Chapter 12

International Financial Management
by Jeff Madura
1
Managing Economic Exposure and Translation
12 Exposure
Chapter Objectives
 Explain how an MNC’s economic exposure can be

hedged
 Explain how an MNC’s translation exposure can be
hedged
2
2
Managing Economic Exposure
 Economic exposure represents the impact of

exchange rate fluctuations on a firm’s future cash
flows. (Exhibit 12.1)
• Recall that corporate cash flows can be affected by
exchange rate movements in ways not directly associated
with foreign transactions (i.e. real growth, inflation,
interest rates, government actions etc.)
 Assessing economic exposure

An MNC must measure its exposure to each
currency in terms of its cash inflows and cash
outflows. (Exhibit 12.2)
3
Managing Economic Exposure
 Restructuring to reduce economic exposure, e.g.:

a. Increase sensitivity of revenues to exchange rate movements.
b. Decrease sensitivity of expenses to exchange rate movements.
(Exhibit 12.3 & 12.4)
1. increasing/reducing sales in new or existing foreign markets,
2. increasing/reducing dependency on foreign suppliers,
3. establishing or eliminating production facilities in foreign
markets, and/or
4. increasing or reducing the level of debt denominated in foreign
currencies.
 Expediting the Analysis with Computer Spreadsheets
Determining the sensitivity of cash flows (ignoring tax effects) to
alternative exchange rate scenarios can be expedited by using a
computer to create a spreadsheet similar to Exhibit 12.3.
4
Exhibit 12.1 How Managing Exposure Can Increase an
MNC’s Value
5
Exhibit 12.2 Original Impact of Possible Exchange Rates on
Cash Flows of Madison Co. (in Millions)
6
Exhibit 12.3 Impact of Possible Exchange Rate Movements on
Earnings under Two Alternative Operational Structures (in Millions)
7
Exhibit 12.4 Economic Exposure Based on the Original and
Proposed Operating Structures
8
Issues Involved in the Restructuring Decision
 Should the firm attempt to increase or reduce sales

in new or existing foreign markets?
 Should the firm increase or reduce its dependency
on foreign suppliers?
 Should the firm establish or eliminate production
facilities in foreign markets?
 Should the firm increase or reduce its level of debt
denominated in foreign currencies?
9
Exhibit 12.5 How to Restructure Operations to Balance the
Impact of Currency Movements on Cash Inflows and Outflows
10
A Case on Hedging Economic Exposure:
Savor Co., a U.S. firm with exposure to the Euro
 Assessment of economic exposure: assess the

relationship between the euro’s movement and each
unit’s cash flows over last 9 quarters.
 Assessment of each unit’s exposure using
regression analysis
 Identifying the source of each unit’s exposure
 See Exhibit 12.6
11
 Possible strategies to hedge economic exposure:

 Pricing policy
 Hedging with forward contracts
 Purchasing foreign supplies
 Financing with foreign funds
 Revising operations of other units
12
Exhibit 12.6 Assessment of Savor Co.’s Cash Flows and the
Euro’s Movements
13
1. Savor’s Hedging Strategy: instruct other

units to do their financing in Euros as well
2. Limitations of Savor’s Optimal Hedging
Strategy: impact of Euro’s movements on
Savor’s cash outflows is known with certainty
but impact on cash inflows is uncertain.
14
Hedging Exposure to Fixed Assets
1. Hedging the sale of fixed assets by:

a. Selling the currency forward in long-term forward
contract
b. Creating a liability in that currency that matches the
expected value of the assets in the future.
2. Limitations of hedging the sale of fixed assets:
a. MNC may not know the date when it will sell the assets
b. MNC may not know the price in the local currency at
which it will sell them.
15
Managing Translation Exposure
 Translation exposure occurs when each subsidiary’s financial

data is translated to its home currency for consolidated
financial statements.
 Translation exposure does not directly affect cash flows, but
some firms are concerned about it because of its potential
impact on reported consolidated earnings.
 An MNC may attempt to avoid translation exposure by
matching its foreign liabilities with its foreign assets.
 To hedge translation exposure, forward or futures contracts
can be used.
 Specifically, an MNC may sell the currency that its foreign
subsidiary receive as earnings forward, thus creating an
16
offsetting cash outflow in that currency.
 Limitations of hedging translation exposure:

 Inaccurate earnings forecasts - earnings in a future period
are uncertain.
 Inadequate forward contracts for some currencies -
forward contracts are not available for all currencies.
 Accounting distortions - the forward rate gain or loss
reflects the difference between the forward rate and the
future spot rate, whereas the translation gain or loss is caused
by the change in the average exchange rate over the period in
which the earnings are generated.
 Increased transaction exposure – the MNC may be
increasing its transaction exposure
17
 In particular, if the foreign currency depreciates

during the fiscal year, the transaction loss generated
by a forward contract position will somewhat offset
the translation gain.
 Note that the translation gain is simply a paper gain,
while the loss resulting from the hedge is a real loss.
 Perhaps, the best way for MNCs to deal with
translation exposure is to clarify how their
consolidated earnings have been affected by
exchange rate movements.
18
Impact of Hedging Economic Exposure on an MNC’s
Value
Hedging Decisions on
Economic Exposure
m 
n 
 
E CFj , t  E ER j , t  
 j 1 
Value =   
t =1  1  k  t

 
E (CFj,t )= expected cash flows in currency j to be
received by the U.S. parent at the end of period t
E (ERj,t ) = expected exchange rate at which
currency j can be converted to dollars at the end of
period t

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International Financial Management

 Explain how an MNC’s economic exposure can be

 Economic exposure represents the impact of

 Assessing economic exposure

 Restructuring to reduce economic exposure, e.g.:

 Should the firm attempt to increase or reduce sales

 Assessment of economic exposure: assess the

 Possible strategies to hedge economic exposure:

1. Savor’s Hedging Strategy: instruct other

1. Hedging the sale of fixed assets by:

 Translation exposure occurs when each subsidiary’s financial

 Limitations of hedging translation exposure:

 In particular, if the foreign currency depreciates

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