1. Managing Economic Exposure and Translation Exposure
CHAPTER 12
Managing Economic Exposure
and Translation Exposure
© 2000 South-Western College Publishing 1

2. Chapter Objectives
To explain how an MNC’s economic exposure can be hedged; and
To explain how an MNC’s translation exposure can be hedged.

3. Economic Exposure
Economic exposure refers to the impact exchange rate fluctuations can have on a firm’s future cash flows. Recall that cash flows can be affected in ways not directly associated with foreign transactions.
The management of economic exposure tends to result in a long-term solution. Its importance can be seen from the bankruptcy of Laker Airways, and from the impact the 1997/8 Asian crisis had on firms.

4. Example: Madison Inc

5. Exchange rate scenarios

7. Economic Exposure
A firm can assess its economic exposure by determining the sensitivity of its expenses and revenues to various possible exchange rate scenarios.
The firm can then reduce its exposure by restructuring its operations.

8. Economic Exposure
For example, a firm may attempt to balance its exchange-rate-sensitive revenues and expenses by :
1. increasing or reducing sales in new or existing
foreign markets,
2. increasing or reducing its dependency on
foreign suppliers,
3. establishing or eliminating production facilities
in foreign markets, and/or
4. increasing or reducing its level of debt
denominated in foreign currencies.

9. Economic Exposure
Note that computer spreadsheets can be very helpful in assessing alternative scenarios.
MNCs must be very confident about the long-term potential benefits before they proceed to restructure their operations, because of the high costs of reversal.

10. Issues in restructuring
Should the firm attempt to increase or reduce sales in new or existing foreign markets?
Should the firm increase or reduce its dependency on foreign suppliers?
Should the firm establish or eliminate production faclities in foreign markets?
Should the firm increase or reduce its level of debt denominated in foreign currencies?

11. Translation Exposure
Translation exposure results when an MNC translates each subsidiary’s financial data to its home currency for consolidated financial reporting.
Some firms are concerned about translation exposure because of its potential impact on reported consolidated earnings, and may attempt to avoid it by matching its foreign liabilities with its foreign assets.
To hedge translation exposure, forward contracts can be used.

12. Translation Exposure
For example, a U.S.-based MNC that is concerned about the translated value of its British earnings may enter a one-year forward contract to sell pounds.
If the pound depreciates during the fiscal year, the gain generated from the forward contract position may offset the translation loss.

13. Translation Exposure Hedging translation exposure is limited by:
inaccurate earnings forecasts,
inadequate forward contracts for some currencies,
accounting distortions, and
increased transaction exposure.
Perhaps, the best way for MNCs to deal with translation exposure is to clarify how their consolidated earnings have been affected by exchange rate movements.

14. Impact of Hedging Economic Exposure
on an MNC’s Value
Hedging decisions on
economic exposure
E (CFj,t ) = expected cash flows in currency j to be received
by the U.S. parent at the end of period t
E (ERj,t ) = expected exchange rate at which currency j can
be converted to dollars at the end of period t
k = the weighted average cost of capital of the U.S. parent

15. Chapter Review Managing Economic Exposure
Importance of Managing Economic Exposure
Assessing Economic Exposure
Reducing Economic Exposure by Restructuring
Expediting the Analysis with Computer Spreadsheets
Issues Involved in the Restructuring Decision

16. Chapter Review Managing Translation Exposure
Use of Forward Contracts to Hedge Translation Exposure
Limitations of Hedging Translation Exposure
Alternative Solution to Hedging Translation Exposure
How Economic Exposure Management Affects an MNC’s Value