Mastering Multinational Exposure: Exchange Rate Fluctuations

2. 10 Measuring Exposure to Exchange Rate Fluctuations Chapter Objectives This chapter will: A. Discuss the relevance of an MNC’s exposure to exchange rate risk B. Explain how transaction exposure can be measured C. Explain how economic exposure can be measured D. Explain how translation exposure can be measured 2

3. Relevance of Exchange Rate Risk • 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 • Stakeholder Diversification Argument: if stakeholders are well diversified, they will be somewhat insulated against losses due to MNC exchange rate risk.

4. Forms of Exchange Rate Exposure • Transaction exposure • Economic exposure • Translation exposure

5. Transaction Exposure • Definition: sensitivity of the firm’s contractual transactions in foreign currencies to exchange rate movements. • To assess transaction exposure, the MNC must: • Estimate net cash flows in each currency • Measure potential impact of the currency exposure

6. Exposure of an MNC’s Portfolio Affected by: • Measurement of currency variability • Currency variability over time • Measurement of currency correlations • Applying currency correlations to net cash flows • Currency correlations over time

7. Transaction Exposure Based on Value at Risk (VaR) • Measures the potential maximum 1-day loss on the value of positions of an MNC that is exposed to exchange rate movements. • Factors that affect the maximum 1-day loss: • Expected percentage change in the currency rate for the next day • Confidence level used • Standard deviation of the daily percentage changes in the currency

8. Using Value at Risk • Applying VaR to longer time horizons • Applying VaR to transaction exposure of a portfolio • Estimating VaR with an electronic spreadsheet • Limitations of VaR • Presumes that the distribution of exchange rate movements is normal • Assumes that the volatility of exchange rate movements is stable over time

9. Economic Exposure • Definition: The sensitivity of the firm’s cash flows to exchange rate movements, sometimes referred to as operating exposure. • Economic exposure arises from: • Exposure to local currency appreciation • Exposure to local currency depreciation

10. Measuring Economic Exposure • Use of sensitivity analysis • Use of regression analysis

11. Translation Exposure • Definition: The exposure of the MNC’s consolidated financial statements to exchange rate fluctuations. • Does translation exposure matter? • Cash flow perspective • Stock price perspective • Determinants of translation exposure: • The proportion of business conducted by foreign subsidiaries • The locations of foreign subsidiaries • The accounting methods used