Chapter 10
Measuring Exposure to
Exchange Rate Fluctuations
Cost and Management
International
Accounting:
FinancialAn
Management,
Introduction,
2nd7th
edition
edition
Jeff
Colin
Madura
Drury
and Roland Fox
ISBN 978-1-40803-213-9
ISBN 978-1-4080-3229-9
© 2011©Cengage
2011 Cengage
Learning
Learning
EMEAEMEA
Chapter Objectives
•
•
•
•
To discuss the relevance of an
MNC’s exposure to exchange rate risk.
To explain how transaction exposure can
be measured.
To explain how economic exposure can be
measured.
To explain how translation exposure can
be measured.
Cost and Management
International
Accounting:
FinancialAn
Management,
Introduction,
2nd7th
edition
edition
Jeff
Colin
Madura
Drury
and Roland Fox
ISBN 978-1-40803-213-9
ISBN 978-1-4080-3229-9
© 2011©Cengage
2011 Cengage
Learning
Learning
EMEAEMEA
Is Exchange Rate Risk
Relevant? (1)
Purchasing Power Parity Argument
 Exchange rate movements will be matched by price
movements.
 PPP does not necessarily hold.
The Investor Hedge Argument
 MNC shareholders can hedge against exchange rate
fluctuations on their own.
 The investors may not have complete information on
corporate exposure. They may not have the capabilities to
correctly insulate their individual exposure too.
Cost and Management
International
Accounting:
FinancialAn
Management,
Introduction,
2nd7th
edition
edition
Jeff
Colin
Madura
Drury
and Roland Fox
ISBN 978-1-40803-213-9
ISBN 978-1-4080-3229-9
© 2011©Cengage
2011 Cengage
Learning
Learning
EMEAEMEA
Is Exchange Rate Risk
Relevant? (2)
Currency Diversification Argument
 An MNC that is well diversified should not be affected
by exchange rate movements because of offsetting
effects.
 This is a naive presumption.
Stakeholder Diversification Argument
 Well diversified stakeholders will be somewhat
insulated against losses experienced by an MNC due
to exchange rate risk.
 MNCs may be affected in the same way because of
exchange rate risk.
Cost and Management
International
Accounting:
FinancialAn
Management,
Introduction,
2nd7th
edition
edition
Jeff
Colin
Madura
Drury
and Roland Fox
ISBN 978-1-40803-213-9
ISBN 978-1-4080-3229-9
© 2011©Cengage
2011 Cengage
Learning
Learning
EMEAEMEA
Is Exchange Rate Risk
Relevant? (3)
Response from MNCs
• Many MNCs have attempted to stabilize
their earnings with hedging strategies
because they believe exchange rate risk is
relevant.
Cost and Management
International
Accounting:
FinancialAn
Management,
Introduction,
2nd7th
edition
edition
Jeff
Colin
Madura
Drury
and Roland Fox
ISBN 978-1-40803-213-9
ISBN 978-1-4080-3229-9
© 2011©Cengage
2011 Cengage
Learning
Learning
EMEAEMEA
Is Exchange Rate Risk
Relevant?
Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
Types of Exposure
Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
Transaction Exposure
Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
Transaction Exposure
• The degree to which the value of future
cash transactions can be affected by
exchange rate fluctuations is referred to as
transaction exposure.
• To measure transaction exposure:
estimate the net cash inflows or outflows in
each currency, and
2. measure the potential impact of the exposure
to those currencies.
1.
Cost and Management
International
Accounting:
FinancialAn
Management,
Introduction,
2nd7th
edition
edition
Jeff
Colin
Madura
Drury
and Roland Fox
ISBN 978-1-40803-213-9
ISBN 978-1-4080-3229-9
© 2011©Cengage
2011 Cengage
Learning
Learning
EMEAEMEA
Estimating Net Currency Flows
• MNCs can usually anticipate foreign cash
flows for an upcoming short-term period
with reasonable accuracy.
• After the consolidated net currency flows for
the entire MNC has been determined, each
net flow is converted into a point estimate
(or range) of a chosen currency.
• The exposure for each currency can then
be assessed using the same measure.
