UNIVERSITY OF ECONOMICS AND LAW

FACULTY OF FINANCE AND BANKING

Chapter 8
Measuring Exposure to Exchange Rate Fluctuations
I N T E R N AT I O N A L F I N A N C E

Contents
1. Transaction Exposure

2. Economic Exposure

3. Translation Exposure

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 1. Transaction Exposure
Definition: Sensitivity of the firm’s contractual transactions in foreign currencies to
exchange rate movements.
Example
Seahawk Co. is a U.S. firm that wants to assess its transaction exposure over the next
quarter. It has only one international transaction pending. It just received an order from
Spain for its products, and it will receive 1 million euros in one quarter (90 days). The
euro’s spot rate is currently $1.35, but Seahawk is more concerned about the spot rate that
will exist when it exchanges 1 million euros for dollars at the end of the next quarter.

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1. Transaction Exposure

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 1. Transaction Exposure
Assessing transaction exposure:

1. Estimating net cash flows in each currency

2. Assess exposure of an MNC’s portfolio

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1. Transaction Exposure
1. Estimating net cash flows in each currency

Example

Miami Co. conducts its international business in four currencies. It wants to

measure its exposure in each currency over the next quarter, so that it can decide
whether to hedge that exposure. Miami should measure the dollar value of net
cash flows for each currency over the next quarter, so that it can compare the
exposure per currency using a standardized measurement.

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 1. Transaction Exposure

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1. Transaction Exposure
2. Assess exposure of an MNC’s portfolio
Measure potential impact of the currency exposure

WX, WY = proportion of total portfolio value that represented by currency X, Y

ϬX,ϬY = standard deviation of quarterly percentage changes in the dollar value of
currency X, Y
CORRXY = correlation coefficient of quarterly percentage changes in the dollar
values of currencies X and Y
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 1. Transaction Exposure
▪ Measurement of currency volatility
The standard deviation statistic measures the degree of movement for each
currency. In any given period, some currencies clearly fluctuate much more
than others.
▪ Currency volatility over time
The volatility of a currency may not remain consistent from one time period to
another. An MNC can identify currencies whose values are most likely to be
stable or highly volatile in the future.
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1. Transaction Exposure
▪ Measurement of currency correlations
The correlations coefficients indicate the degree to which two currencies
move in relation to each other.
▪ Applying currency correlations to net cash flows
If an MNC has positive net cash flows in various currencies that are highly
correlated, it may be exposed to exchange rate risk. However, many MNCs
have some negative net cash flow positions in some currencies to complement
their positive net cash flows in other currencies.
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 1. Transaction Exposure
Example
Miami Co. anticipates net cash inflows in British pounds equivalent to $15
million and net cash outflows in Swedish krona equivalent to $15 million at the
end of the quarter.
These currencies are highly positively correlated against the dollar.
→ One possible scenario is that these two currencies will appreciate against the
U.S. dollar over the next quarter, such that Miami would be adversely affected by
its exposure to the krona but favorably affected by its pounds exposure.
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1. Transaction Exposure
Example

An alternative scenario is that these two currencies might depreciate against the
dollar over the next quarter, in which case Miami would be adversely affected by
its pounds exposure but favorably affected by its krona exposure.

→ Although Miami does not know which of the two scenarios will play out, it has
determined that offsetting effects would occur with either scenario.

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 1. Transaction Exposure
Example

Given these offsetting effects, Miami is not concerned about its transaction
exposure to the British pound or the Swedish krona over the next quarter.

However, it is somewhat concerned about its exposure to the Canadian dollar and
the Mexican peso.

→ Miami decides to conduct some additional analysis to determine its transaction

exposure to these two currencies.

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1. Transaction Exposure

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 1. Transaction Exposure
Transaction Exposure Based on Value at Risk (VaR)
Estimates the maximum possible loss on the value of currency positions that are
exposed to exchange rate movements.

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1. Transaction Exposure
Example
Miami Co. has determined that its exposures to British pounds and Swedish krona
are offsetting → it needs to be concerned only about the exposure of its net cash
flows in Canadian dollars and Mexican pesos.
Assume for the moment that Miami needs to worry about just its transaction
exposure to Canadian dollar net cash flows. It can use the VaR method to estimate
the maximum expected loss.

