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Chapter 10
Measuring Exposure to Exchange Rate Fluctuations
Lecture Outline
Relevance of Exchange Rate Risk
Transaction Exposure
Estimating “Net” Cash Flows in Each Currency
Exposure of an MNC’s Portfolio
Transaction Exposure Based on Value-at-Risk
Economic Exposure
Economic Exposure to Local Currency Appreciation
Economic Exposure to Local Currency Depreciation
Economic Exposure of Domestic Firms
Measuring Economic Exposure
Translation Exposure
Determinants of Translation Exposure
Exposure of an MNC's Stock Price to Translation Effects
Chapter Theme
This chapter distinguishes among three forms by which MNCs are exposed to exchange rate risk: (1)
transaction exposure, (2) economic exposure, and (3) translation exposure. Each firm differs in degree of
exposure. A firm should be able to measure its degree of each type of exposure as described in this
chapter. Then, it can decide how to cover that exposure using methods described in the following two
chapters.
Topics to Stimulate Class Discussion
1. Describe in general terms how you would measure the transaction exposure of a particular MNC.
2. What is the relationship between transaction exposure and economic exposure?
3. A small firm in New York City produces various metals and sells them to local manufacturers. It has
no foreign sales and purchases all supplies and materials locally. Does transaction exposure exist for
this firm? Does economic exposure exist for this firm?
POINT/COUNTER-POINT:
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Measuring Exposure to Exchange Rate Fluctuations 2
Should Investors Care about an MNC’s Translation Exposure?
POINT: No. The present value of an MNC’s cash flows is based on the cash flows that the parent
receives. Any impact of the exchange rates on the financial statements is not important unless cash flows
are affected. MNCs should focus their energy on assessing the exposure of their cash flows to exchange
rate movements and should not be concerned with the exposure of their financial statements to exchange
rate movements. Value is about cash flows, and investors focus on value.
COUNTER-POINT: Investors do not have sufficient financial data to derive cash flows. They commonly
use earnings as a base, and if earnings are distorted, so will be their estimates of cash flows. If they
underestimate cash flows because of how exchange rates affected the reported earnings, they may
underestimate the value of the MNC. Even if the value is corrected in the future once the market realizes
how the earnings were distorted, some investors may have sold their stock by the time the correction
occurs. Investors should be concerned about an MNC’s translation exposure. They should recognize that
the earnings of MNCs with large translation exposure may be more distorted than the earnings of MNCs
with low translation exposure.
WHO IS CORRECT? Use the Internet to learn more about this issue. Which argument do you support?
ANSWER: Translation exposure affects earnings, and therefore can affect the value of the firm. If it
affects the value of the MNC, translation exposure is relevant to the firm, to the investors who are
affected by changing values, and to the managers whose compensation may be affected by changing
values.
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
