MEASURING EXPOSURE TO EXCHANGE RATE FLUCTUATIONS

Importance of Measuring
Exchange

rates may not be forecasted with perfect accuracy

Therefore,
Firms

can at least measure their exposure to exchange rate fluctuations.

Types of Exposure
TRANSACTION ECONOMIC TRANSLATION

TRANSACTION EXPOSURE

DEFINITION
The degree to which the value of future cash transactions can be affected by exchange rate fluctuations is referred to as transaction exposure.

To measure transaction exposure

1. Estimate the net cash inflows or

outflows in each currency, and

2. Measure the potential impact of the exposure to those currencies.

MNCs can expect foreign cash flows for the future period with sound accuracy. After the combined net currency flows for the entire MNC has been determined, each net flow is converted into the chosen currency. This step helps to determine the MNCs overall position in each currency.

1.Estimating Net Currency Flows

1.Estimating Net Currency Flows

THE CURRENCY NET INFLOW & OUTFLOWS

THE RANGE OF NET INFLOW & OUTFLOWS IN EACH CURRENCY

CONSOLIDATED NET CASH FLOW ASSESSMENT

currency Total

Total inflow outflow

Net inflow Or outflow

Current Exchange Rate

Net inflow or Outflow as measured in US dollar

C $ E
EURO

2 M 11 M

6M 12 M

4M 1M
200 M 6M

$ 0.80 $ 3.2M
OUTFLOW

0.30

0.3M
OUTFLOW

JAPAN Y SWISS
FRANC

300 M 100 M 1M 7M

0.005 1.0M
INFLOW

0.50

3.0M
OUTFLOW

1.Estimating Net Currency Flows

THE RANGE OF NET INFLOWS &

OUTFLOWS IN EACH CURRENCY

ESTIMATING THE RANGE OF NET INFLOW &

OUTFLOWS IN EACH CURRENCY

CURRENCY NET INFLOW RANGE OF
OR OUTFLOW POSSIBLE EXCHANGE RATE AT THE PERIOD
RANGE OF POSSIBLE NET INFLOWS OR OUTFLOWS IN US $ BASED ON RANGE OF POSSIBLE EXRATES

C$

4M
INFLOW

$.75 TO .85

$ 3 M TO 3.4

EURO

1M
OUTFLOW

.20 TO .50

.20 M TO .50

JAPAN Y 200 M
INFLOW

.004 TO .0006 .8 M TO 1.2

SWISS
FRANC

6M
OUTFLOW

.40 TO .70

2.4 M TO 4.2

2. Measuring the Potential Impact

The

net cash flows of an MNC can be viewed as portfolio of currencies

The

exposure of the portfolio can be measured by St. deviation find how the value deviate from the expected

To

Currency Variability
The

St. Deviation measures the degree of movement for each currency currencies fluctuate much more than

Some

others

The

variability of a currency will not necessarily remain constant from one period to another.

CURRENCY VARIABILITY (STANDARD DEVIATION)

CURRENCY 1995-2005 1995-1997 1998-2000 2001-2003 2004-2005

MXP GBP EUR JPY

1.525% 1.2% 2.47 3.09 0.99 1.31 1.05 0.73

1.5% 1.96 3.88 0.69

1.8% 2.31 2.46 1.27

1.6% 3.42 3.90 0.99

Currency Correlation
The

correlations among currency movements can be measured by their correlation coefficients It indicates the degree to which two currencies move in relation to each other Perfect positive correlation

(correlation coefficients)= (correlation coefficients)= -

1.00 1.00

Perfect negative correlation

CURRENCY CORRELATION
CURRENCY PAIR USD GBP CAD JPY USD CAD JPY USD GBP JPY USD GBP CAD 1995-1997 1998-2000 2001-2003 2004-2005

.15 .55 .67 .15 .45 .35 .55 .45 .40 .67 .35

.33 .66 .50 .33 .87 .67 .25 .45 .67

.23 .77 .69 .23 .45 .34

-.15 .88 .65 -.15 .87 .39

GBP

CAD

JPY

CORRELATION
X

%CHANGE

Y
Z

TIME PERIOD

Impact of Cash Flow and Correlations on an MNCs Exposure

Pg: 305

If the MNCs Expected Cash Flow Situation is:

