Chapter 12
Managing Economic Exposure and
Translation Exposure
Jeff Madura, International Financial Management, 14th Edition. © 2021 Cengage. All Rights Reserved. May not be scanned,
copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Chapter Objectives
• Explain how an MNC’s economic exposure can be hedged.
• Explain how an MNC’s translation exposure can be hedged.
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Managing Economic Exposure (1 of 3)
Economic exposure represents the impact of exchange rate fluctuations on a
firm’s future cash flows. (Exhibit 12.1)
Assessing economic exposure
• An MNC must determine how it is subject to exchange rate movements
before it can manage its economic exposure.(Exhibit 12.2)
Restructuring to reduce economic exposure:
• Restructuring involves shifting the sources of revenue or expenses to better
match cash inflows and outflows in foreign currencies.(Exhibit 12.3 & 12.4)
Jeff Madura, International Financial Management, 14th Edition. © 2021 Cengage. All Rights Reserved. May not be scanned,
copied or duplicated, or posted to a publicly accessible website, in whole or in part.
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Managing Economic Exposure (2 of 3)
Restructuring to reduce economic exposure (Continued)
• How Restructuring Depends on the Form of Economic Exposure
o The way a firm restructures its operations to reduce economic exposure to
exchange rate risk depends on the form of exposure. Any restructuring of
operations that can reduce the difference between a foreign currency’s inflows
and outflows can consistently reduce the firm’s economic exposure to that
currency’s movements over several future quarters. (Exhibit 12.5)
Jeff Madura, International Financial Management, 14th Edition. © 2021 Cengage. All Rights Reserved. May not be scanned,
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Exhibit 12.1 How Managing Exposure Can Increase
an MNC’s Value
Jeff Madura, International Financial Management, 14th Edition. © 2021 Cengage. All Rights Reserved. May not be scanned,
copied or duplicated, or posted to a publicly accessible website, in whole or in part.
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Exhibit 12.2 Original Impact of Possible Exchange
Rates on Cash Flows of Madison Co. (in Millions)
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copied or duplicated, or posted to a publicly accessible website, in whole or in part.
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Exhibit 12.3 Impact of Possible Exchange Rate Movements
on Earnings under Two Alternative Operational Structures
(in Millions)
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copied or duplicated, or posted to a publicly accessible website, in whole or in part.
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Exhibit 12.4 Economic Exposure Based on the
Original and Proposed Operating Structures
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copied or duplicated, or posted to a publicly accessible website, in whole or in part.
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Exhibit 12.5 Restructuring Operations to Balance the Impact
of Currency Movements on Cash Inflows and Outflows
TYPE OF
OPERATION
RECOMMENDED ACTION WHEN
A FOREIGN CURRENCY HAS A
GREATER IMPACT ON CASH
INFLOWS
Sales in foreign
currency units
Consider pricing foreign sales in the
MNC's local currency.
Increase foreign sales.
Reliance on foreign
supplies
Increase foreign supply orders.
Reduce foreign supply orders.
Proportion of debt
structure
representing foreign
debt
Restructure debt to increase debt
payments in foreign currency.
Restructure debt to reduce debt payments
in foreign currency.
RECOMMENDED ACTION WHEN A
FOREIGN CURRENCY HAS A GREATER
IMPACT ON CASH OUTFLOWS
Jeff Madura, International Financial Management, 14th Edition. © 2021 Cengage. All Rights Reserved. May not be scanned,
copied or duplicated, or posted to a publicly accessible website, in whole or in part.
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Managing Economic Exposure (3 of 3)
Limitations of Restructuring Intended to Reduce Economic Exposure
• MNCs may desire to reduce their economic exposure to exchange rate
movements, their decisions should focus on maximizing their value. And to
reduce their economic exposure, they could potentially reduce their foreign
sales, but that would also reduce their cash flows.
• Movement of production facilities to foreign countries could prevent an MNC
from fully capitalizing on economies of scale.
Jeff Madura, International Financial Management, 14th Edition. © 2021 Cengage. All Rights Reserved. May not be scanned,
copied or duplicated, or posted to a publicly accessible website, in whole or in part.
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A Case on Hedging Economic Exposure (1 of 3)
Savor Co.’s Assessment of Economic Exposure
U.S. firm with exposure to the euro
• Process Used to Detect Economic Exposure
o Since the exact nature of its economic exposure to the euro is unknown, Savor
attempts to assess the relationship between the euro’s movements and each
unit’s cash flows over the last nine quarters.
o The quarterly cash flows and movements in the euro are shown in Exhibit 12.6
o Savor applies regression analysis to determine whether the quarterly percentage
change in its total cash flow is related to the quarterly percentage change in the
euro’s value over time:
PCFt  a0  a1  PCE   t
Jeff Madura, International Financial Management, 14th Edition. © 2021 Cengage. All Rights Reserved. May not be scanned,
copied or duplicated, or posted to a publicly accessible website, in whole or in part.
