International Banking and Trade Finance

International Banking and Trade Finance Chpt 10

Measuring Exposure to Exchange Rate Fluctuations Chapter 10

Overview • Present the relevance of an MNC’s exchange rate exposure • Explain measurement of transaction exposure • Explain how economic exposure is measured • Explain measurement of translation exposure

Exchange Rate Risk • definition • the risk that a company’s performance will be effected by exchange rate movements

Relevance of Exchange Rate Risk • Arguments against relevance • some people say that a firm’s exposure to exchange rate risk is not relevant • one argument for irrelevance is that , according to purchasing power parity (PPP) theory, exchange rate movements should be matched by price movements • argues that similar costs exist across countries

Relevance of Exchange Rate Risk • Arguments against relevance • according to purchasing power parity (PPP) theory, • a lower dollar means imports are more expensive • but a lower dollar also means inflation is high so domestic stuff cost more to make

Relevance of Exchange Rate Risk • Arguments against relevance • re: purchasing power parity (PPP) theory, • PPP does not hold true in real life • the exchange rate does not change in accordance with the inflation difference between the two countries

Relevance of Exchange Rate Risk • Arguments supporting relevance • hedging reduces volatility of MNC operations • creditors may prefer that the firms to which they lend maintain low exposure to exchange rate risk • creditors are usually the banks and they are serving their own interests since the things companies will do to reduce exchange rate risk will involve using the services of banks

Relevance of Exchange Rate Risk • Arguments supporting relevance • volatile foreign earnings can also cause more volatile growth • which is costly • hedging can reduce the volatility of cash flows cause the firm’s payments and receipts are not forced to fluctuate in accordance with the currency movements Page 294

Chpt 10 Chpt 10 is about “measuring” exchange rate exposure Chpt 11 Chpt 11 is about using techniques to reduce exchange rate exposure

Before knowing what techniques to use to reduce exchange rate exposure, we first of all have to measure it to see if it is of any consequence

Transaction Exposure • The degree to which transactions can be effected by exchange rate fluctuations is transaction exposure

Transaction Exposure TWO steps are involved in measuring transaction exposure • 1. Determine the projected net amount of inflows and outflows in each foreign currency • 2. Determine the overall risk of exposure to those currencies Page 295

Transaction Exposure • Affects exposure to net cash flow • consolidates subsidiaries’ cash in/outflows • e.g., minimal exposure in Mexican peso if • Subsidiary A has net inflow of PS9,000,000 • Subsidiary B has net outflow of PS8,700,000 MNC net flow = PS300,000

Transaction Exposure • Exposure to currency variability • MNC develops range of projected exchange rates for the end of the specified period • standard deviation may be helpful • variability changes over time

Transaction Exposure • Currency correlation • pattern of movement between two currencies • affects net exposure for MNC

Transaction Exposure • Currency correlation, example • German mark and Swiss franc increase in value • MNC X has net inflow exposure from Germany • MNC Y has net outflow exposure in Germany with similar sized inflow exposure from Switzerland • DM and SF have a correlation of 94 percent • Net transaction exposures • MNC X maintains currency risk exposure • MNC Y has offsetting DM and SF exposure

Transaction Exposure • Steps to assess transaction exposure • assess MNC’s position in each currency • estimate how an exposure in a currency affects the MNC • use standard deviations and correlations • assess the “net” effect of currency exposures

Economic Exposure Measures how greatly an MNC’s present value of future cash flows is affected by exchange rate fluctuations • Currency fluctuations affect more than currency transactions • e.g., an increase in inflation in France may: • 1. lower value of outflow from France (transaction exposure) • 2. increase subsidiary’s French sales • 3. raise financing cost in France

Economic Exposure • Impact of local currency depreciation • inflows of local currency

Economic Exposure • Impact of local currency depreciation • outflows of local currency

Economic Exposure • Indirect exposure • impact from currency revaluation • e.g., exporters may increase prices to compensate for devaluation of home currency

Economic Exposure • Exposure of domestic firms • impacted by foreign competition and financial markets

Economic Exposure • Exposure of domestic firms • impacted by foreign competition and financial markets • Exposure of MNCs • face exposure on domestic and foreign soils • Jan-May 1993:13% appreciation of Japanese yen against $US • many US firms increase US market share • Japanese firms often priced out of the US market

Economic Exposure:Measurement • Assess sensitivity of earnings to exchange rate fluctuations • sort income statement items by currency • project future values from estimated rates • conduct sensitivity analysis on estimates A firm is relatively insulated from exchange rate movements if costs and revenues are affected by similar magnitudes.

Ledger Translation Exposure Measures impact that exchange rate fluctuations have upon an MNC’s consolidated financial statement • Affects value of assets, liabilities and earnings • Argument for relevance to MNC • affects financial statements (MNC performance) • reflects an earlier trend in opinions

Ledger Translation Exposure Measures impact that exchange rate fluctuations have upon an MNC’s consolidated financial statement • Affects value of assets, liabilities and earnings • Argument for relevance to MNC • affects financial statements (MNC performance) • reflects an earlier trend in opinions • Argument for irrelevance to MNC • does not affect cash flows • weak foreign currency may be retained or invested in foreign country

Translation ExposureDeterminants • Level of foreign involvement by foreign subsidiaries • a greater exposure exists when: • a larger contribution is made offshore

Translation ExposureDeterminants • Locations of foreign subsidiaries • affects currencies used in initial measurements

Translation ExposureDeterminants • Accounting methods • affect how and what financial numbers are reported Accounting Accounting

Summary • Exchange rate exposure may affect financing costs • volatile cash flow from exchange rate changes increases risk • Transaction exposure • reflects the exposure of an MNC’s future cash transactions to exchange rate movements

Summary • Economic exposure • measures the direct and indirect risks to cash flows from exchange rate movements • Translation exposure • focuses on consolidated financial statements

International Banking and Trade Finance