And the Currencies are:

The MNCs Exposure is Relatively:

Assessing transaction exposure

currency Total inflows Total outflows Current ex-rate in $ $ 0.15 $ 1.50 Danish krone(DK) GBP DK 50,000,000 GBP 2,000,000 DK 40,000,000 GBP 1,000,000

Assume that the Movements in the Danish krone and pound are highly correlated. Provide your assessment as to your firms degree of transaction exposure (as to whether the exposure is high or low)

The Net exposure to each currency in USD is derived below

Foreign currency Net inflows in Current Value of foreign Currency Ex-Rate Exposure

DK

+DK 10,000,000 $ 0.15

$ 1,500,000

GBP

+GBP 1,000,000 $ 1.50

$ 1,500,000

ECONOMIC EXPOSURE

Definition
The degree to which a firms present value of future cash flows can be influenced by exchange rate fluctuations.

Some of these affected cash flows do not require currency conversion. Even a purely domestic firm may be affected by economic exposure if it faces foreign competition in its local markets.

Economic Exposure to Exchange Rate Fluctuations

Transactions that Influence the Firms Cash Inflows
Local sales (relative to foreign competition in local markets) Firms exports denominated in local currency Firms exports denominated in foreign currency Interest received from foreign investments Transactions that Influence the Firms Cash Outflows Firms imported supplies denominated in local currency Firms imported supplies denominated in foreign currency Interest owed on foreign funds borrowed
Local Currency Appreciates Local Currency Depreciates

Decrease Decrease Decrease Decrease

Increase Increase Increase Increase

No change

No change

Decrease
Decrease

Increase
Increase

Transactions that reflect transaction exposure

FORMS OF ECONOMIC EXPOSURE TO EXCHANGE RATE FLUCTUATION

VARIABLES THAT INFLUENCE THE LOCAL CURRENCY INFLOWS
IMPACT OF LOCAL CURRENCY

APPRECIATION

IMPACT OF LOCAL CURRENCY

DEPPRECIATION

LOCAL SALES (RELATIVE TO FOREIGN COMPETITION

MARKETS)

IN LOCAL

FIRMS EXPORTS DENOMINATED IN LOCAL CURRENCY FIRMS EXPORTS DENOMINATED IN FOREIGN CURRENCY INTEREST RECEIVED FROM FOREIGN INVESTMENTS

VARIABLES THAT INFLUENCE THE LOCAL CURRENCY OUTFLOWS

FIRMS IMPORTED SUPPLIES (DENOMITED IN LOCAL
CURRENCY)

NO CHANGE

NO CHANGE

FIRMS IMPORTED SUPPLIES (DENOMITED IN FOREIGN

CURRFENCY)

INTEREST OWED ON FOREIGN FUNDS BORROWED

VARIABLES THAT INFLUENCE THE LOCAL CURRENCY

Local currency APPRECIATION

INFLOWS

If APPRECIATION In Local currency

LOCAL SALES (RELATIVE TO FOREIGN COMPETITION IN LOCAL MARKETS)

CONSUMERS OF PAKISTAN WILL START BUYING FOREIGN PRODUCTS BECAUSE HOME CURRENCY HAS BECAME STRONGER
THEREFORE

LOCAL SALES WILL DECLINE

AND AS A RESULT THE INFLOW WILL DECLINE

If APPRECIATION In Local currency

FIRMS EXPORTS

DENOMINATED IN LOCAL CURRENCY

FOR THE FOREIGNERS IMPORTS BECAME EXPENSIVE BECAUSE PAKISTANI CURRENCY HAS STRENGTHEN SO FOREIGN IMPORTERS WILL STOP BUYING PAKISTANI PRODUCTS

