSWER: Economic exposure still exists because a weak euro would encourage Belgian customers to switch to local products.

Chapter 12 Managing Economic Exposure You may hedge some of transaction exposure, but you can not eliminate transaction exposure because you cannot predict all future transactions. It is difficult to determine exactly how a specific exchange rate movement will affect the demand and supply of materials and products.

Managing Economic Exposure Restructuring operations to reduce economic exposure to exchange rate risk, that is, shifting the sources of costs or revenue to other locations in order to match cash inflows and outflows in foreign currencies. Examples: (1) Madison Co. on page 381; (2) Savor Co. on page 385 and its possible strategies to hedge economics exposure on page 387.

Example Baltimore, Inc is a US based MNC that obtains 10% of its supplies from European manufactures. Sixty percent of its revenues are from its exports to Europe, where its product is invoiced in euro. Explain how Baltimore can reduce its economic exposure to exchange rate risk in the euro. ANSWER: Baltimore Inc. could reduce its economic exposure by shifting some of its U.S. expenses to Europe. This may involve buying more from Europe, or shifting part of its production process to Europe. So that the inflow and outflow of euro will offset each other.

Discussion in next class What benefits can an auto Co. get for FDI? What is the benefit and cost to the local economy?

Homework 7 Chapter10 Q&A: 6,7,11,12,13. Chapter12 Q&A: 2,3.