Transaction exposure refers to gains or losses that can arise from settlement of transactions whose terms are stated in foreign currencies. The value of a firm’s future contractual transactions in foreign currencies is affected by exchange rate movements. The sensitivity of the firm’s contractual transactions in foreign currencies to exchange rate movements is referred to as transaction exposure. Transaction exposure can have a substantial impact on a firm’s value. It is not unusual for a currency to change by as much as 10 percent in a given year. If an exporter denominates its exports in a foreign currency, a 10 percent decline in that currency will reduce the dollar value of its receivables by 10 percent. This effect could possibly eliminate any profits from exporting. To assess transaction exposure, an MNC needs to
(1) estimate its net cash flows in each currency and
(2) measure the potential impact of the currency exposure.
Estimating Net Cash Flows MNCs tend to focus on transaction exposure over an upcoming short-term period (such as the next month or the next quarter) for which they can anticipate foreign currency cash flows with reasonable accuracy. Since MNCs commonly have foreign subsidiaries spread around the world, they need an information system that can track their currency positions. To measure its transaction exposure, an MNC needs to project the consolidated net amount in currency inflows or outflows for all its subsidiaries, categorized by currency. One foreign subsidiary may have inflows of a foreign currency while another has outflows of that same currency. In that case, the MNC’s net cash flows of that currency overall may be negligible. If most of the MNC’s subsidiaries have future inflows in another currency, however, the net cash flows in that currency could be substantial. Estimating the consolidated net cash flows per currency is a useful first step when assessing an MNC’s exposure because it helps to determine the MNC’s overall position in each currency. Measuring potential impact The dollar net cash flows of an MNC are generated from a portfolio of currencies. The exposure of the portfolio of currencies can be measured by the standard deviation of the portfolio, which indicates how the portfolio’s value may deviate from what is expected. The risk (as measured by the standard deviation of monthly percentage changes) of a two-currency portfolio (_p) can be estimated as follows: The equation shows that an MNC’s exposure to multiple currencies is influenced by the variability of each currency and the correlation of movements between the currencies. Std deviation measures the degree of movement for each currency. Some may fluctuate more than others. USD-CAD (stable), GBP-USD (stable). Currencies in emerging markets (unstable). Change in govt. policy, eco policy, oil, war have effect on measures of variability. Assessing Transaction Exposure Based on Value at Risk. A related method for assessing exposure is the value-at-risk (VAR) method, which measures the potential maximum one-day loss on the value of positions of an MNC that is exposed to exchange rate movements. Applying VAR to Longer Time Horizons. The VAR method can also be used to assess exposure over longer time horizons. The standard deviation should be estimated over the time horizon in which the maximum loss is to be measured. Applying VAR to Transaction Exposure of a Portfolio. Since MNCs are commonly exposed to more than one currency, they may apply the VAR method to a currency portfolio. When considering multiple currencies, software packages can be used to perform the computations. Limitations of VAR. The VAR method presumes that the distribution of exchange rate movements is normal. If the distribution of exchange rate movements is not normal, the estimate of the maximum expected loss is subject to error. In addition, the VAR method assumes that the volatility (standard deviation) of exchange rate...