Cost and Management
International
Accounting:
FinancialAn
Management,
Introduction,
2nd7th
edition
edition
Jeff
Colin
Madura
Drury
and Roland Fox
ISBN 978-1-40803-213-9
ISBN 978-1-4080-3229-9
© 2011©Cengage
2011 Cengage
Learning
Learning
EMEAEMEA
Youth PLC
Currency
Euros
Swiss Franc
Yen
US dollar
Total inflow Total outflow Net flow Expected rate Expected flow in £
17 000 000
7 000 000 10 000 000
0,680
6 800 000
12 000 000
2 000 000 10 000 000
0,440
4 400 000
200 000 000 900 000 000 -700 000 000
0,005
-3 500 000
10 000 000
7 000 000
3 000 000
0,550
1 650 000
Currency
Euros
Swiss Franc
Yen
US dollar
Total inflow Total outflow Net flow Expected rate Expected flow in £
17 000 000
7 000 000 10 000 000
0,650
6 500 000
12 000 000
2 000 000 10 000 000
0,400
4 000 000
200 000 000 900 000 000 -700 000 000
0,004
-2 800 000
10 000 000
7 000 000
3 000 000
0,520
1 560 000
Currency
Euros
Swiss Franc
Yen
US dollar
Total inflow Total outflow Net flow Expected rate Expected flow in £
17 000 000
7 000 000 10 000 000
0,710
7 100 000
12 000 000
2 000 000 10 000 000
0,480
4 800 000
200 000 000 900 000 000 -700 000 000
0,006
-4 200 000
10 000 000
7 000 000
3 000 000
0,580
1 740 000
Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
Youth PLC
• It is assumed that the range represents
95 % confidence intervals
• Assuming normal distribution, 95 %
represents +/- 1.96 standard deviations
from the expected value
• Euro: Range = 600 000
• Standard deviation = £ 600 000/(2 * 1.96)
= £153 061
Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
Standard deviation
Expected value
Euros
6 800 000
Swiss Francs
4 400 000
Japanese yen
-3 500 000
USD
1 650 000
Range
Standard deviation
600 000
153 061
800 000
204 082
1 400 000
357 143
180 000
45 918
Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
Measuring the Potential
Impact (1)
• An MNC’s exposure can be measured
by considering the proportion of each
currency together with the currency’s
variability and the correlations among
the movements of the currencies.
• For a two-currency portfolio,
σ p  w   w   2w x w y x y CORRxy
2
x
2
x
2
y
2
y
Cost and Management
International
Accounting:
FinancialAn
Management,
Introduction,
2nd7th
edition
edition
Jeff
Colin
Madura
Drury
and Roland Fox
ISBN 978-1-40803-213-9
ISBN 978-1-4080-3229-9
© 2011©Cengage
2011 Cengage
Learning
Learning
EMEAEMEA
Measuring the Potential
Impact (2)
• The standard deviation statistic
measures currency variability.
• Correlation coefficients indicate the
degree to which two currencies move in
relation to each other.
Perfect positive correlation
No correlation
Perfect negative correlation
Coefficient
1.00
0.00
–1.00
• Both variability and correlations vary among currencies
and over time.
Cost and Management
International
Accounting:
FinancialAn
Management,
Introduction,
2nd7th
edition
edition
Jeff
Colin
Madura
Drury
and Roland Fox
ISBN 978-1-40803-213-9
ISBN 978-1-4080-3229-9
© 2011©Cengage
2011 Cengage
Learning
Learning
EMEAEMEA
Correlations
Euros
Euros
Swiss Franc
Japanese Yen
USD
Swiss Franc Japanese Yen
1
0,76
0,29
1
0,27
1
Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
USD
0,22
0,04
0,32
Variance/covariance
Euros Swiss Franc Japanese Yen
USD
Euros
Var (€) Cov (€/SF) Cov (€/JPY)
Cov (€/$)
Swiss Franc
Var (SF) Cov (SF/JPY)
Cov (SF/$)
Japanese Yen
Var (JPY)
Cov (JPY/$)
USD
Var ($)
Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
Overall risk faced by Youth plc
Currency
Euro
1,00
0,76
0,29
0,22
Euros
Swiss Francs
Japanese Yen
US dollars
Currency
Euros
Swiss Francs
Japanese Yen
US dollars
Expected CF
Total variance
Standard deviation
SD/Expected CF
1.96 sd up
1.96 sd down
Euro
23 427 738 442
23 740 108 288
-15 852 769 679
1 546 230 737
Swiss Franc
0,76
1,00
0,27
0,04
Yen
US dollar
0,29
0,27
1,00
0,32
0,22
0,04
0,32
1,00
Swiss Franc
Yen
23 740 108 288 -15 852 769 679
41 649 312 786 -19 679 300 292
-19 679 300 292 127 551 020 408
374 843 815 -5 247 813 411
US dollar
1 546 230 737
374 843 815
-5 247 813 411
2 108 496 460
9 350 000
164 499 167 014
405 585
4,34 %
10 144 947
8 555 053
Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
Impact of Cash Flow and Correlation Conditions
on an MNC’s Exposure
Expected Net Cash Flow
Currency x Currency y
MNC’s
Correlation between
Currencies x and y Exposure
+Q
+Q
Highly positive
High
+Q
+Q
Slightly positive
Moderate
+Q
–Q
Highly positive
Low
+Q
–Q
Slightly positive
Moderate
+Q
–Q
Negative
High
International Financial Management, 2nd edition
Jeff Madura and Roland Fox
ISBN 978-1-4080-3229-9 © 2011 Cengage Learning EMEA
Transaction Exposure
• A related method, the value-at-risk (VAR)
method, incorporates currency volatility
and correlations to determine the potential
maximum loss over a given time period
• Historical data is used to determine the
potential decline in a particular currency.