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 1. Transaction Exposure
Example
Assume that Miami estimates the standard deviation of quarterly percentage
changes of the Canadian dollar to be 4% over the last 40 quarters. If these
quarterly percentage changes are normally distributed, then the maximum one-
quarter loss is determined by the lower boundary (the left tail) of the probability
distribution, which, based on a 95% confidence level, is approximately 1.65
standard deviations away from the expected percentage change in the Canadian
dollar.
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1. Transaction Exposure
Example
Assume that Miami expects that the Canadian dollar will depreciate by 1% against
the U.S. dollar over the next quarter. Based on this forecast, along with the
estimated standard deviation of 4%, the maximum expected loss due to Miami’s
transaction exposure in Canadian dollars over the next quarter is:

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 1. Transaction Exposure
Example
The U.S. dollar value of Miami’s net cash flow position in Canadian dollars over
the next quarter is $8 million
→ a decline in the Canadian dollar’s value over the next quarter would cause
Miami’s Canadian dollar position to experience a loss of:

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1. Transaction Exposure
Example
Assume that Miami is only concerned about the maximum one-quarter loss due to
a potential decline in the Mexican peso’s value. Assume that the company
believes the expected percentage change in the Mexican peso is 21% during the
next quarter, and that Miami estimated the standard deviation of exchange rate
movements of the Mexican peso to be 6% over the past 40 quarters. Based on
these assumptions, Miami’s maximum expected one-quarter loss due to its
transaction exposure in Mexican pesos over the next quarter is:
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 1. Transaction Exposure
Factors that affect the maximum 1-day loss:

▪ Expected percentage change in the currency for the next day

▪ Confidence level used

▪ Standard deviation of the daily percentage changes in the currency

Maximum one-day loss = E(et) – (1.65 x ϬMXN)

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1. Transaction Exposure
▪ 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.

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 1. Transaction Exposure
Example

Miami Co. is expecting net cash flows in Canadian dollars at the end of the
quarter valued at $8 million, and net cash flows in Mexican pesos valued at $8
million → Miami is exposed to a currency portfolio weighted 50% in Canadian
dollars and 50% in Mexican pesos. Miami wants to determine the maximum
expected one-quarter loss in its portfolio of these two currencies (based on a 95%
confidence level). Miami estimates the standard deviation of quarterly percentage
changes to be 4% for the Canadian dollar and 6% for the Mexican peso.
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1. Transaction Exposure
Also assume that Miami estimates a correlation coefficient of 0.20 between these
two currencies. The portfolio’s standard deviation is estimated to be:

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 1. Transaction Exposure
If the quarterly percentage changes of each currency are normally distributed, then
the quarterly percentage changes of the portfolio should be normally distributed.
The maximum one-quarter loss of the currency portfolio is determined by the
lower boundary (the left tail) of the probability distribution, which, based on a
95% confidence level, is approximately 1.65 standard deviations away from the
expected percentage change in the currency portfolio.

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1. Transaction Exposure
Assuming an expected percentage change of 21% for the currency portfolio, the
maximum expected one-quarter loss is:

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 1. Transaction Exposure
Limitations of VaR
▪ If the distribution of exchange rate movements is not normal, the estimate of
the maximum expected loss is subject to error.
▪ The VaR method assumes that the volatility (standard deviation) of exchange
rate movements is stable over time. If exchange rate movements are less
volatile in the past than in the future, the estimated maximum expected loss
derived from the VaR method will be underestimated.

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2. Economic Exposure
Definition: The sensitivity of the firm’s cash flows to exchange rate movements,
sometimes referred to as operating exposure.

▪ Exposure to local currency appreciation

▪ Exposure to local currency depreciation

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 2. Economic Exposure
Example
Intel (a U.S.-based MNC) invoices many of its computer chip exports in U.S.
dollars, which avoids transaction exposure. Yet if the euro weakens against the
dollar, European importers will need more euros to pay for Intel’s chips and,
therefore, might decide to purchase computer chips from European manufacturers
instead. While Intel’s decision to price exports in dollars can avoid transaction
exposure, its cash flows could still be reduced when the euro weakens. Thus, it is
still subject to economic exposure.
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2. Economic Exposure
▪ Exposure to local currency appreciation
Appreciation in the firm’s local currency causes a reduction in both cash
inflows and outflows. The impact on a firm’s net cash flows will depend on
whether the inflow transactions are affected more or less than the outflow
transactions.

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 2. Economic Exposure
▪ Exposure to local currency depreciation
Depreciation of the firm’s local currency causes an increase in both cash
inflows and outflows.

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2. Economic Exposure

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 2. Economic Exposure
Measuring Economic Exposure

▪ Using sensitivity analysis

▪ Using regression analysis

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2. Economic Exposure
▪ Using sensitivity analysis

Consider how sales and expense categories are affected by various exchange rate
scenarios.