THEREFORE THE EXPORTS WILL DECLINE AND AS A RESULT INFLOWS WILL

DECLINE

If APPRECIATION In Local currency

FIRMS EXPORTS

DENOMINATED IN FOREIGN CURRENCY

WHEN

PAKISTANI EXPORTER CONVERTS FOREIGN CURRENCY RECEIVED FROM EXPORTS IT WILL GET A FEW UNITS OF PAK RS

BECAUSE HOME CURRENCY HAS APPRECIATED

THE

LOCAL CURRENCY INFLOWS WILL DECLINE EXPORTS WILL DECLINE

Therefore

If APPRECIATION In Local currency

FROM FOREIGN INVESTMENTS

WHEN

INTEREST RECEIVED

PAKISTANI INVESTOR CONVERTS FOREIGN CURRENCY RECEIVED AS INTEREST OR DIVIDENDS IT WILL GET A FEW UNITS OF PAK RS

BECAUSE HOME CURRENCY HAS APPRECIATED

INTEREST RECEIVED will DECLINE LOCAL CURRENCY INFLOWS WILL DECREASE

VARIABLES THAT INFLUENCE THE LOCAL CURRENCY

APPRECIATION

OUTFLOWS

FIRMS IMPORTED SUPPLIES

(DENOMITED IN LOCAL CURRENCY) THERE WILL BE NO EFFECT If APPRECIATION In Local currency BECAUSE PAKISTANI RS APPRECIATION WILL NOT EVEN INCREASE OR DECREASE THE OUTFLOW HENCE THE OUTFLOW WILL REMAIN SAME

FIRMS IMPORTED SUPPLIES

(DENOMITED IN FOREIGN CURRFENCY)
MNC HAS TO PAY LESS MONEY FOR IMPORTS BECAUSE If APPRECIATION
In Local currency PAK RS HAS STRENGTHEN IT WILL TAKE FEW UNITS OF PAK RS AND RECEIVE MORE UNITS OF FOREIGN CURRENCY

HENCE THE PAK RS OUTFLOW WILL

DECLINE

(ON FOREIGN FUNDS BORROWED)

MNC HAS TO PAY LESS MONEY FOR INTEREST BECAUSE PAK RS HAS STRENGTHEN YOU WILL TAKE FEW UNITS OF PAK RS AND RECEIVE MORE UNITS OF FOREIGN CURRENCY HENCE THE PAK RS OUTFLOW WILL

INTEREST OWED

DECLINE

VARIABLES THAT INFLUENCE THE LOCAL CURRENCY

DEPRECIATION

INFLOWS

If DEPRECIATION In Local currency

LOCAL SALES
(RELATIVE TO FOREIGN COMPETITION IN LOCAL MARKETS)

. CONSUMERS OF PAKISTAN WILL START BUYING LOCAL PRODUCTS BECAUSE HOME CURRENCY HAS BECAME WEAKER

THEREFORE LOCAL SALES WILL INCREASE

AND AS A RESULT THE INFLOW WILL

INCREASE

If DEPRECIATION In Local currency

DENOMINATED IN LOCAL CURRENCY

FOR THE FOREIGNERS IMPORTS BECAME CHEAPER BECAUSE PAKISTANI CURRENCY HAS WEAKENED SO FOREIGN IMPORTERS WILL START BUYING MORE PAKISTANI PRODUCTS

FIRMS EXPORTS

THEREFORE THE EXPORTS WILL INCREASE AND AS A RESULT INFLOWS WILL

INCREASE

FIRMS EXPORTS

If DEPRECIATION In Local currency

DENOMINATED IN FOREIGN CURRENCY

WHEN PAKISTANI EXPORTER CONVERTS FOREIGN CURRENCY RECEIVED FROM EXPORTS IT WILL GET MORE UNITS OF PAK RS BECAUSE FOREIGN CURRENCY HAS STRENGTHEN

EXPORTS WILL REMAIN SAME BUT THE LOCAL CURRENCY INFLOWS WILL

INCREASE

INTEREST RECEIVED
FROM FOREIGN INVESTMENTS

If DEPRECIATION In Local currency

WHEN PAKISTANI INVESTORS CONVERT FOREIGN CURRENCY RECEIVED AS INTEREST OR DIVIDENDS IT WILL GET MORE UNITS OF PAK RS BECAUSE FOREIGN CURRENCY HAS BECOME STRONGER
AMOUNT OF INTEREST IN FOREIGN CURRENCY WILL NOT CHANGE BUT THE LOCAL CURRENCY INFLOWS WILL

