10/23/2015Multinational Corporate Finance Prof. R.A. Michelfelder 1 Outline 7 7. Measuring and...

04/20/23 Multinational Corporate Finance Prof. R.A. Michelfelder

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Outline 7

7. Measuring and Managing Economic Exposure

7.1Value of the MC

7.2 Types of Exposure

7.3 Economic Exposure

7.4 Measuring Economic Exposure

7.5 Managing Economic Exposure

7.6 Transactions Exposure

7.7 Measuring Transaction Exposure

7.8 Managing Transactions Exposure


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7.1 Value of the MC Firm

V

E C F E E R

k

j t j tj

m

tt

n

, ,1

1 1

V = value of MCE(CFj,t)= expected cash flow denominated in currency j to be received in period tE(ERj,t)= expected exchange rate at which currency j can be converted to $ at end of period tk = weighted average cost of capitalm= number of currenciesn= number of periods


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7.1 Value of the MC Firm

V

E C F E E R

k

j t j tj

m

tt

n

, ,1

1 1

TransactionsExposure

Economic Exposure


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7.2 Types of FX Exposure

• Economic exposure

– Degree to which PV of future CF’s, or, V is influenced by exchange rate fluctuations

• Transactions exposure

– Degree to which the value of CF transactions can be affected by exchange rate fluctuations. This is a subset of economic exposure.

• Translation exposure

– Degree to which MC’s consolidated financial statements are influenced by exchange rate fluctuations

– Relevance?: Translation of financial statements for consolidated reporting does not itself affect MC’s CF’s. Some analysts argue that translation exposure is not relevant. It depends on whether foreign

subsidiaries remit earnings to parent company.


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• Degree to which a firm’s PV of future cash flows are influenced by FX rate fluctuations– Transactions that cause transactions exposure

also cause economic exposure as these CF’s can be effected by FX rate fluctuations

– Other types of business that do not cause transactions exposure can cause economic exposure from FX rate fluctuations


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• Economic exposure to local currency depreciation and appreciation:– Appreciation:

• Causes a reduction in both cash inflows and outflows thus its difficult to generalize about the net CF impact (Inflows affected more than outflows?)

– Depreciation:• Causes opposite impact of appreciation: increase in

cash inflows and outflows – net CF’s depends on whether inflows are affected more than outflows


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7.3 Economic Exposure Transactions That Influence the Firm’s Local Currency Inflows

Impact of Local Currency Appreciation

Impact of Local Currency Depreciation

Local sales (relative to foreign competition in local markets)

Decrease Increase

Firm’s exports denominated in local currency

Decrease Increase

Firm’s exports denominated in foreign currency

Decrease Increase

Interest received from foreign investments Decrease Increase


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Transactions That Influence the Firm’s Local Currency Outflows

Impact of Local Currency Appreciation

Impact of Local Currency Depreciation

Firm’s imported supplies denominated in local currency

No change No change

Firm’s imported supplies denominated in foreign currency

Decrease Increase

Interest owed on foreign funds borrowed

Decrease Increase


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• MC’s should assess the potential degree of exposure they face and then determine whether to insulate against it– Assessing economic exposure of an MC with

subsidiaries around the world is difficult due to interaction of CF’s denominated in various currencies into, out of, and within the MC

– The overall impact of FX fluctuations on MC is very complex


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• Sensitivity of Earnings to FX rates:– Classify the CF’s into different income

statement items and predict each item based on a scenario of exchange rates

– Develop alternative FX rate scenarios and revise income statement items and income statement


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• Sensitivity of CF’s to FX rates:Can be assessed by applying regression analysis to historical CF

and FX rate data:

%CFt = a0 + a1 % Et + t

CFt = inflation-adjusted CF’s measure in home currency in time t

Et = home currency price of foreign exchange in time t

t = error term in time t

a0 = intercept

a1 = slope, reflects the sensitivity of CF’s to E (elasticity)

Can add more E’s if the CF depends on may FX rates.


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“The economic impact of currency exchange rates on us is complex because such changes are often linked to variability in real growth, inflation, interest rates, governmental actions, and other factors. These changes, if material, can cause us to adjust our financing and operating strategies.”

PepsiCo


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• Managing economic exposure in the long-run involves strategic decisions beyond short-term FX hedging to minimize CF exposure

• Restructuring operations can reduce economic exposure:– Involves shifting the sources of costs or

revenues to other locations to match cash inflows and outflows or foreign currencies


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• Restructuring operations to reduce economic exposure more difficult than hedging any foreign currency transaction– Managing economic exposure more difficult

than managing transactions exposure

• Long-term solution and therefore very costly to reverse or eliminate


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7.6 Transactions Exposure

• Degree to which the value of future cash transactions can be affected by FX rate fluctuations– E.g. US exporters that sold products to Asian countries

during the 97-98 Asian currency crisis. Some Asian currencies depreciated by 80%. If invoiced in Asian currencies, exporters’ CF’s may have fallen 80%. If invoiced in dollars, exporters’ CF’s not affected but Asian importers would face it.


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7.7 Measuring Transactions Exposure

• Two steps:1. Determine the net amount of inflows and

outflows in each foreign currency

2. Determine the overall risk of exposure to those currencies


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• A MC needs to project the consolidated net amount in currency inflows or outflows for all of its subsidiaries, categorized by currency– One subsidiary may have inflows of a currency

while another has outflows of the same, and the MC’s net CF’s in that currency overall may be nil.


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• Transactions exposure based currency variability:– Previous e.g. FX rates were forecasted without

discussing method for predicting

• Measurement of currency variability:– Standard deviation of FX rates

• Historical statistics indicate the potential movement in an exchange rate – some move a lot more than others. Standard deviation will provide a range for estimating the upper and lower range of a cash flow forecast in different currencies


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• Measurement of currency variability:– Currency correlations: can be used to determine the

degree to which two currencies will move in relation to each other; less correlation among FX rates you deal in means less exposure due to currency diversification

– Value-at-Risk: incorporates volatility and currency correlations to determine the potential maximum one-day loss on the value of positions of a MC exposed to FX rates


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• Techniques to eliminate transactions exposure:– Futures hedge– Forward hedge– Currency option hedge


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Hedging Method To Hedge Payables To Hedge Receivables

Futures Hedge Buy a currency futures contract(s) for the amount of the payables

Sell a currency futures contract(s) for the amount of the receivables

Forward Hedge Negotiate a forward contract to buy the amount of currency needed to cover payables

Negotiate a forward contract to sell the amount of currency from receivables

Currency Option Hedge Buy a call option(s) to buy the amount of currency needed to make the payment

Buy a put option(s) to sell the amount of currency from receivables

10/23/2015Multinational Corporate Finance Prof. R.A. Michelfelder 1 Outline 7 7. Measuring and...

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