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
Translation Exposure
Determinants of Translation Exposure
Exposure of an MNC’s Stock Price to Translation Effects
Measuring Exposure to Exchange Rate Fluctuations ❖ 2
Chapter Theme
This chapter distinguishes among three forms by which MNCs are exposed to exchange rate risk: (1)
Topics to Stimulate Class Discussion
1. Describe in general terms how you would measure the transaction exposure of a particular MNC.
POINT/COUNTER-POINT:
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?
Measuring Exposure to Exchange Rate Fluctuations ❖ 3
Answers to End of Chapter Questions
1. Transaction versus Economic Exposure. Compare and contrast transaction exposure and economic
exposure. Why would an MNC consider examining only its “net” cash flows in each currency when
assessing its transaction exposure?
ANSWER: Transaction exposure is due only to international transactions by a firm. Economic
exposure includes any form by which the firm’s cash flow will be affected. Foreign competition may
2. Assessing Transaction Exposure. Your employer, a large MNC, has asked you to assess its
transaction exposure. Its projected cash flows are as follows for the next year:
Currency
Total Inflow
Total Outflow
Current Exchange
Rate in U.S. Dollars
Danish krone (DK)
DK50,000,000
DK40,000,000
$.15
British pound (£)
£2,000,000
£1,000,000
$1.50
Assume that the movements in the Danish krone and the pound are highly correlated. Provide your
assessment as to your firm’s degree of transaction exposure (as to whether the exposure is high or
low). Substantiate your answer.
ANSWER: The net exposure to each currency in U.S. dollars is derived below:
Danish krone (DK)
+DK10,000,000
$1,500,000
British pound (£)
+£1,000,000
$1,500,000
Net Inflows in
Current
3. Factors That Affect a Firm’s Transaction Exposure. What factors affect a firm’s degree of
transaction exposure in a particular currency? For each factor, explain the desirable characteristics
that would reduce transaction exposure.
ANSWER: Currency variability—low level is desirable.
4. Currency Correlations. Kopetsky Co. has net receivables in several currencies that are highly
correlated with each other. What does this imply about the firm’s overall degree of transaction
exposure? Are currency correlations perfectly stable over time? What does your answer imply about
Kopetsky Co. or any other firm using past data on correlations as an indicator for the future?
5. Currency Effects on Cash Flows. How should appreciation of a firm’s home currency generally
affect its cash inflows? How should depreciation of a firm’s home currency generally affect its cash
outflows?
6. Transaction Exposure. Fischer Inc., exports products from Florida to Europe. It obtains supplies
and borrows funds locally. How would appreciation of the euro likely affect its net cash flows?
Why?
7. Exposure of Domestic Firms. Why are the cash flows of a purely domestic firm exposed to
exchange rate fluctuations?
8. Measuring Economic Exposure. Memphis Co. hires you as a consultant to assess its degree of
economic exposure to exchange rate fluctuations. How would you handle this task? Be specific.
ANSWER: Regression analysis can be used to determine the relationship between the firm’s value
9. Factors That Affect a Firm’s Translation Exposure. What factors affect a firm’s degree of
translation exposure? Explain how each factor influences translation exposure.
Measuring Exposure to Exchange Rate Fluctuations ❖ 5
10. Translation Exposure. Consider a period in which the U.S. dollar weakens against the euro. How
will this affect the reported earnings of a U.S.-based MNC with European subsidiaries? Consider a
period in which the U.S. dollar strengthens against most foreign currencies. How will this affect the
reported earnings of a U.S.-based MNC with subsidiaries all over the world?
11. Transaction Exposure. Aggie Co. produces chemicals. It is a major exporter to Europe, where its
main competition is from other U.S. exporters. All of these companies invoice the products in U.S.
dollars. Is Aggie’s transaction exposure likely to be significantly affected if the euro strengthens or
weakens? Explain. If the euro weakens for several years, can you think of any change that might
occur in the global chemicals market?