INCREASE

VARIABLES THAT INFLUENCE THE LOCAL CURRENCY

DEPRECIATION

OUTFLOWS

FIRMS IMPORTED SUPPLIES

(DENOMITED IN LOCAL CURRENCY)
THERE WILL BE NO EFFECT BECAUSE PAKISTANI RS DEPRECIATION WILL NOT EVEN INCREASE OR DECREASE THE OUTFLOWS
If DEPRECIATION In Local currency

HENCE THE OUTFLOWS WILL REMAIN SAME

If DEPRECIATION In Local currency

FIRMS IMPORTED SUPPLIES

(DENOMITED IN FOREIGN CURRFENCY)

NOW YOU WILL PAY MORE MONEY FOR IMPORTS BECAUSE PAK RS HAS WEAKENED YOU WILL TAKE MORE UNITS OF PAK RS AND RECEIVE LESS UNITS OF FOREIGN CURRENCY HENCE THE PAK RS OUTFLOWS WILL

INCREASE

If DEPRECIATION In Local currency

INTEREST OWED
ON FOREIGN FUNDS BORROWED
NOW YOU WILL PAY MORE MONEY IN INTEREST

(INTEREST REMAINS THE SAME)

BECAUSE PAK RS HAS WEAKENED YOU WILL TAKE MORE UNITS OF PAK RS AND RECEIVE LESS UNITS OF FOREIGN CURRENCY HENCE THE PAK RS OUTFLOW WILL

INCREASE

INDIRECT ECONOMIC EXPOSURE

Eg: FIRMS IMPORTED SUPPLIES
(DENOMITED IN LOCAL CURRFENCY)

THERE WILL BE NO AFFECT ON THE OUTFLOWS

BECAUSE PAK RS HAS WEAKENED

BUT THE US EXPORTER IS AFFECTED US EXPORTER WILL RECEIVE LESS UNITS OF PAK RS
THEREFORE

IT WILL CHARGE MORE MONEY NEXT TIME

ECONOMIC EXPOSURE OF DOMESTIC FIRM

FIRM

SELLING ITS PRODUCT IN LOCAL MARKET WILL BE AFFECTED THERE IS FOREIGN PRODUCT IN THE MARKET THE LOCAL CURRENCY APPRECIATES

IF

WHEN THE

FOREIGN PRODUCT WILL BECOME CHEAP WILL SHIFT TO BUY MORE FOREIGN

CUSTOMERS

PRODUCTS

ECONOMIC EXPOSURE OF MNC

World Example

GENERAL

MOTORS Co. USED TO SELL SOFTWARE PRODUCTS TO MEXICO

DEPRECIATED BY 40%

MXP

AS A RESULT SOFTWARE DEMAND DECLINED

EVALUATION OF MNCS SENSITIVITY TO EXCHANGE RATE

Regression

Analysis could help to determine whether a particular policy has :

Or

Reduced Increased
MNC

s exposure

a
Where:

REGRESSION ANALISIS

rs = ao + a1 PAK-SI + a2 E
= % change in the stock price of the company PAK-SI = % change in Pak stock Index E = % change in foreign currency

rs

Regression coefficients :

ao= Constant a1= % change in company value sensitivity to % change in PAK-IS a2= % change in company value sensitivity to % change in E

SENSETIVITY OF A COMPANYS STOCK VALUE TO

REGRESSION COEFFICIENT REGRESSION COEFFICIENT

CURRENCY MOVEMENTS BASED ON REGRESSION ANALYSIS

CURRENCY CANADIAN $ FRENCH EURO JAPAN

FRANC

a2

EARLIER SUBPERIOD

a2
MORE RECENT SUBPERIOD

-0.81 0.05 -0.73 -0.26

-0.06 0.05 -0.01 -0.27

C Y

b
Where:

REGRESSION ANALISIS

rs = bo + b1 PAK-SI + b2 CAD + b3 USD + b4 GBP + b5 EUR

rs

= % change in the stock price of the company

PAK-SI = % change in Pak stock Index CAD , USD , GBP , EUR = % change in foreign currency
Regression coefficients :

bo= Constant b1= % change in company value sensitive to % change in PAK-IS b2= % change in company value sensitive to % change in Foreign currency

