EXCHANGE RATE
EXPOSURES
WHAT WILL WE STUDY?
• Three types of exchange rate exposures
• Translation exposure
• Transaction exposure
• Operating exposure
• How to measure exposures
WHAT IS EXCHANGE RATE
EXPOSURE?
• Changes in the value of assets / liabilities or cash
flows resulting from exchange rate changes
WHY DO WE CARE ABOUT
EXPOSURES?
• Logical step before hedging
• The next topic
• We need to know what the risks are before we can
decide whether and how to hedge them
• Exposures represent the various types of exchange rate
risks faced by the firm
THREE TYPES OF EXPOSURES:
TRANSLATION EXPOSURE
• Adjustments to the balance sheet due to exchange
rate changes
• Driven by foreign currency assets and liabilities
• Occurs due to changes in the nominal exchange
rate since the last balance sheet date
THREE TYPES OF EXPOSURES:
TRANSACTION EXPOSURE
• Changes in the value of outstanding nominal
financial obligations
• Occurs due to unexpected changes in the nominal
exchange rate between the date the contract is
struck and the date it is settled
THREE TYPES OF EXPOSURES:
OPERATING EXPOSURE
• Changes in operating cash flows from future
transactions
• Occurs due to unexpected changes in the real
exchange rate
ECONOMIC EXPOSURE
• Refers to the cash flow effects of exchange rate
changes
• Only arises because of transaction or operating
exposures
• Translation exposure does not directly affect cash
flows
TRANSLATION EXPOSURE
• Accounting-based changes in owner’s equity
• It results from translation of foreign currency
financial statements
• E.g. consolidation of the balance sheet of foreign
subsidiary with the balance sheet of parent
• It does not directly affect cash flows
• May do so indirectly through bonuses or bond
agreements
TRANSLATION EXPOSURE
• A Canadian firm owns a British subsidiary with a
value of £100m
• The value of the sub is not affected by S($/£)
• If the £ appreciates from $2.50 to $2.65, the parent
will record an accounting gain of $15m
• Note that this change has no cash flow effects
• Firms find such fluctuations in value undesirable
• Solution Always translate assets at historical
exchange rates, but that has its own issues
TRANSLATION EXPOSURE
• Two common methods of translating accounting
statements
• Temporal rate method
• Current rate method
• The current rate method has superseded the
temporal method in many countries
• Neither is perfect so both methods exist
TEMPORAL RATE METHOD
• Assets and liabilities are translated using the
exchange rate matching the timing of the accounting
measurement
• Historical cost items are translated at historical exchange
rates, current cost items at the current exchange rate
• Evaluation/Problems
• Different conversion rates distort financial ratios
• Historical costs do not provide an accurate index of
economic performance
⇒ Not good for international performance evaluation
TEMPORAL RATE METHOD:
EXAMPLE
• The Canadian parent invests £100,000 in its British
sub
• The sub buys inventory for £50,000 in two stages
• The exchange rate is $2.50/£ at the time of the initial
investment and the first inventory purchase, and
$2.65/£ at the time of the second inventory purchase
TEMPORAL RATE METHOD:
EXAMPLE
Initial investment
Translation effects
£ value S($/£) $ value
£ value S($/£) $ value
Cash 100,000 2.5 250,000 Inventory (t=1 50,000 2.5 125,000
Equity 100,000 2.5 250,000 Inventory (t=2 50,000 2.65 132,500
100,000 2.5 250,000
Equity
• Dollar assets exceed dollar liabilities by $7,500
• This is recorded on the income statement as a credit
• It increases volatility in the income statement
CURRENT RATE METHOD
• Assets and liabilities are translated using the
current exchange rate
• Like the foreign currency balance sheet, the translated
balance sheet will also balance ⇒ volatility in the income
