International%20Banking

1
International Banking and Trade Finance
Chpt 10
2
Measuring Exposure to Exchange Rate Fluctuations

• Chapter 10

3
Overview

• Present the relevance of an MNCs exchange rate
  exposure
• Explain measurement of transaction exposure
• Explain how economic exposure is measured
• Explain measurement of translation exposure

4

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

5
Relevance of Exchange Rate Risk

• Arguments against relevance
• some people say that a firms 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

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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

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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

8
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

9
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 firms payments and receipts are not
  forced to fluctuate in accordance with the
  currency movements

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

• 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

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Transaction Exposure

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

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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

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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
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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

16
Transaction Exposure

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

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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

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Transaction Exposure

• Steps to assess transaction exposure
• assess MNCs 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

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Economic Exposure
Measures how greatly an MNCs 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 subsidiarys French sales
• 3. raise financing cost in France

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Economic Exposure

• Impact of local currency depreciation
• inflows of local currency

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Economic Exposure

• Impact of local currency depreciation
• outflows of local currency

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Economic Exposure

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

23
Economic Exposure

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

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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 199313 appreciation of Japanese yen
  against US
• many US firms increase US market share
• Japanese firms often priced out of the US market

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Economic ExposureMeasurement

• 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.
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Translation Exposure
Measures impact that exchange rate fluctuations
have upon an MNCs 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

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Translation Exposure
Measures impact that exchange rate fluctuations
have upon an MNCs 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

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Translation ExposureDeterminants

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

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Translation ExposureDeterminants

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

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Translation ExposureDeterminants

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

Accounting
Accounting
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Summary

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

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Summary

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