This decline is then applied to the net cash
flows in that currency.
Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
Value at Risk
• The basic approach to determining the value at
risk involves four elements:
– The amount of exposure (A)
– The volatility (σ) of the asset position
– A confidence limit α in terms of the number of standard
deviations, usually 1 – 2 standard deviations on a
normal distribution
– A time horizon over which decisions can be made about
the position (T). If T is less than a year, the volatility is
adjusted by square root of T
Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
Transaction Exposure
• For foreign currency x, the maximum oneday loss = E(ex ) – z[P]   x
E(ex) = expected % in x for the next day
z[P] = if u ~ N(0,1), Prob (u < z[P] ) = P
for 95% confidence level, z[.95] = 1.65
x
= standard deviation of the daily % in x
VaR  A      T
Cost and Management
International
Accounting:
FinancialAn
Management,
Introduction,
2nd7th
edition
edition
Jeff
Colin
Madura
Drury
and Roland Fox
ISBN 978-1-40803-213-9
ISBN 978-1-4080-3229-9
© 2011©Cengage
2011 Cengage
Learning
Learning
EMEAEMEA
VaR – example
• Celia Company will receive 10 000 000
Norwegian Krone (NOK) tomorrow
• Current spot rate = £0.09/NOK
• Daily standard deviation of the NOK: 1.2 %
• Alpha: 1.65 standard deviations (95 %)
VaR  10 000 000  0,09  0,012  1,65  17 820
or 17 820/900 000  1,98 %
Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
Value at Risk
Amount in
Exchange Pound
foreign currency rate
equivalent
30 000 000
1,4 21 428 571
72 000 000
1,6 45 000 000
Currency
Euro
Dollar
Volatility Euro (year)
Volatility Dollar (year)
Confidence limit
Time horizon (months)
VaR Euro
VaR Dollar
0,15
0,20
1,95
1
1 809 375
5 066 249
Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
Value at Risk
• What is the portfolio risk?
• We need the correlation coefficient
between the two assets:
 €,$  VaR(€ / £)2  VaR($ / £)2  2   VaR(€ / £)VaR($ / £)
Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
Value at Risk - portfolio
Amount in
Exchange
Pound
foreign currency rate
equivalent
30 000 000
1,4 21 428 571
72 000 000
1,6 45 000 000
Currency
Euro
Dollar
Volatility Euro
Volatility Dollar
Confidence limit
Time horizon (months)
VaR Euro
VaR Dollar
Correlation
Var portfolio
0,15
0,20
1,95
1
1 809 375
5 066 249
0,6
6 319 873
Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
VaR – example 2
Rupiah
Baht
SD Rupiah month
SD Bath month
Correlation
Alpha
VaR Rupiah
Var Baht
Var Portfolio
600 000
400 000
7%
8%
0,5
1,65
69 300
52 800
106 063
Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
11,55 %
13,20 %
10,61 %
Economic Exposure
• Economic exposure refers to the degree to
which a firm’s present value of future cash
flows can be influenced by exchange rate
fluctuations.
• Some of these affected cash flows do not
require currency conversion.
• Even a purely domestic firm may be
affected by economic exposure if it faces
foreign competition in its local markets.
Cost and Management
International
Accounting:
FinancialAn
Management,
Introduction,
2nd7th
edition
edition
Jeff
Colin
Madura
Drury
and Roland Fox
ISBN 978-1-40803-213-9
ISBN 978-1-4080-3229-9
© 2011©Cengage
2011 Cengage
Learning
Learning
EMEAEMEA
Example – Mannerton plc
• Mannerton plc sells to the UK and Europe
– A strong € increases UK sales somewhat due
to increased competitiveness
– European sales are assumed to be constant
at €40 and European costs are much higher
(about € 200)
• Mannerton therefore lose money if the €
appreciates
Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
Impact of exchange rate movements
Euro exc. rate
UK sales (£)
European sales (€ 40)
Total sales
Scenario 1 Scenario 2 Scenario 3
0,6
0,7
0,8
300,00
304,00
307,00
24,00
28,00
32,00
324,00
332,00
339,00
Cost of goods sold:
UK costs
European Costs
Total costs
50,00
120,00
170,00
50,62
141,73
192,35
51,08
163,46
214,54
Gross profit
154,00
139,65
124,46
Operating expenses:
UK fixed costs
UK variable costs
Total
30,00
30,72
60,72
30,00
31,10
61,10
30,00
31,38
61,38
EBIT
93,28
78,56
63,08
Interest expense:
UK interest
European interest (10 m €)
Total
3,00
6,00
9,00
3,00
7,00
10,00
3,00
8,00
11,00
Earnings before taxes (EBT)
84,28
68,56
52,08
Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
Economic Exposure
• Economic exposure can be measured by
assessing the sensitivity of the firm’s
earnings to exchange rates.