statement is eliminated
• Evaluation/Problems
• If PPP holds, prices should adjust with exchange rates ⇒
the current rate method accurately measures value
• But it is problematic to convert historical values on the
balance sheet at current rates ⇒ it is hard to interpret the
results after translation
CURRENT RATE METHOD:
EXAMPLE
• A Canadian company invests £100,000 in British real
estate, when S($/£) = 2.50
• Ten years later, British inflation has raised the price
of the property to £150,000
• Under PPP, the £ should have ↓ to S($/£) = 1.667,
assuming inflation in Canada is 0%
CURRENT RATE METHOD:
EXAMPLE
CURRENT RATE METHOD
• Accounting loss = $83,300
• But nothing has changed in real terms
•
£150,000 × 1.667 = $250,000, as before
• Had the land been converted at its current value,
things would have been fine
• Or if the historical exchange rate had been used in
conversion
• The problems with the current rate and temporal
rate methods cannot be simultaneously resolved
TRANSACTION EXPOSURE
• Arises when a contract is struck in foreign currency
terms
• Since the foreign currency payment is fixed in
nominal terms, the home currency value of the
payment depends on the exchange rate
TRANSACTION EXPOSURE:
EXAMPLE
• A Canadian firm sells a computer system to a British
customer
• The price is £80,000 and the payment is due in 90
days
• At the current spot rate S($/£) = 2.50, the receivable
is worth $200,000 (ignoring the time value of money)
• If, 90 days from now
• S($/£) = 2.20, the firm receives $176,000
• S($/£) = 2.70, the firm receives $216,000
TRANSACTION EXPOSURE:
EXAMPLE
• The company does not have to accept foreign
currency payments
• However, insisting on $ payments merely shifts the
transaction exposure to the British firm
• If you hold foreign currency assets, you gain (lose)
from ↑ (↓) of foreign currency
• If you hold foreign currency liabilities, you gain (lose)
from ↓ (↑) of foreign currency
TRANSACTION EXPOSURE:
EXAMPLE
• Unexpected changes in the nominal exchange rate
determine the amount of transaction exposure
• Expected receipts / payments are capitalized into
firm value
• In the example, assuming the exchange rate follows
a random walk, $200,000 is the expected value of
the receivable
TRANSACTION EXPOSURE:
EXAMPLE
• Transaction exposure =
80,000 × {St+90($/£)-Et[St+90($/£)]}
• By contrast, the total change in the exchange rate is
relevant in the case of translation exposure
OPERATING EXPOSURE
• Reflects the effect of the real exchange rate on
future cash flows
• Implies changes in competitiveness
• If the nominal exchange rate changes but prices
adjust to maintain PPP, there should be no effects
on firm revenues or costs, or on cash flows
25
OPERATING EXPOSURE
• This is much more important than translation or
transaction exposure
• It affects all future cash flows vs. a single year’s assets or
liabilities or a single transaction
• But it is also harder to estimate
• It involves assessing the effects of exchange rate
changes on cash flows from future transactions
• Look at the previous slide
• Operating exposure is closely related to the nature
of the firm’s activities and the structure of its
market, and to the idea of passthrough (see below)
OPERATING EXPOSURE
• Think of firms as having an economic position in
foreign currency (FC)
• Some firms are long FC
• Their receipts are denominated in FC or linked to the FC
price
⇒ They gain from FC appreciation
OPERATING EXPOSURE
• Other firms are short FC
• Their payments are denominated in FC or linked to the
FC price
⇒ They gain from FC depreciation
• Many firms have both inflows and outflows in FC
• For them, the net position is important
OPERATING EXPOSURE:
PASSTHROUGH
• Passthrough is a measure of pricing behavior
• Why is this an issue?