SENSETIVITY OF A COUNTRYS STOCK VALUE TO COUNTRY ECONOMIES BASED ON REGRESSION ANALYSIS STOCK INDEX OF :
REGRESSION COEFFICIENT EARLIER SUBPERIOD REGRESSION COEFFICIENT MORE RECENT SUBPERIOD

CANADA FRANCE

0.5 0.1

0.7 0.1

GERMANY
JAPAN

0.9
0.3

1.4
0.8

To assess how the MNC is influenced by economic conditions of foreign countries

The result will indicate a Companys economic exposure due to the change in the economic conditions of each country. There are several possibilities :

GNP NI

But these variables do not indicate anticipated future conditions of economy

So the best measure is the foreign countrys stock index

C
Where:

REGRESSION ANALISIS rs = co + c1 HI + c2 FI

rs

Return of the companys stock

HI = the return on the home stock Index FI = the return on the foreign stock Index
Regression coefficients :

co= Constant c1= % change in company value sensitive to % change in home-IS c2= % change in company value sensitive to % change in foreign-IS

TRANSLATION EXPOSURE

DEFINITION
The exposure of the MNC s consolidated financial statements to exchange rate fluctuation is known as accounting or translation exposure

 The

risk that the company equities, assets, liabilities or income will change in value as a result of exchange rate changes. occurs when a firm denominates its equities, assets, liabilities or income in a foreign currency many cases this exposure will be recorded in the financial statement as an exchange rate gain (or loss)

This

In

 The

MNC s where great business is conducted in foreign subsidiaries Then Higher will be the chance of translation exposure
The

MNC s where foreign business is in the shape of exports Then Less will be the chance of translation exposure

FOUR METHODS OF TRANSLATION

A. Current/Noncurrent Method B. Monetary/Nonmonetary Method C. Temporal Method D. Current Rate Method

A. Current/Noncurrent Method
1. Current accounts use current exchange rate

for conversion. 2. Income statement accounts use average exchange rate for the period.

B.

Monetary/Nonmonetary Method

1. Monetary accounts use current rate Includes: -

cash accounts receivable accounts payable long term debt

B.

Monetary/Nonmonetary Method

2. Nonmonetary accounts use historical rates Includes: Inventory fixed assets long term investments 3. Income statement accounts use average exchange rate --- for the period.

C. Temporal Method
1. Similar to monetary/nonmonetary method. 2. Uses current method for inventory.

D. Current Rate Method

all statements use current exchange rate for conversions

EXCHANGE RATES USED IN VARIOUS TRANSLATION METHODS (C=current , H=historical)

ACCOUNTS TITLES
CASH CURRENT RECEIVABLES & PAYBLES INVENTORY
CURRENT NONCURRENT TEMPORAL MONETARY NONMONETARY CURRENT

C C H

C C or H H

C H H

C C C

FIXED ASSENTS LONG-TERM

RECEIVABLES & PAYABLES

FASB 52 (STATEMENT OF FINANCIAL

ACCOUNTING STANDARDS NO. 52)
Many of the important consolidated accounting rules for US based MNCs are based on FASB 52

65

STATEMENT OF FINANCIAL ACCOUNTING STANDARDS NO. 52

Balance sheet translation uses current rate method.

66

STATEMENT OF FINANCIAL ACCOUNTING STANDARDS NO. 52 Income statement uses 1. Weighted average rate during period or

2.

The rate in effect when revenue and expenses incurred.

67

STATEMENT OF FINANCIAL ACCOUNTING STANDARDS NO. 52 Translation Gains or Losses

1.
2.

Recorded in separate equity

account on balance sheet. Known as cumulative translation adjustment

account.
68

STATEMENT OF FINANCIAL ACCOUNTING STANDARDS NO. 52 Functional currency For foreign subsidiary it is the currency used in the primary economic environment in which it operates.

69

STATEMENT OF FINANCIAL ACCOUNTING STANDARDS NO. 52 2. Reporting currency the currency the parent firm uses to prepare its financial statements.

70