ANSWER: If the euro strengthens, European customers can purchase Aggie’s goods with fewer
12. Economic Exposure. Longhorn Co. produces hospital equipment. Most of its revenues are in the
United States. About half of its expenses require outflows in Philippine pesos (to pay for Philippine
materials). Most of Longhorn’s competition is from U.S. firms that have no international business at
all. How will Longhorn Co. be affected if the peso strengthens?
13. Economic Exposure. Lubbock, Inc., produces furniture and has no international business. Its major
competitors import most of their furniture from Brazil and then sell it out of retail stores in the United
States. How will Lubbock, Inc., be affected if Brazil’s currency (the real) strengthens over time?
14. Economic Exposure. Sooner Co. is a U.S. wholesale company that imports expensive high-quality
luggage and sells it to retail stores around the United States. Its main competitors also import
high-quality luggage and sell it to retail stores. None of these competitors hedge their exposure to
exchange rate movements. Why might Sooner’s market share be more volatile over time if it hedges
its exposure?
ANSWER: If Sooner Company hedged its imports, then it would have an advantage over the
competition when the dollar weakened (since its competitors would pay higher prices for the
15. PPP and Economic Exposure. Boulder, Inc., exports chairs to Europe (invoiced in U.S. dollars) and
competes against local European companies. If purchasing power parity exists, why would Boulder
not benefit from a stronger euro?
16. Measuring Changes in Economic Exposure. Toyota Motor Corp. measures the sensitivity of its
exports to the yen exchange rate (relative to the U.S. dollar). Explain how regression analysis could
be used for such a task. Identify the expected sign of the regression coefficient if Toyota primarily
exports to the United States. If Toyota established plants in the United States, how might the
regression coefficient on the exchange rate variable change?
ANSWER: The dependent variable is a percentage change (from one period to the next) in Toyota’s
17. Impact of Exchange Rates on Earnings. Cieplak, Inc., is a U.S.-based MNC that has expanded into
Asia. Its U.S. parent exports to some Asian countries, with its exports denominated in the Asian
currencies. It also has a large subsidiary in Malaysia that serves that market. Offer at least two
reasons related to exposure to exchange rates why Cieplak’s earnings were reduced during the Asian
crisis.
Measuring Exposure to Exchange Rate Fluctuations ❖ 7
ANSWER: First, its receivables from its exports were converted to fewer dollars due to the
Advanced Questions
18. Speculating Based on Exposure. Periodically, there are rumors that China will weaken its
currency (the yuan) against the U.S. dollar and many European currencies. This causes
investors to sell stocks in Asian countries such as Japan, Taiwan, and Singapore. Offer an
intuitive explanation for such an effect. What types of Asian firms would be affected the
most?
19. Comparing Transaction and Economic Exposure. Erie Co. has most of its business in the U.S.,
except that it exports to Belgium. Its exports were invoiced in euros (Belgium’s currency) last year. It
has no other economic exposure to exchange rate risk. Its main competition when selling to
Belgium’s customers is a company in Belgium that sells similar products, denominated in euros.
Starting today, Erie Co. plans to adjust its pricing strategy to invoice its exports in U.S. dollars
instead of euros. Based on the new strategy, will Erie Co. be subject to economic exposure to
exchange rate risk in the future? Briefly explain.
20. Using Regression Analysis to Measure Exposure.
a. How can a U.S. company use regression analysis to assess its economic exposure to fluctuations
in the British pound?
b. In using regression analysis to assess the sensitivity of cash flows to exchange rate movements,
what is the purpose of breaking the database into subperiods?
Measuring Exposure to Exchange Rate Fluctuations ❖ 8
c. Assume the regression coefficient based on assessing economic exposure was much higher in
the second sub period than in the first sub period. What does this tell you about the firm’s
degree of economic exposure over time? Why might such results occur?
21. Transaction Exposure. Vegas Corp. is a U.S. firm that exports most of its products to Canada. It
historically invoiced its products in Canadian dollars to accommodate the importers. However, it was
adversely affected when the Canadian dollar weakened against the U.S. dollar. Since Vegas did not
hedge, its Canadian dollar receivables were converted into a relatively small amount of U.S. dollars.