• Because of imperfect competition
• Firms with international operations are large and have
market power
• But this market power is limited by other foreign and
domestic firms
• Imperfect competition ⇒ price is a decision variable
PASSTHROUGH (PT)
• 𝑃𝑃𝑃𝑃 =
% 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑖𝑖𝑖𝑖 𝐹𝐹𝐹𝐹 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝
% 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑖𝑖𝑖𝑖 𝑆𝑆($/𝐹𝐹𝐹𝐹)
or 𝑃𝑃𝑃𝑃 =
% 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑖𝑖𝑖𝑖 𝐹𝐹𝐹𝐹 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝
% 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑖𝑖𝑖𝑖 𝑆𝑆(𝐹𝐹𝐹𝐹/$)
• PT = % ∆ in FC price of a commodity divided by % ∆
in S($/FC)
• Reflects how the firm changes the price of its product in
response to an exchange rate change
• For small exchange rate changes, PT ≈ % ∆ in FC
price of a commodity divided by % ∆ in S(FC/$)
• We will switch between these definitions to keep PT
positive
VALUES OF PT
• Values of PT usually lie between 0 and 1
• Suppose
• S(£/$) = 1.00
• A Canadian exporter charges £10 for its product (= $10)
• Now S(£/$) changes to 1.20 (i.e. the $ ↑ by 20%)
• PT = 0 ⇒ no change in FC price
• The firm leaves £ price at 10 ⇒ receives $8.33
• This means that the firm is forced to absorb the effects of
the exchange rate change
• Likely due to competition in the UK
• Elasticity of demand (ηd) is high
VALUES OF PT
• PT = 1 ⇒ change in FC price = exchange rate
change = 20%
• The firm ↑ £ price to 12 ⇒ receives $10, as before
• The firm passes along the entire exchange rate change
to UK customers
• It is able to do so because of limited competition (low ηd)
• Its $ revenues are constant
• But it loses sales (due to the higher price in the UK)
PT: MARGIN VS. MARKET
SHARE FLUCTUATIONS
• PT = 0 ⇒ home currency (HC) profit margin
fluctuations
• Because the FC price never changes
• PT = 1 ⇒ a constant HC profit margin, but foreign
market share fluctuations
• Because the FC price always changes
• 0 < PT < 1 is an intermediate case
• The FC price changes but by less than the exchange
rate change
PT: MARGIN VS. MARKET
SHARE FLUCTUATIONS
• Strategic behavior
• Set PT = 0 when the HC appreciates and set PT = 1 when
the HC depreciates
• This is aggressive pricing, and is an attempt to maximize
market share
• e.g. Japanese firms in 1980s
• Passive pricing ⇒ always set PT = 1
• This leads to fixed HC prices
• e.g. US firms before the mid-1980s
THE COMPETITIVE EFFECTS
OF PT: EXAMPLE 1
• Consider two firms producing the same good in the UK and
Canada
• Assume that export prices are determined in the local market
• Initially, S(£/$) = 2.00
Cost of production
Price at home
Price of exports
Canada
$5
$10
£20 = $10
UK
£10
£20
$10 = £20
Profit margins:
Domestic sales
Exports
$5
$5
£10
£10
PT EXAMPLE 1
• Suppose S(£/$) goes to 1.00 and PT for exports = 0
Cost of production
Price at home
Price of exports
Canada
$5
$10
£20 = $20
UK
£10
£20
$10 = £10
Profit margins:
Domestic sales
Exports
$5
$15
£10
£0
• The UK firm breaks even on exports, while the Canadian
firm’s profit on exports triples
THE COMPETITIVE EFFECTS
OF PT: EXAMPLE 2
• Consider the same two firms in the UK and Canada
• But the Canadian firm sells only in Canada and uses
Canadian inputs
• The initial S(£/$) = 2.00
Cost of production
Price at home
Price of exports
Profit margins:
Domestic sales
Exports
Canada
$5
$10
UK
£10
£20
$10 = £20
$5
£10
£10
PT EXAMPLE 2
• Now, S(£/$) goes to 2.50
• Assume that the UK firm has PT = 1 ⇒ sells exports for $8
Canada
UK
Cost of production
$5
£10
Price at home