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Exhibit 12.6 Assessment of Savor Co.’s Cash Flows and
the Euro’s Movements
(1)
(2)
(3)
(4)
(5)
(6)
QUARTER
% CHANGE IN
UNIT A'S CASH
FLOWS
% CHANGE IN
UNIT B'S CASH
FLOWS
% CHANGE IN
UNIT C'S CASH
FLOWS
% CHANGE IN
TOTAL CASH
FLOWS
% CHANGE IN
VALUE OF THE
EURO
1
−3
2
1
0
2
2
0
1
3
4
5
3
6
−6
−1
−1
−3
4
−1
1
−1
−1
0
5
−4
0
−1
−5
−2
6
−1
−2
−2
−5
−5
7
1
−3
3
1
4
8
−3
2
1
0
2
9
4
−1
0
3
−4
Jeff Madura, International Financial Management, 14th Edition. © 2021 Cengage. All Rights Reserved. May not be scanned,
copied or duplicated, or posted to a publicly accessible website, in whole or in part.
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A Case on Hedging Economic Exposure (2 of 3)
Savor Co.’s Assessment of Economic Exposure (Continued)
• Assessment of Each Unit’s Exposure
o Savor Co. wants to determine whether and how each of its business units is
subject to movements in the euro, so that it can then consider how it might
reduce that exposure.
o Results suggest that the cash flows of Units A and B are not subject to economic
exposure. However, Unit C is subject to economic exposure.
Jeff Madura, International Financial Management, 14th Edition. © 2021 Cengage. All Rights Reserved. May not be scanned,
copied or duplicated, or posted to a publicly accessible website, in whole or in part.
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A Case on Hedging Economic Exposure (3 of 3)
Using a Financing Strategy to Hedge Economic Exposure
• Savor’s Unit C partially hedge its economic exposure by financing a portion
of its business with loans in euros rather than in dollars.
• If the euro weakens, Unit C will need fewer dollars to cover the loan
repayments. This favorable effect can partially offset the adverse effect of a
weak euro on the unit’s revenue.
• If the euro strengthens, Unit C will need more dollars to cover the loan
repayments, but this adverse effect will be offset by the favorable effect of the
strong euro on the unit’s revenue.
Jeff Madura, International Financial Management, 14th Edition. © 2021 Cengage. All Rights Reserved. May not be scanned,
copied or duplicated, or posted to a publicly accessible website, in whole or in part.
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Managing Exposure to Fixed Assets
Hedging the sale of fixed assets by:
• Selling the currency forward in long-term forward contract
• Creating a liability in that currency that matches the expected value of the
assets in the future.
Limitations of hedging the sale of fixed assets:
• MNC may not know the date when it will sell the assets.
• MNC may not know the price in the local currency at which it will sell them.
Jeff Madura, International Financial Management, 14th Edition. © 2021 Cengage. All Rights Reserved. May not be scanned,
copied or duplicated, or posted to a publicly accessible website, in whole or in part.
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Managing Translation Exposure (1 of 2)
Translation exposure occurs when each subsidiary’s financial data is translated
to its home currency for consolidated financial statements.
Hedging Translation Exposure with Forward Contracts
• Translation exposure can be hedged with forward or futures contracts.
Jeff Madura, International Financial Management, 14th Edition. © 2021 Cengage. All Rights Reserved. May not be scanned,
copied or duplicated, or posted to a publicly accessible website, in whole or in part.
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Managing Translation Exposure (2 of 2)
Limitations of hedging translation exposure:
• Inaccurate earnings forecasts — Earnings in a future period are uncertain.
• Inadequate forward contracts for some currencies — Forward contracts
are not available for all currencies.
• Accounting distortions — The forward rate gain or loss reflects the
difference between the forward rate and the future spot rate, whereas the
translation gain or loss is caused by the change in the average exchange
rate over the period in which the earnings are generated.
• Increased transaction exposure — The MNC may be increasing its
transaction exposure.
Jeff Madura, International Financial Management, 14th Edition. © 2021 Cengage. All Rights Reserved. May not be scanned,
copied or duplicated, or posted to a publicly accessible website, in whole or in part.
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Summary (1 of 2)
• Economic exposure can be managed by balancing the sensitivity of revenue
and expenses to exchange rate fluctuations. To accomplish this, however,
the firm must first recognize how its revenue and expenses are affected by
exchange rate fluctuations. For some firms, revenue is more susceptible.
These firms are most concerned that their home currency will appreciate
against foreign currencies since the unfavorable effects on revenue will more
than offset the favorable effects on expenses. Conversely, firms whose
expenses are more sensitive to exchange rates than their revenue are most
concerned that their home currency will depreciate against foreign
currencies. When firms reduce their economic exposure, they reduce not
only these unfavorable effects but also the favorable effects if the home
currency value moves in the opposite direction.
Jeff Madura, International Financial Management, 14th Edition. © 2021 Cengage. All Rights Reserved. May not be scanned,
copied or duplicated, or posted to a publicly accessible website, in whole or in part.
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Summary (2 of 2)
• Translation exposure can be reduced by selling forward the foreign currency
used to measure a subsidiary’s income. If the foreign currency depreciates
against the home currency, the adverse impact on the consolidated income
statement can be offset by the gain on the forward sale in that currency. If the
foreign currency appreciates over the time period of concern, there will be a
loss on the forward sale that is offset by a favorable effect on the reported
consolidated earnings. However, many MNCs would not be satisfied with a
“paper gain” that offsets a “cash loss.”
Jeff Madura, International Financial Management, 14th Edition. © 2021 Cengage. All Rights Reserved. May not be scanned,
copied or duplicated, or posted to a publicly accessible website, in whole or in part.
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