Measuring Exposure to Exchange Rate Fluctuations
Is Exchange Rate Risk Relevant?
Transaction Exposure to ―Net‖ Cash Flows in Each Currency
Measuring the Potential Impact of the Currency Exposure
Assessing Transaction Exposure Based on Value-at-Risk
Economic Exposure to Local Currency Appreciation
Economic Exposure to Local Currency Depreciation
Economic Exposure of Domestic Firms
Measuring Economic Exposure
Does Translation Exposure Matter?
Determinants of Translation Exposure
Examples of Translation Exposure
142 International Financial Management
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. It should be emphasized that a firm sometimes benefits due to exposure. Yet, it typically would prefer to control its own destiny and therefore be insulated from 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?
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 InfoTrac or some other search engine 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.
Chapter 10: Measuring Exposure to Exchange Rate Fluctuations 143
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
transaction exposure. Transaction exposure is a subset of economic exposure.
Consideration of all cash flows in a particular currency is not necessary when some inflows and
outflows offset each other. Only net cash flows are necessary.
2. Assessing Transaction Exposure. Your employer, a large MNC, has asked you to assess its
transaction exposure. Its projected cash flows are as follows for the next year:
Currency Total Inflow Total Outflow Rate in U.S. Dollars
Danish krone (DK) DK50,000,000 DK40,000,000 $.15
British pound (?) ?2,000,000 ?1,000,000 $1.50
Assume that the movements in the Danish krone and the pound are highly correlated. Provide your
assessment as to your firm’s degree of transaction exposure (as to whether the exposure is high or
low). Substantiate your answer.
ANSWER: The net exposure to each currency in U.S. dollars is derived below:
Net Inflows in Current
Foreign Currency Foreign Currency Exchange Rate Value of Exposure
Danish krone (DK) +DK10,000,000 $.15 $1,500,000
British pound (?) +?1,000,000 $1.50 $1,500,000
The krone and pound values move in tandem against the dollar. Both the krone and the pound
exposure show positive net inflows. Thus, their exposure should be magnified if their exchange
rates against the U.S. dollar continue to be highly correlated.
3. Factors That Affect a Firm’s Transaction Exposure. What factors affect a firm’s degree of
transaction exposure in a particular currency? For each factor, explain the desirable characteristics
that would reduce transaction exposure.
ANSWER: Currency variability—low level is desirable.
Currency correlations—low level is desirable for currencies that are net inflows, while a high level
is desirable for pairs of currencies in which one currency shows future net inflows while the other
currency shows future net outflows.
144 International Financial Management
4. Currency Correlations. Kopetsky Co. has net receivables in several currencies that are highly
correlated with each other. What does this imply about the firm’s overall degree of transaction
exposure? Are currency correlations perfectly stable over time? What does your answer imply
about Kopetsky Co. or any other firm using past data on correlations as an indicator for the future?
ANSWER: Its exposure is high since all currencies move in tandem—no offsetting effect is
likely. If one of these currencies depreciates substantially against the firm’s local currency, all
others will as well, and this reduces the value of these net receivables.
No! Thus, past correlations will not serve as perfect forecasts of future correlations.
Firms can not presume that past correlations will be perfectly accurate forecasts of future
correlations. Yet, historical data may still be useful if the general ranking of correlations is
5. Currency Effects on Cash Flows. How should appreciation of a firm’s home currency generally
affect its cash inflows? How should depreciation of a firm’s home currency generally affect its cash
ANSWER: Appreciation of the firm’s home currency reduces inflows since the foreign demand for
the firm’s goods is reduced and foreign competition is increased.
Depreciation of the firm’s home currency should increase inflows since it will likely increase foreign
demand for the firm’s goods and reduce foreign competition.
6. Transaction Exposure. Fischer Inc., exports products from Florida to Europe. It obtains supplies
and borrows funds locally. How would appreciation of the euro likely affect its net cash
ANSWER: Fischer Inc. should benefit from the appreciation of the euro, because it should
experience a strong demand for its products when the euro has more purchasing power (can obtain
dollars at a low price).
