Foreign Exchange Exposure
What is it and How it Affects the
Multinational Firm?
What is Foreign Exchange Exposure?
• Simply put, foreign exchange exposure is the
risk associated with activities that involve a
global firm in currencies other than its home
currency.
• Essentially, it is the risk that a foreign currency
may move in a direction which is financially
detrimental to the global firm.
• Given our observed potential for adverse
exchange rate movements, firms must:
– Assess and Manage their foreign exchange
exposures.
Does Foreign Exchange Exposure Matter?
What do Global Firms Say
• Nike: “Our international operations and sources of supply
are subject to the usual risks of doing business abroad,
such as possible revaluation of currencies…” (2005).
• Starbucks: “In fiscal 2004, international company revenue
[in US dollars] increased 32%, [in part] because of the
weakening U.S. dollar against both the Canadian dollar
and the British pound.” (2005).
• McDonalds: “In 2000, the weak euro, British pound and
Australian dollar had a negative impact upon reported
[US dollar] results.” (2000).
FX Exposure and the Valuation of a
MNC
 E CF$,t 
V  
t 
t 1  1  k  
n
• where E(CF$,t) represents expected cash flows to be
received at the end of period t,
• n represents the number of periods into the future in which
cash flows are received, and
• k represents the required rate of return by investors.
4
Impact of Foreign Exchange Exposure


E CF$,t    E CFj ,t  E S j ,t 
m
j 1
• where CFj,t represents the amount of cash flow denominated in a
particular foreign currency j at the end of period t,
• Sj,t represents the exchange rate at which the foreign currency
(measured in dollars per unit of the foreign currency) can be
converted to dollars at the end of period t.
5
Global Companies and FX Exposure
• What are the specific risks to a global firm from
foreign exchange exposure?
– Cash inflows and outflows, as measured in home
currency equivalents, associated with foreign operations
can be adversely affected.
• Revenues (profits) and Costs
– Settlement value of foreign currency denominated
contracts, in home currency equivalents, can be
adversely affected.
• For Example: Loans in foreign currencies.
– The global competitive position of the firm can be
affected by adverse changes in exchange rates.
• Influence on required return.
– End Result: The value (market price) of the firm can be
adversely affected.
Types of Foreign Exchange Exposure
• There are three distinct types of foreign exchange
exposures that global firms may face as a result of their
international activities.
• These foreign exchange exposures are:
– Transaction exposure
• Any MNC engaged in current transactions involving foreign
currencies.
– Economic exposure
• Results for future and unknown transactions in foreign currencies
resulting from a MNC long term involvement in a particular
market.
– Translation exposure (sometimes called “accounting”
exposure).
• Important for MNCs with a physical presence in a foreign country.
• We will develop each of these in the slides which
follow.
Transaction Exposure
• Transaction Exposure: Results from a firm
taking on “fixed” cash flow foreign currency
denominated contractual agreements.
– Examples of translation exposure:
• An Account Receivable denominate in a foreign
currency.
• A maturing financial asset (e.g., a bond) denominated
in a foreign currency.
• An Account Payable denominate in a foreign currency.
• A maturing financial liability (e.g., a loan) denominated
in a foreign currency.
Economic Exposure
• Economic Exposure: Results from the “physical” entry
(and on-going presence) of a global firm into a foreign
market.
– This is a long term foreign exchange exposure resulting from a
previous FDI location decision.
• Over time, the firm will acquire foreign currency
denominated assets and liabilities in the foreign
country.
• The firm will also have operating income and operating
costs in the foreign country.
– Economic exposure impacts the firm through contracts and
transactions which have yet to occur, but will, in the future,
because of the firm’s location.
• These are really “future” transaction exposures which
are unknown today.
– Economic exposure can have profound impacts on a global firm’s
competitive position and on the market value of that firm.
The Two Channels of Economic Exposure
Foreign currency
denominated asset
& liability exposure
Exchange
Rate
Fluctuations
Operating exposure
(Revenues and Costs)
Impact on the home
currency value of
foreign assets and
liabilities
MNC’s
Competitive
Position and Value
Impact on home
currency amount of
future operating
cash flows
Translation Exposure
• Translation Exposure: Results from the need of
a global firm to consolidated its financial
statements to include results from foreign
operations.
– Consolidation involves “translating” subsidiary
financial statements from local currencies (in the
foreign markets where the firm is located) to the
home currency of the firm (i.e., the parent).
– Consolidation can result in either translation gains
or translation losses.
• These are essentially the accounting system’s attempt
to measure foreign exchange “ex post” exposure.
Assessing Foreign Exchange Exposure
• All global firms are faced with the need to analyze their
foreign exchange exposures.
– In some cases, the analysis of foreign exchange exposure is
fairly straight forward and known.
– For example: Transaction exposure.
• There is a fixed (and thus known) contractual obligation
(in some foreign currency) .
– While in other cases, the analysis of the foreign exchange
exposure is complex and less certain.
– For example: Economic exposure
• There is great uncertainty as to what the firm’s
exposures will look like over the long term.
– Specifically when they will take place and what the
amounts will be.
Using a Hedge to Deal with Exposures
• In using a hedge, a firm establishes a situation opposite
to its initial foreign exchange exposure.
– A firm with a long position: i.e., it expects to receive
foreign currency in the future, will:
• Offset that position with a short position (i.e., a
payment in the future) in the same currency.
– A firm with a short position: i.e., it expects to pay foreign
currency in the future, will:
• Offset that position with a long position in the same
currency.
– In essence, the firm is “covering” (“offsetting”) the original
foreign exchange position.
• Since the firm has “two” opposite foreign exchange
positions, they will cancel each other out.
To Hedge or Not to Hedge?
• What are some of the factors that would influence a global
firm’s decision to hedge its exposures?
– Perhaps the firm’s assessment of the future strength or weakness
of the foreign currency it is exposed in.
• This involves forecasting and how comfortable the firm is with the
results of the forecast.
• For example; If the firm has a long position in what they think will be a
strong currency they may decide not to hedge, or do a partial hedge.
• Under these assumptions, a firm might accept an “open” position.
– On the other hand, firms may decide not have any currency
exposures and simply focus on their core business.
• Does Starbuck’s want to sell coffee overseas or “speculate” on
currency moves?
• Obviously, this is different from a company managing a hedge fund, or
a currency trading floor?
Hedging Strategies
• It appears that most MNC firms (except for those
involved in currency-trading) would prefer to hedge
their foreign exchange exposures.
• But, how can firms hedge?
– (1) Financial Contracts
• Forward contracts (also futures contracts)
• Options contracts (puts and calls)
• Borrowing or investing in local markets.
– (2) Operational Techniques
• Geographic diversification (spreading the risk)