$8
£20
Price of exports
$8 = £20
Profit margins:
Domestic sales
Exports
$3
£10
£10 = $4
• Thus, due to foreign competition at home, a firm without
international operations can have exchange rate exposures
PT EXAMPLE 3
• The case of imported inputs
• Consider the same firms, but with different cost
structures
• Assume S(£/$) = 2.00
PT EXAMPLE 3
Cost of production
Local
Imported inputs
Price at home
Price of exports
Canada
$5
$3
£4 = $2
$10
£20 = $10
UK
£10
£6
$2 = £4
£20
$10 = £20
Profit margins:
Domestic sales
Exports
$5
$5
£10
£10
PT EXAMPLE 3
• Suppose S(£/$) goes to 2.50
• Assume that PT = 0 for outputs and = 1 for inputs
Canada
UK
Cost of production
$4.6
£11
Local
$3
£6
Imported inputs
£4 = $1.6
$2 = £5
Price at home
$10
£20
Price of exports
£20 = $8
$10 = £25
Profit margins:
Domestic sales
Exports
$5.4
$3.4
£9
£14
PT EXAMPLE 3
• The UK firm’s profits on exports ↑ while its profits on
domestic sales ↓
• The Canadian firm’s profits on exports ↓ while its
profits on domestic sales ↑
• The net effect for each firm is determined by the
fraction of its total sales accounted for by exports
PT EXAMPLE 4
• Exchange rate exposures can exist through
subsidiaries
• The sub can have economic exposures, as in the
above examples
• Even if the sub does not have any exchange rate
exposures, there still is translation exposure
SUMMARY OF OPERATING
EXPOSURES
Effects of a home currency appreciation
Firm type
Exporter
Importer
Import competitor
Foreign producer
Profit Margin
–
+
–
+
SUMMARY OF OPERATING
EXPOSURES
Effects of a home currency appreciation
•
•
•
•
Exporters are hurt because they face either lower HC
revenues at constant FC prices or lower sales at higher FC
prices
Importers benefit because they face lower HC costs and / or
higher sales (assuming payments are in FC)
Import competitors are hurt because imports become
cheaper
Foreign producers benefit because they sell imports which
are cheaper
MEASURING EXCHANGE RATE
EXPOSURES
• Two methods of quantifying exchange rate
exposures
• Flow measures
• Stock measures
FLOW MEASURES
• Find the exposures of the different parts of the firm
and add them up
• This is a logical way of proceeding
• Focuses on where the firm's exposures come from
• Problems
• It becomes difficult for large firms
• Measuring operating exposure relies on subjective
assessments
STOCK MEASURES: RISK
• Risk is measured by stock price or earnings or
cash flow variability:
Risk = Var(Pt ) or Var(Et ) or Var(CFt )
• Logic: variability = uncertainty
• Here
• Var means variance
• Pt is stock price, Et is earnings, CFt is cash flow
STOCK MEASURES OF
EXPOSURE
• Regress the stock return for the firm on the
percentage change in the spot rate, S(HC/FC)
ΔSt
+ εt
Rt =
α+γ
St −1
• Rt = (Pt-Pt-1)/Pt-1 = ∆Pt/Pt-1
• You could run the regression in terms of differences,
rather than % differences
• In fact, the regression with differences yields the
theoretically correct measure of the exchange rate
exposure
THE LOGIC BEHIND THIS
APPROACH
• Consider a firm that exports to the UK and uses
Japanese inputs who set a PT of 1
• P is affected by S($/£), S($/¥)
• Say, good news arrives about the £
⇒ The £ should appreciate now
• The appreciation of the £ should increase the firm’s
expected UK cash flows ⇒ P should increase now
• So ∆P and ∆S($/£) should be positively associated
⇒ ∆S($/£) > 0 → ∆P > 0
THE LOGIC BEHIND THIS
APPROACH
• If the ¥ appreciates, expected costs should rise and
cash flows fall, so ∆P and ∆S($/¥) should be negatively
associated
⇒ ∆S($/¥) > 0 → ∆P < 0
• The regression model uncovers these associations
