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Types of Exposure. Three exposures from Exchange Rate Risk:a. Transaction exposureb. Economic exposurec. Translation exposure. Transaction Exposure. The sensitivity of the firm's contractual transactions in foreign currencies to exchange rate movements.e.g. an US exporter denominates its exports in euro. A 10% percent decline in that currency will reduce the dollar value of its receivables by 10%. This effect could possibly eliminate any profits from exporting..
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1. FINC3240 International Finance Chapter 10
Measuring Exposure to Exchange Rate Fluctuations
2. Types of Exposure Three exposures from Exchange Rate Risk:
a. Transaction exposure
b. Economic exposure
c. Translation exposure
3. Transaction Exposure The sensitivity of the firms contractual transactions in foreign currencies to exchange rate movements.
e.g. an US exporter denominates its exports in euro. A 10% percent decline in that currency will reduce the dollar value of its receivables by 10%. This effect could possibly eliminate any profits from exporting.
4. Transaction Exposure MNC may have multiple foreign subsidiaries spread around the work, it needs to project the consolidated net amount in currency inflows or outflows for all its subsidiaries, categorized by currency. Aggregate inflows and outflows of a foreign currency may offset and therefore the net cash flows of that currency overall may be negligible.
5. Economic Exposure The sensitivity of the firms cash flows to exchange rate movements is referred to as economic exposure. Transaction exposure is a subset of economic exposure.
e.g. Intel invoices 65% of its chip export in US dollars. It is not subject to transaction exposure for its dollar-denominated exports. However, if the euro weaken against the dollar, the European importers costs of importing the chips increases and they may decide to purchase fewer chips from Intel. Consequently, Intels cash flows from its exports will be reduced, even though these exports are invoiced in dollars.
6. Exhibit 10.6 Examples That Subject a Firm to Economic Exposure
7. Economic Exposure Economic Exposure to Local Currency Appreciation
local sales decreases, because foreign products invoiced in foreign currency are cheaper.
Export denominated in home currency decreases, because foreign importers will need more of their currency to pay for the same products.
The cost of imported supplies denominated in foreign currency decrease.
The cost (in terms of the local currency) of interest to be paid on foreign currencies decreases.
8. Economic Exposure Economic Exposure to Local Currency Depreciation
local sales increases, because foreign products invoiced in foreign currency are more expensive.
Export denominated in home currency increases, because foreign importers will need less of their currency to pay for the same products.
The cost of imported supplies denominated in foreign currency increase.
The cost (in terms of the local currency) of interest to be paid on foreign currencies increases.
9. Economic Exposure Economic Exposure of Domestic Firms
e.g. Burlington, Inc. is a US manufacturer of steel that purchase all its supplies locally and sells all steel locally. It is not subject to transaction exposure. It is subject to economic exposure because it faces foreign competition. If the exchange rate of the foreign currency depreciate against the dollar, foreign steel will be cheaper. Consequently, demand for Burlingtons steel will decreases, and so will its net cash inflows.
10. Measuring Economic Exposure a. Using Sensitivity Analysis
How Sales and expense are affected by various exchange rate scenarios.
b. Using Regression Analysis
PCF=percentage change in cash flows measured in home currency
E= percentage change in the exchange rate
11. Translation Exposure A subsidiarys financial statement is normally measured in local currency. To be consolidated, each subsidiarys financial statement must be translated into the currency of the MNCs parent. The exposure of the MNCs consolidated financial statements to exchange rate fluctuation is translation exposure.
12. Translation Exposure Determinants of Translation Exposure
a. Proportion of its business conducted by foreign subsidiaries
b. Locations of foreign subsidiaries
c. Accounting methods
13. Example Question 19 on page 300.
ANSWER: Economic exposure still exists because a weak euro would encourage Belgian customers to switch to local competitors.
14. Chapter 10 Homework Q&A: 1,3,5,6,7,11,12,13.
15. Chapter 11(skip) Managing transaction exposure
Futures, Forwards, Options, Swaps.
16. Chapter 12 Managing Economic Exposure You may hedge some of transaction exposure, but you can not eliminate transaction exposure because you cannot predict all future transactions.
It is difficult to determine exactly how a specific exchange rate movement will affect the demand and supply of materials and products.
17. Managing Economic Exposure Restructuring operations to reduce economic exposure to exchange rate risk, that is, shifting the sources of costs or revenue to other locations in order to match cash inflows and outflows in foreign currencies.
Examples:
(1) Madison Co. on page 348;
(2) Savor Co. on page 352 and its possible strategies to hedge economics exposure on page 354.
18. Example Baltimore, Inc is a US based MNC that obtains 10% of its supplies from European manufactures. Sixty percent of its revenues are due to exports to Europe, where it is product is invoiced in euros. Explain how Baltimore can reduce its economic exposure to exchange rate risk in the euro.
ANSWER: Baltimore Inc. could reduce its economic exposure by shifting some of its U.S. expenses to Europe. This may involve shifting its sources of materials or even part of its production process to Europe.
19. Chapter 12 homework Q&A: 2,3.
