Measuring Exposure to Exchange Rate Fluctuations

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Chapter 10
Measuring Exposure to Exchange Rate Fluctuations Lecture Outline Is Exchange Rate Risk Relevant? Transaction Exposure
Estimating “Net” Cash Flows in Each Currency Measuring the Potential Impact of the Currency Exposure Assessing Transaction Exposure Based on Value-at-Risk

Economic Exposure
Economic Exposure to Local Currency Appreciation Economic Exposure to Local Currency Depreciation Economic Exposure of Domestic Firms Measuring Economic Exposure

Translation Exposure
Does Translation Exposure Matter? Determinants of Translation Exposure Examples of Translation Exposure

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Chapter 10: Measuring Exposure to Exchange Rate Fluctuations

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Chapter Theme
This chapter distinguishes among three forms by which MNCs are exposed to exchange rate risk: (1) transaction exposure, (2) economic exposure, and (3) translation exposure. Each firm differs in degree of exposure. A firm should be able to measure its degree of each type of exposure as described in this chapter. Then, it can decide how to cover that exposure using methods described in the following two chapters.

Topics to Stimulate Class Discussion
1. Describe in general terms how you would measure the transaction exposure of a particular MNC. 2. What is the relationship between transaction exposure and economic exposure? 3. A small firm in New York City produces various metals and sells them to local manufacturers. It has no foreign sales and purchases all supplies and materials locally. Does transaction exposure exist for this firm? Does economic exposure exist for this firm?

POINT/COUNTER-POINT: Should Investors Care about an MNC’s Translation Exposure? POINT: No. The present value of an MNC’s cash flows is based on the cash flows that the parent receives. Any impact of the exchange rates on the financial statements is not important unless cash flows are affected. MNCs should focus their energy on assessing the exposure of their cash flows to exchange rate movements and should not be concerned with the exposure of their financial statements to exchange rate movements. Value is about cash flows, and investors focus on value. COUNTER-POINT: Investors do not have sufficient financial data to derive cash flows. They commonly use earnings as a base, and if earnings are distorted, so will be their estimates of cash flows. If they underestimate cash flows because of how exchange rates affected the reported earnings, they may underestimate the value of the MNC. Even if the value is corrected in the future once the market realizes how the earnings were distorted, some investors may have sold their stock by the time the correction occurs. Investors should be concerned about an MNC’s translation exposure. They should recognize that the earnings of MNCs with large translation exposure may be more distorted than the earnings of MNCs with low translation exposure. WHO IS CORRECT? Use the Internet to learn more about this issue. Which argument do you support? ANSWER: Translation exposure affects earnings, and therefore can affect the value of the firm. If it affects the value of the MNC, translation exposure is relevant to the firm, to the investors who are affected by changing values, and to the managers whose compensation may be affected by changing values.

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International Financial Management

Answers to End of Chapter Questions
1. Transaction versus Economic Exposure. Compare and contrast transaction exposure and economic exposure. Why would an MNC consider examining only its “net” cash flows in each currency when assessing its transaction exposure? ANSWER: Transaction exposure is due only to international transactions by a firm. Economic exposure includes any form by which the firm’s cash flow will be affected. Foreign competition may increase due to currency fluctuations. This could affect the firm’s cash flow, but did not affect the value of any ongoing transactions. Thus, it represents a form of economic exposure but not...
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