• This approach assumes that markets are efficient
⇒ The market forms unbiased expectations about the
implications of news for S($/£) or S($/¥) and for P, and the
arrival of news leads to changes in each variable
• ∆S($/£), ∆S($/¥) and ∆P are the variables to study (as in
our earlier random walk discussion)
STOCK MEASURES: EXCHANGE
RATE RISK
• Exchange rate risk is measured by the stock return
variation due to exchange rate changes
2
ˆ
FX _ Risk = Var(Rt ) = γ Var (∆St / St −1 )
• 𝑅𝑅�𝑡𝑡 means that it is the predicted value from the
regression
STOCK MEASURES: EXCHANGE
RATE RISK
• The regression R2 measures the fraction of stock
return variation due to exchange rate variation
2
ˆ
Var(R
)
γ
Var (∆St / St −1 )
2
t
R =
=
Var(Rt )
Var(Rt )
• The closely related concept of adjusted R2 is a
better measure to use since it imposes a penalty for
insignificant factors
• Treat a negative adjusted R2 as an R2 of zero ⇒ the
factors add nothing in terms of explanatory power
REGRESSION: WHAT TO LOOK
FOR
• The exposure coefficient γ
• Tells us the size of the exposure
• The significance of γ (t-stat or p-value)
• If the t-stat is small (less than 2 in abs value) γ = 0
•
Statistically speaking, we don’t need to worry about the
exchange rate exposure in this case
• Nevertheless, it probably is a good idea to consider
hedging if γ is large, even if it is not statistically
significant
REGRESSION: WHAT ELSE
TO LOOK FOR
• The regression R2
• The fraction of stock return variability explained by
currency variability
• Indicates the extent to which the stock return is
explained by the exchange rate
• If the R2 is small, the exchange rate has limited
explanatory power
⇒ hedging cannot materially ↓ return variability, i.e. risk
THE BOTTOM LINE RE. THE
HEDGING DECISION
• We should be concerned about hedging exposures
with large and significant γ and large R2
• The hedge ratio = -γ
• This is the amount of foreign currency needed to offset
the effects of exchange rate variations
• The hedge ratio can be positive or negative, depending
on the nature of the firm’s activities (which are reflected
in γ)
HOW DO WE QUANTIFY RISKS?
• We combine the estimate of γ and plausible
changes in the spot rate to determine changes in the
stock price that could realistically occur due to the
spot rate
• The next figure shows the distribution of daily returns
in the $-USD spot market
• The spot rate is S($/USD)
THE DISTRIBUTION OF DAILY
S($/USD) RETURNS, 1971-2019
Tail risk
6 sigma bounds are roughly ±0.0234
Tail risk
HOW DO WE QUANTIFY RISKS?
• Multiply a spot rate change you are concerned about
by γ to get a ‘bad’ outcome change in the stock
price
• E.g. a large depreciation of the USD if you are an
exporter to the US
• If the effect on the stock price is large you might
want to hedge even if γ is not significant
REGRESSION: MODIFICATIONS
• Want to include more than one risk factor?
• Run a multiple regression
Rt =
α + β Rm ,t + γ1
ΔS1,t
S1,t −1
+ γ2
ΔS 2,t
S 2,t −1
+ γ3
ΔPOil ,t
POil ,t −1
+ εt
• Here, there are risks due to two exchange rates, oil
prices and the market factor
• Before proceeding, you should examine correlations
among the independent variables (collinearity)
REGRESSION: MODIFICATIONS
• Want to estimate operating exposure?
• Re-estimate the above model using real exchange
rates
Rt =
α + β Rm ,t + γ1
ΔS 1,Real
t
Real
S 1,t −1
+ γ2
ΔS 2,Real
t
Real
S 2,t
+ εt
• Remember, however, that hedging instruments
typically are based on nominal, and not real,
exchange rates
REGRESSION: MODIFICATIONS
• Want to estimate earnings/cash flow effects?