7. Exposure of Domestic Firms. Why are the cash flows of a purely domestic firm exposed to
exchange rate fluctuations?
ANSWER: If the firm competes with foreign firms that also sell in a given market, the consumers
may switch to foreign products if the local currency strengthens.
8. Measuring Economic Exposure. Memphis Co. hires you as a consultant to assess its degree of
economic exposure to exchange rate fluctuations. How would you handle this task? Be specific.
ANSWER: Regression analysis can be used to determine the relationship between the firm’s value
and exchange rate fluctuations. Stock returns can be used as a proxy for the change in the firm’s
value. The time period can be segmented into two subperiods so that regression analysis can be run
for each subperiod. The sign and magnitude of the regression coefficient will imply how the firm’s
value is influenced by each currency. Also, the coefficients can be compared among subperiods for
each currency to determine how the impact of a currency is changing over time.
Chapter 10: Measuring Exposure to Exchange Rate Fluctuations 145
9. Factors That Affect a Firm’s Translation Exposure. What factors affect a firm’s degree of
translation exposure? Explain how each factor influences translation exposure.
ANSWER: The greater the percentage of business conducted by subsidiaries, the greater is the
translation exposure. The greater the variability of each relevant foreign currency relative to the
headquarters’ home (reporting) currency, the greater is the translation exposure. The type of
accounting method employed can also affect translation exposure.
10. Translation Exposure. Consider a period in which the U.S. dollar weakens against the euro. How
will this affect the reported earnings of a U.S.-based MNC with European subsidiaries? Consider a
period in which the U.S. dollar strengthens against most foreign currencies. How will this affect the
reported earnings of a U.S.-based MNC with subsidiaries all over the world?
ANSWER: The consolidated earnings will be increased due to the strength of the subsidiaries’
local currency (the euro).
The consolidated earnings will be reduced due to the weakness of the subsidiaries’ local currencies.
11. Transaction Exposure. Aggie Co. produces chemicals. It is a major exporter to Europe, where its
main competition is from other U.S. exporters. All of these companies invoice the products in U.S.
dollars. Is Aggie’s transaction exposure likely to be significantly affected if the euro strengthens or
weakens? Explain. If the euro weakens for several years, can you think of any change that might
occur in the global chemicals market?
ANSWER: If the euro strengthens, European customers can purchase Aggie’s goods with fewer
euros. Since Aggie’s competitors also invoice their exports in dollars, Aggie Company will not gain
a competitive advantage. Nevertheless, the overall demand for the product could increase because
the chemicals are now less expensive to European customers.
If the euro weakens, European customers will need to pay more euros to purchase Aggie’s
goods. Since Aggie’s competitors also invoice their exports in dollars, Aggie Company may not
necessarily lose some of its market share. However, the overall European demand for chemicals
could decline because the prices paid for them have increased.
If the euro remained weak for several years, some companies in Europe may begin to produce the
chemicals, so that customers could avoid purchasing dollars with weak euros. That is, the U.S.
exporters could be priced out of the European market over time if the euro continually weakened.
12. Economic Exposure. Longhorn Co. produces hospital equipment. Most of its revenues are in the
United States. About half of its expenses require outflows in Philippine pesos (to pay for Philippine
materials). Most of Longhorn’s competition is from U.S. firms that have no international business
at all. How will Longhorn Co. be affected if the peso strengthens?
ANSWER: If the peso strengthens, Longhorn will incur higher expenses when paying for the
Philippine materials. Because its competition is not affected in a similar manner, Longhorn
Company is at a competitive disadvantage when the peso strengthens.