– This involves reviewing how the earnings
forecast in the firm’s income statement changes
in response to alternative exchange rate
scenarios.
• In general, firms with more foreign costs
than revenues tend to be unfavorably
affected by stronger foreign currencies.
Cost and Management
International
Accounting:
FinancialAn
Management,
Introduction,
2nd7th
edition
edition
Jeff
Colin
Madura
Drury
and Roland Fox
ISBN 978-1-40803-213-9
ISBN 978-1-4080-3229-9
© 2011©Cengage
2011 Cengage
Learning
Learning
EMEAEMEA
Economic Exposure
• Economic exposure can also be measured
by assessing the sensitivity of the firm’s
cash flows to exchange rates through
regression analysis.
• For a single foreign currency:
PCFt = a0 + a1et + t
PCFt = %  in inflation-adjusted cash flows measured in
the firm’s home currency over period t
et
= %  in the exchange rate over period t
Cost and Management
International
Accounting:
FinancialAn
Management,
Introduction,
2nd7th
edition
edition
Jeff
Colin
Madura
Drury
and Roland Fox
ISBN 978-1-40803-213-9
ISBN 978-1-4080-3229-9
© 2011©Cengage
2011 Cengage
Learning
Learning
EMEAEMEA
Economic Exposure
• The model may be revised to handle
additional currencies by including them
as additional independent variables.
• By replacing the dependent variable
(cash flows), the impact of exchange
rates on the firm’s value (as measured
by its stock price), earnings, exports,
sales, etc. may also be assessed.
Cost and Management
International
Accounting:
FinancialAn
Management,
Introduction,
2nd7th
edition
edition
Jeff
Colin
Madura
Drury
and Roland Fox
ISBN 978-1-40803-213-9
ISBN 978-1-4080-3229-9
© 2011©Cengage
2011 Cengage
Learning
Learning
EMEAEMEA
Translation Exposure
• The exposure of an MNC’s consolidated
financial statements to exchange rate
fluctuations is known as translation
exposure.
• In particular, subsidiary earnings
translated into the reporting currency on
the consolidated income statement are
subject to changing exchange rates.
Cost and Management
International
Accounting:
FinancialAn
Management,
Introduction,
2nd7th
edition
edition
Jeff
Colin
Madura
Drury
and Roland Fox
ISBN 978-1-40803-213-9
ISBN 978-1-4080-3229-9
© 2011©Cengage
2011 Cengage
Learning
Learning
EMEAEMEA
Does Translation Exposure
Matter?
Cash Flow Perspective
 The translation of financial statements for
consolidated reporting purposes does not
by itself affect an MNC’s cash flows.
 However, a weak spot rate today may
result in a weak exchange rate forecast
(and hence a weak expected cash flow) for
the point in the future when subsidiary
earnings are to be remitted.
Cost and Management
International
Accounting:
FinancialAn
Management,
Introduction,
2nd7th
edition
edition
Jeff
Colin
Madura
Drury
and Roland Fox
ISBN 978-1-40803-213-9
ISBN 978-1-4080-3229-9
© 2011©Cengage
2011 Cengage
Learning
Learning
EMEAEMEA
Does Translation Exposure
Matter?
Stock Price Perspective
 Since an MNC’s translation exposure affects its
consolidated earnings and many investors tend
to use earnings when valuing firms, the MNC’s
valuation may be affected.
Cost and Management
International
Accounting:
FinancialAn
Management,
Introduction,
2nd7th
edition
edition
Jeff
Colin
Madura
Drury
and Roland Fox
ISBN 978-1-40803-213-9
ISBN 978-1-4080-3229-9
© 2011©Cengage
2011 Cengage
Learning
Learning
EMEAEMEA
Translation Exposure
• An MNC’s degree of translation
exposure is dependent on:
1. the proportion of its business conducted
by foreign subsidiaries
2. the locations of its foreign subsidiaries
3. the accounting methods that it uses.
Cost and Management
International
Accounting:
FinancialAn
Management,
Introduction,
2nd7th
edition
edition
Jeff
Colin
Madura
Drury
and Roland Fox
ISBN 978-1-40803-213-9
ISBN 978-1-4080-3229-9
© 2011©Cengage
2011 Cengage
Learning
Learning
EMEAEMEA