• Re-estimate the model using the change in
earnings or cash flows as the dependent variable
ΔEt
ΔSt
=
+ εt
α+γ
Et −1
St −1
ΔCFt
ΔSt
=
+ εt
α+γ
CFt −1
St −1
• Concerns
• Fewer observations create statistical problems
• Poor quality data: Accounting data can be manipulated
• Permanent effects are better captured by stock prices
HOW TO HEDGE USING STOCK
MEASURES
• Suppose γ = 0.1
• There is only one exchange rate in the regression
• This means, that for every 1% change in the
exchange rate, firm value ↑ by 0.1%
• To hedge this exposure, the firm should take a
short position in FX
• Sell FX in an amount equal to 10% of the value of the
firm
• We will discuss this as part of hedging
STOCK MEASURES:
ADVANTAGES & LIMITATIONS
• Advantages
• Simple
• No assumptions or guesses about coefficient values
• Disadvantages
• The regressions usually are estimated using historical
data (and the relation may have changed if the firm’s
operations have changed)
• Assumes an efficient market (if using stock prices)
• The exposure coefficient often is statistically insignificant
THE BOTTOM LINE
• Think of flow and stock measures as complements
• Try to use both
EVIDENCE ON EXCHANGE
RATE EXPOSURES
• Exchange rate exposures are large for many firms
• Exposures should be getting larger with increasing
globalization
• As a result, hedging will become more important
• The next topic discusses hedging principles
MULTINATIONAL FIRM
EXPOSURES
• Multinationals receive an increasing fraction of their
revenues from overseas
• E.g. Apple 60% in 2023 vs 50% in 1997
• Toyota ⇒ a 1 ¥ ↑ in USD adds ¥ 34 bn (≈ USD 442
m) to profits
• Burberry ⇒ a 10% ↓ in the £ ↑ operating profits by
20%
• Approximately 15% of manufacturing costs and 40% of
operating expenses are in £, while the U.K. accounts for
only 10% of sales
CANADIAN MINING EXPOSURES
• Canadian mining ⇒ 1000 jobs were saved by the ↓
in loonie versus the USD
• Labor costs in $, revenues in USD
• E.g. gold price = USD 300 ⇒ if S($/USD) = 1.60, they were
selling gold for $480
• Even inefficient mines were able to stay open
JAPAN’S EXPOSURES
• The Nikkei and the ¥
have tracked each
other closely
• June 2013
• As the USD fell vs. the
¥, the Nikkei fell, too
• Japanese stocks are
heavily dependent on
the ¥
THE EXPOSURES OF
ARGENTINA’S WINE INDUSTRY
• When the peso was pegged to USD
• Argentine exports were expensive
• But wineries were able to buy new equipment and upgrade
production methods
• When the peso was devalued 3-1 in Dec 2001
• Wine exports became cheaper
• It attracted tourists who liked the wines
• Argentine wineries exported 16% of harvest in 2005
compared to < 1% in 1992
THE EFFECTS OF CHF
APPRECIATION (SOURCE: WSJ)
71
CHF APPRECIATION EFFECTS
• Jan 2015 The CHF-€ peg was abandoned
• The CHF appreciated by ≈ 9%
• Exports were down 3%, especially to the Eurozone
(7%)
• Tourism declined
• Firm profits dropped
• GDP growth slowed, unemployment rose
• Firms started to move jobs offshore
THE EFFECTS OF USD
DEPRECIATION (2017/08)
Source: WSJ, Thomson Reuters Datastream, FactSet
THE EFFECTS OF USD
APPRECIATION (2023/24)
• Q2 earnings are down 18% for foreign focused firms
but up 4% for domestically oriented firms
• Definition 50% of revenue outside the US
• Apple → Q2 revenues reduced by 4%
• UPS’ Q2 international revenue down 14%
READING AND PROBLEMS
• Reading
• Translation exposure: IFM, chapter 10
• This is for accountants interested in the details
• Transaction exposure: IFM, chapter 8
• Economic exposure: IFM, chapter 9
• Problems
• No problems for topic 4