13. Economic Exposure. Lubbock, Inc., produces furniture and has no international business. Its
major competitors import most of their furniture from Brazil and then sell it out of retail stores in
146 International Financial Management
the United States. How will Lubbock, Inc., be affected if Brazil’s currency (the real) strengthens
ANSWER: If the Brazilian real strengthens, U.S. retail stores will likely have to pay higher prices
for the furniture from Brazil, and may pass some or all of the higher cost on to
customers. Consequently, some customers may shift to furniture produced by Lubbock Inc. Thus,
Lubbock Inc. is expected to be favorably affected by a strong Brazilian real.
14. Economic Exposure. Sooner Co. is a U.S. wholesale company that imports expensive high-quality
luggage and sells it to retail stores around the United States. Its main competitors also import
high-quality luggage and sell it to retail stores. None of these competitors hedge their exposure to
exchange rate movements. The treasurer of Sooner Co. told the board of directors that the firm’s
performance would be more volatile over time if it hedged its exchange rate exposure. How could a
firm’s cash flows be more stable as a result of such high exposure to exchange rate fluctuations?
ANSWER: If Sooner Company hedged its imports, then it would have an advantage over the
competition when the dollar weakened (since its competitors would pay higher prices for the
luggage), and could possibly gain market share or would have a higher profit margin. It would be
at a disadvantage relative to the competition when the dollar strengthened and may lose market
share or be forced to accept a lower profit margin.
When Sooner Company does not hedge, the amount paid for imports would depend on exchange
rate movements, but this is also true for all of its competitors. Thus, Sooner is more likely to retain
its existing market share.
15. PPP and Economic Exposure. Boulder, Inc., exports chairs to Europe (invoiced in U.S. dollars)
and competes against local European companies. If purchasing power parity exists, why would
Boulder not benefit from a stronger euro?
ANSWER: If purchasing power parity exists, a stronger euro would occur only because the U.S.
inflation is higher than European inflation. Thus, the European demand for Boulder’s chairs may
not be affected much since the inflated prices of U.S.-made chairs would have offset the European
consumer’s ability to obtain cheaper dollars. The European consumer’s purchasing power of
European chairs versus U.S. chairs is not affected by the change in the euro’s value.
16. Measuring Changes in Economic Exposure. Toyota Motor Corp. measures the sensitivity of its
exports to the yen exchange rate (relative to the U.S. dollar). Explain how regression analysis could
be used for such a task. Identify the expected sign of the regression coefficient if Toyota primarily
exports to the United States. If Toyota established plants in the United States, how might the
regression coefficient on the exchange rate variable change?
ANSWER: The dependent variable is a percentage change (from one period to the next) in
Toyota’s export volume to the U.S. The independent variables are (1) the percentage change in the
yen’s value with respect to the dollar, (2) a measure of the strength of the U.S. economy, and (3)
any other factors that could affect the volume of Toyota’s exports. The regression coefficient
related to the exchange rate variable (as defined here) would be negative, since a decrease in the
yen’s value is likely to cause an increase in the U.S. demand for Toyotas built in Japan.
Chapter 10: Measuring Exposure to Exchange Rate Fluctuations 147
If Toyota established plants in the U.S., dealers do not need to purchase Toyotas in Japan. Thus,
the demand for Toyotas is less sensitive to the exchange rate, which should cause the regression
coefficient for the exchange rate variable to decrease.
17. Impact of Exchange Rates on Earnings. Cieplak, Inc., is a U.S.-based MNC that has expanded
into Asia. Its U.S. parent exports to some Asian countries, with its exports denominated in the
Asian currencies. It also has a large subsidiary in Malaysia that serves that market. Offer at least
two reasons related to exposure to exchange rates why Cieplak's earnings were reduced during the
ANSWER: First, its receivables from its exports were converted to fewer dollars due to the
depreciation of the Asian currencies. Second, any funds remitted by the Malaysian subsidiary
converted to fewer dollars for the parent. Third, the earnings generated by the Malaysian subsidiary
were translated to fewer dollars on the consolidated income statement (translation exposure) even if
it did not remit any earnings to the parent.
