International Banking and Trade Finance

International Banking and Trade Finance Chpt 12

Managing Economic Exposure and Translation Exposure Chapter 12

Exchange Rate Exposure Reminder: There are 3 forms by which a MNC is exposed to exchange rate fluctuations • 1. Transaction exposure • 2. Economic Exposure - Chapter 12 • 3. Translation Exposure

Economic Exposure • is essentially the fact that the cash flows of the MNCs are sensitive to exchange rate movements • if the exchange rate goes up, or down, usually this is caused by economic circumstances in the particular country - this is why we call it Economic Exposure

Managing Economic Exposure • Economic exposure • any impact of exchange rate fluctuations on future cash flows • affect cash flows in manner not associated with currency transactions • an MNC would examine how all cash flow is affected by exchange rate movement

Transaction Exposure • is the fact that you have to make conversions of the currency into foreign currency for some parts of the intl business • Economic Exposure • is the fact that once you make that conversion - the currency could go up or down - and give you advantages or disadvantages

Sometimes Hedging isnot relevant • “Corporate cash flows can sometimes be effected by exchange rate movements in ways not directly associated with foreign exchange transactions” • “Thus firms cannot JUST focus on hedging - they have to determine how cash flows will be affected

Managing Economic Exposure • Example: British Laker Airlines • What happened? • Revenues generated in pounds • large amount of expenses in dollars • when dollar strengthens, expenses creep up • bank loan also denominated in dollars Laker went bankrupt

Managing Economic Exposure • Assessing economic exposure • examine sensitivity of revenues and costs to exchange rate fluctuation • an imbalance between costs and revenues creates higher exposure level • determine sensitivity of earnings to exposure

Restructuring Page 378 • You can increase advertising costs and hope to increase sales • you can borrow money from one country, to pay back loans in another

Economic Exposure Measuring exposure for US MNC Y • US firm with subsidiary in Japan • most revenue raised in the US dollars • most costs occur in Japanese yen • most borrowing occurs in Japan • a currency imbalance exists between costs and revenues • Income statement becomes sensitive to currency fluctuations

Economic Exposure Measuring exposure for US MNC Y • Income statement becomes sensitive to currency fluctuations • effect of currency imbalance among costs and revenues Net earnings Costs Revenues

Economic Exposure Measuring exposure for US MNC Y • Impact if yen were to strengthen • increases MNC Y’s production costs • increases MNC Y’s interest expenses • decreases net earnings Costs Net earnings

Economic Exposure Measuring exposure for US MNC Y • Response to a strong yen over time • MNC Y may change emphasis of the two sites • increase Japanese revenue • shift costs to US • attempt to reduce effect of currency imbalance

Analysis with Computer Spreadsheets • Allows you to understand the results of different scenarios because you can plug in the different exchange rate changes - and see the subsequent results Page 380

When Deciding to Restructure One must address the following questions Each of these 4 questions is important because they reflect a different part of the firm’s income statement

When Deciding to Restructure One must address the following questions • Should the firm attempt to increase or decrease sales • Should the firm increase or decrease its dependency on foreign suppliers

When Deciding to Restructure the following questions, , , , • Should the firm establish or eliminate production facilities • Should the firm increase or reduce its level of debt denominated in foreign currencies

By making cars in the U.S.A., they pay for parts in dollars, and sell the cars for dollars, and pay employees in dollars, • so if dollars change in respect to Yen, it doesn’t mean much cause very little has to be paid for in Yen, and very little goes back to Japan in Yen

Summary • Economic exposure • balances sensitivity of revenues and expenses to exchange rate fluctuations

International Banking and Trade Finance