Ch. 10 Measuring FX Exposure. Is Exchange Rate Risk Relevant? MNCs Take on FX Risk

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1 Ch. 10 Measuring FX Exposure Topics Exchange Rae Risk: Relevan? Types of Exposure Transacion Exposure Economic Exposure Translaion Exposure Is Exchange Rae Risk Relevan?? Purchasing Power Pariy: Exchange rae movemens will be mached by price movemens.? Invesor Hedge: MNC shareholders can hedge agains exchange rae flucuaions on heir own.? Currency Diversificaion: An MNC ha is well diversified should no be affeced by exchange rae movemens because of offseing effecs.? Sakeholder Diversificaion: Well diversified sakeholders will be somewha insulaed agains losses experienced by an MNC due o exchange rae risk. MNCs Take on FX Risk Many MNCs aemp o sabilize heir earnings wih hedging sraegies because hey believe exchange rae risk is relevan. Because we manufacure and sell producs in a number of counries hroughou he world, we are exposed o he impac on revenues and expenses of movemens in currency exchange raes. Procor & Gamble Co. Increased volailiy in foreign exchange raes may have an adverse impac on our business resuls and financial condiion. PepsiCo 1

2 Foreign Exchange Rae Exposure Alhough exchange raes canno be forecased wih perfec accuracy, firms can a leas measure heir exposure o exchange rae flucuaions. Exposure o exchange rae flucuaions comes in hree forms: Transacion exposure Economic exposure Translaion exposure Transacion Exposure Transacion exposure: The degree o which he value of fuure cash ransacions can be affeced by exchange rae flucuaions Transacion exposure is due only o inernaional ransacions by a firm. Transacion exposure is a subse of economic exposure. Transacion Exposure o Ne Cash Flows Transacion Exposure Based on Value-a-Risk Transacion Exposure Based on Currency Variabiliy Transacion Exposure Based on Currency Correlaions Key Facors Measuremen of currency volailiy The sandard deviaion saisic measures he degree of movemen for each currency. In any given period, some currencies clearly flucuae much more han ohers. Currency volailiy over ime The volailiy of a currency may no remain consisen from one ime period o anoher. An MNC can idenify currencies whose values are mos likely o be sable or highly volaile in he fuure. 2

3 Key Facors Measuremen of currency correlaions The correlaions coefficiens indicae he degree o which wo currencies move in relaion o each oher. If a MNC has posiive ne cash flows in various currencies ha are highly correlaed, i may be exposed o exchange rae risk. However, many MNCs have some negaive ne cash flow posiions in some currencies o complemen heir posiive ne cash flows in oher currencies. Because currency correlaions change over ime, an MNC canno use previous correlaions o predic fuure correlaions wih perfec accuracy. Transacion Exposure Based on Value a Measures he poenial maximum 1-day loss on he value of posiions of an MNC ha is exposed o exchange rae movemens. Facors ha affec he maximum 1-day loss: Expeced percenage change in he currency rae for he nex day Confidence level used Sandard deviaion of he daily percenage changes in he currency Example: Mexican peso wih 95% confidence inerval Transacion Exposure Based on Value a Applying VaR o Longer Time Horizons The sandard deviaion should be esimaed over he ime horizon in which he maximum loss is o be measured. Applying VaR o Transacion Exposure of a Porfolio Since MNCs are commonly exposed o more han one currency, hey may apply he VaR mehod o a currency porfolio. When considering muliple currencies, sofware packages can be used o perform he compuaions. 3

4 Transacion Exposure Based on Value a Limiaions of VaR If he disribuion of exchange rae movemens is no normal, he esimae of he maximum expeced loss is subjec o error. The VaR mehod assumes ha he volailiy (sandard deviaion) of exchange rae movemens is sable over ime. If exchange rae movemens are less volaile in he pas han in he fuure, he esimaed maximum expeced loss derived from he VaR mehod will be underesimaed. Economic Exposure Economic exposure: The degree o which a firm s presen value of fuure cash flows can be influenced by exchange rae flucuaions. I is also called operaing exposure. Economic/operaing exposure includes any form by which he firm s cash flow will be affeced. Cash flows ha do no require conversion of currencies do no reflec ransacion exposure. Ye, hese cash flows may also be influenced significanly by exchange rae movemens. Translaion Exposure Translaion Exposure: The exposure of he MNC s consolidaed financial saemens o exchange rae flucuaions. The funcional currency of an eniy is he currency of he economic environmen in which he eniy operaes. The curren exchange rae as of he reporing dae is used o ranslae he asses and liabiliies of a foreign eniy from is funcional currency ino he reporing currency. Does Translaion Exposure Maer? I does no affec cash flow, since i simply reflecs he impac of exchange rae flucuaion on consolidaed financial saemens. I affecs consolidaed financial saemens, which are ofen used by shareholders o assess he performance of he MNC. 4

5 Impac of FX on an MNC s Value Transacion Exposure Economic Exposure Value = [ ( ) ( )] m E CF n j, E ER j, j = 1 =1 ( 1 + k ) E (CF j, ) = expeced cash flows in currency j o be received by he U.S. paren a he end of period E (ER j, ) = expeced exchange rae a which currency j can be convered o dollars a he end of period k = weighed average cos of capial of he paren 5