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 2. Economic Exposure
Example

Madison Co. is a U.S.-based MNC that purchases most of its materials from
Canada and generates a small portion of its sales from exporting to Canada. Its
U.S. sales and expenses in Canada are denominated in Canadian dollars (C$).
Madison wants to assess its economic exposure. Assume that Madison Co.
expects three possible exchange rates for the Canadian dollar over the period of
concern, all of which have an equal probability of occurring: $0.75, $0.80, or
$0.85.
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2. Economic Exposure

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 2. Economic Exposure

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2. Economic Exposure
▪ Use of regression analysis

PCFt = percentage change in inflation-adjusted cash flows measured in the firm’s

home country currency over period t
et = percentage change in the direct exchange rate of the currency over period t
μt = random error term
a0 = intercept
a1 = slope coefficient
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 2. Economic Exposure
Example
Madison Co. wants to measure its economic exposure over the last 30 quarters. It
applies the regression model just described to estimate how its cash flows have
been affected by quarterly movements in the Canadian dollar’s exchange rate over
the past 30 quarters. Madison’s analysis shows that the estimated regression
coefficient a0 is close to zero and is not significant, but the regression coefficient
a1 = -3.0. This implies that each 1% appreciation in the Canadian dollar over a
quarter results in an estimated 3% reduction in Madison’s cash flows.
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2. Economic Exposure
Example

→ If Madison expects the Canadian dollar to appreciate by 4% in the next quarter,

it would expect its cash flows to decline by 12% in that quarter based on the
results of its regression analysis.

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 3. Translation Exposure
Definition: The exposure of the MNC’s consolidated financial statements to
exchange rate fluctuations.

Determinants of translation exposure

1. proportion of its business conducted by foreign subsidiaries

2. locations of its foreign subsidiaries

3. accounting methods that it uses

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3. Translation Exposure
1. Proportion of business by foreign subsidiaries: The greater the percentage of
an MNC’s business conducted by its foreign subsidiaries, the larger the
percentage of a given financial statement item that is susceptible to translation
exposure.

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 3. Translation Exposure
Example

Locus Co. and Zeuss Co. each generate approximately 30% of their sales from
foreign countries. However, Locus Co. generates all of its international business
by exporting, whereas Zeuss Co. has a large Mexican subsidiary that generates all
of its international business. Locus Co. is not subject to translation exposure
(although it is subject to economic exposure), while Zeuss has substantial
translation exposure.

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3. Translation Exposure
2. Locations of foreign subsidiaries: Location can also influence the degree of
translation exposure because the financial statement items of each subsidiary are
typically measured by the respective subsidiary’s home currency.

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 3. Translation Exposure
Example
Zeuss Co. and Canton Co. each have one large foreign subsidiary that generates
approximately 30% of their respective sales. However, Zeuss Co. is subject to a
much higher degree of translation exposure because its subsidiary is based in
Mexico, and the peso’s value is subject to significant depreciation. In contrast,
Canton’s subsidiary is based in Canada, and the Canadian dollar is very stable
against the U.S. dollar.

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3. Translation Exposure
3. Accounting Methods: MNC translation exposure is affected by accounting
procedures.
▪ The functional currency of an entity is the currency of the economic
environment in which the entity operates.
▪ The current exchange rate of the reporting date is used to translate the assets
and liabilities of a foreign entity from its functional currency into the reporting
currency.

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 3. Translation Exposure
▪ The weighted average exchange rate over the relevant period is used to
translate revenue, expenses, and gains and losses of a foreign entity from its
functional currency into the reporting currency.
▪ Translated income gains or losses due to changes in foreign currency values
are not recognized in current net income but are reported as a second
component of stockholder’s equity.
▪ Realized income gains or losses due to foreign currency transactions are
recorded in current net income, although there are some exceptions.
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3. Translation Exposure
Example
Providence, Inc., is a U.S.-based MNC whose British subsidiary earned £10
million in year 1 and £10 million in year 2. When these earnings are consolidated
along with other subsidiary earnings, they are translated into U.S. dollars at the
weighted average exchange rate for the year in question. Suppose the weighted
average exchange rate is $1.70 in year 1 and $1.50 in year 2.

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 3. Translation Exposure

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3. Translation Exposure
Example: Even though the subsidiary’s earnings in pounds were the same each
year, the translated consolidated dollar earnings were reduced by $2 million in
year 2. This discrepancy reflects the change in the weighted average of the British
pound exchange rate. The drop in earnings is not the fault of the subsidiary but
rather is attributable to the weakened British pound, which makes the subsidiary’s
year 2 earnings look small (when measured in U.S. dollars).

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