After a few more years of continual concern about possible exchange rate movements, Vegas called
its customers and requested that they pay for future orders with U.S. dollars instead of Canadian
dollars. At this time, the Canadian dollar was valued at $.81. The customers decided to oblige, since
the number of Canadian dollars to be converted into U.S. dollars when importing the goods from
Vegas was still slightly smaller than the number of Canadian dollars that would be needed to buy the
product from a Canadian manufacturer. Based on this situation, has transaction exposure changed for
Vegas Corp.? Has economic exposure changed? Explain.
22. Measuring Economic Exposure. Using the following cost and revenue information shown for
DeKalb, Inc., determine how the costs, revenue, and cash flow would be affected by three possible
exchange rate scenarios for the New Zealand dollar (NZ$): (1) NZ$ = $.50, (2) NZ$ = $.55, and (3)
NZ$ = $.60. (Assume U.S. sales will be unaffected by the exchange rate.) Assume that NZ$
earnings will be remitted to the U.S. parent at the end of the period. Ignore possible tax effects.
Forecasted Net Cash Flows: DeKalb Inc.
(in millions of U.S. dollars and New Zealand dollars)
New Zealand
U.S. Business Business
Sales $800 NZ$800
Cost of Materials 500 100
Operating Expenses 300 0
Interest Expense 100 0
Cash Flow –$100 NZ$700
ANSWER:
(Figures are in millions)
Measuring Exposure to Exchange Rate Fluctuations ❖ 9
23. Changes in Economic Exposure. Walt Disney World built an amusement park in France that opened
in 1992. How do you think this project has affected Disney’s economic exposure to exchange rate
movements? Think carefully before you give your final answer. There is more than one way in which
Disney’s cash flows may be affected. Explain.
ANSWER: This is a good question for class discussion. The typical first reaction is that Walt Disney
24. Lagged Effects of Exchange Rate Movements. Cornhusker Co. is an exporter of products to
Singapore. It wants to know how its stock price is affected by changes in the Singapore dollar’s
exchange rate. It believes that the impact may occur with a lag of one to three quarters. How could
regression analysis be used to assess the impact?
ANSWER: A possible regression model for this task is to regress percentage change in its stock price
over quarter t (PSPt) against the percentage change in the Singapore dollar (PSD) in the three
previous quarters, shown as follows.
25. Potential Effects if the United Kingdom Adopted the Euro. The U.K. still has its own currency, the
pound. The pound’s interest rate has historically been higher than the euros interest rate. The U.K. has
considered adopting the euro as its currency. There have been many arguments about whether it
should do so.
Use your knowledge and intuition to discuss the likely effects if the United Kingdom adopts the euro.
For each of the 10 statements below, insert either INCREASE or DECREASE and complete the
Measuring Exposure to Exchange Rate Fluctuations ❖ 10
statement by adding a clear short explanation (perhaps one to three sentences) of why the U.K.’s
adoption of the euro would have that effect.
To help you narrow your focus, follow these guidelines. Assume that the pound is more volatile than
the euro. Do not base your answer on whether the pound would have been stronger than the euro in
the future. Also, do not base your answer on an unusual change in economic growth in the U.K. or in
the euro zone if the euro is adopted.
ANSWERS:
a. The economic exposure of British firms that are heavy exporters to the euro zone would decrease
because no exchange of currencies would be needed.
26. Invoicing Policy to Reduce Exposure. Celtic Co. is a U.S. firm that exports its products to England.
It faces competition from many firms in England. Its price to customers in England has generally
Measuring Exposure to Exchange Rate Fluctuations ❖ 11
been lower than those of the competitors, primarily because the British pound has been strong. It has
priced its exports in pounds, and then converts the pound receivables into dollars. All of its expenses
are in the U.S. and are paid with dollars. It is concerned about its economic exposure. It considers a
change in its pricing policy, in which it will price its products in dollars instead of pounds. Offer your
opinion on why this will or will not significantly reduce its economic exposure.
27. Exposure to Cash Flows. Raton Co. is a U.S. company that has net inflows of 100 million Swiss
francs and net outflows of 100 million British pounds. The present exchange rate of the Swiss franc
is about $.70 while the present exchange rate of the pound is $1.90. Raton Co. has not hedged these
positions. The Swiss franc and British pound are highly correlated in their movements against the
dollar. Explain whether Raton will be favorably or adversely affected if the dollar weakens against
foreign currencies over time.
28. Assessing Exchange Rate Risk. Washington Co. and Vermont Co. have no domestic business.
They have a similar dollar equivalent amount of international exporting business. Washington Co.
exports all of its products to Canada. Vermont Co. exports its products to Poland and Mexico, with
about half of its business in each of these 2 countries. Each firm receives the currency of the country
where it sends its exports. You obtain the end-of-month spot exchange rates of the currencies
mentioned above during the end of each of the last 6 months.
End of Month
Canadian Dollar
Mexican Peso
Polish Zloty
1
$0.8142
$.09334
$.29914
2
0.8176
.09437
.29829
3
0.8395
.09241
.30187
4
0.8542
.09263
.3088
5
0.8501
.09251
.30274
6
0.8556
.09448
.30312
You want to assess the data in a logical manner to determine which firm has a higher degree of
exchange rate risk. Show your work and write your conclusion. [HINT: The percentage change in the
portfolio of currencies is a weighted average of the percentage change in each currency in the
portfolio.]
ANSWER: First, use an excel spreadsheet to determine the monthly percentage change in the
exchange rate. The portfolio’s movements are equal to a weighted average of the movements of each
29. Exposure to Pegged Currency System. Assume that the Mexican peso and the Brazilian
currency (called the “real”) have depreciated against the dollar recently, due to the high inflation rates
in those countries. Assume that inflation in these two countries is expected to continue and that it will
have a major effect on these currencies if they are still allowed to float. Assume that the government
of Brazil decides to peg its currency to the dollar and will definitely maintain the peg for the next
year. Milez Co. is based in Mexico. Its main business is to export supplies from Mexico to Brazil. It
invoices its supplies in Mexican pesos. Its main competition is from firms in Brazil that produce
similar supplies and sell them locally. How will the sales volume of Milez Co.be affected (if at all) by
the Brazilian government’s actions? Explain.
30. Assessing Currency Volatility. Zemart is a U.S. firm that plans to establish international
business in which it will export to Mexico (these exports will be denominated in pesos) and to Canada
(these exports will be denominated in Canadian dollars) once a month and will therefore receive
payments once a month. It is concerned about exchange rate risk. It wants to compare the standard
deviation of exchange rate movements of these 2 currencies against the dollar on a monthly basis. For
this reason, it asks you to
a. estimate the standard deviation of the monthly movements in the Canadian dollar against the U.S.
dollar over the last 12 months
b. estimate the standard deviation of the monthly movements in the Mexican peso against the U.S.
dollar over the last 12 months.
c. Determine which currency is less volatile
You can use the oanda.com web site (or any legitimate web site that has currency data) to obtain the
end of month direct exchange rate of the peso and the Canadian dollar in order to do your analysis.
Show your work. You can use a calculator or a spreadsheet (like excel) to do the actual computations.
31. Exposure of Net Cash Flows. Each of the following U.S. firms is expected to generate $40
million in net cash flows (after including the estimated cash flows from international sales if there are
any) over the next year. Ignore any tax effects. Each firm has the same level of expected earnings.
None of the firms have taken any positions in exchange rate derivatives to hedge their exchange rate
risk. All payments for the international trade by each firm will occur one year from today.
Sunrise Co. has ordered imports from Austria, and its imports are invoiced in euros. The dollar value
of the payables (based on today’s exchange rate) from its imports during this year is $10 million. It
has no international sales.
Copans Co. has ordered imports from Mexico, and its imports are invoiced in U.S. dollars. The dollar
value of the payables from its imports during this year is $15 million. It has no international sales.