18. Speculating Based on Exposure. During the Asian crisis in 1998, there were rumors that China
would weaken its currency (the yuan) against the U.S. dollar and many European currencies. This
caused investors to sell stocks in Asian countries such as Japan, Taiwan, and Singapore. Offer an
intuitive explanation for such an effect. What types of Asian firms would have been affected the
ANSWER: If China weakened its currency, importers of Asian products may purchase more
Chinese products, which could have enhanced the performance of the Chinese exporters, but could
have adversely affected the performance of the exporters in other Asian countries. Thus, there was
concern that depreciation of the yuan would adversely affect the economies of the other countries.
19. Effect of September 11. Explain how the September 11, 2001 terrorist attack caused lower U.S.
interest rates. Explain how this effect on the value of the dollar could have adversely affected some
MNCs that were subject to transaction exposure. Based on your expectations, would U.S. exporters
or importers have been more adversely affected?
ANSWER: The attack could have caused expectations of weak U.S. stock prices and lower U.S.
interest rates, which could reduce capital flows into the U.S. and reduced the value of the dollar. A
weaker dollar adversely affects U.S. importing firms. If students offer logic on why the dollar
should have strengthened as a result of the terrorist attack (such as a weak economy and lower
inflation reducing the U.S. demand for foreign products), then U.S. exporters would have been more
148 International Financial Management
20. Using Regression Analysis to Measure Exposure.
a. How can a U.S. company use regression analysis to assess its economic exposure to
fluctuations in the British pound?
ANSWER: A U.S. company could quantify its performance by measuring the percentage change in
earnings, stock price, or some other variable to be used as the dependent variable. The independent
variable is the percentage change in the British pound. Lagged exchange rate variables could also
be included as additional independent variables to capture any lagged impact of the pound’s
movements on the firm.
b. In using regression analysis to assess the sensitivity of cash flows to exchange rate movements,
what is the purpose of breaking the database into sub periods?
ANSWER: Breaking the database into sub periods enables one to understand how the impact of the
currency is changing over time.
c. Assume the regression coefficient based on assessing economic exposure was much higher in
the second sub period than in the first sub period. What does this tell you about the firm’s
degree of economic exposure over time? Why might such results occur?
ANSWER: The firm is more exposed to change in currency values. This could occur if the firm
hedges currency positions less, or is simply increasing its degree of foreign business.
21. Transaction Exposure. Vegas Corp. is a U.S. firm that exports most of its products to Canada. It
historically invoiced its products in Canadian dollars to accommodate the importers. However, it
was adversely affected when the Canadian dollar weakened against the U.S. dollar. Since Vegas
did not hedge, its Canadian dollar receivables were converted into a relatively small amount of U.S.
dollars. After a few more years of continual concern about possible exchange rate movements,
Vegas called its customers and requested that they pay for future orders with U.S. dollars instead of
Canadian dollars. At this time, the Canadian dollar was valued at $.81. The customers decided to
oblige, since the number of Canadian dollars to be converted into U.S. dollars when importing the
goods from Vegas was still slightly smaller than the number of Canadian dollars that would be
needed to buy the product from a Canadian manufacturer. Based on this situation, has transaction
exposure changed for Vegas Corp.? Has economic exposure changed? Explain.
ANSWER: Transaction exposure is reduced since Vegas will have less receivables in Canadian
dollars. However, the economic exposure will not necessarily be reduced because a weak Canadian
dollar could cause a lower demand for its exports and will still affect cash flows.
22. Measuring Economic Exposure. Using the following cost and revenue information shown for
DeKalb, Inc., determine how the costs, revenue, and earnings items would be affected by three
possible exchange rate scenarios for the New Zealand dollar (NZ$): (1) NZ$ = $.50, (2) NZ$ =
$.55, and (3) NZ$ = $.60. (Assume U.S. sales will be unaffected by the exchange rate.) Assume
that NZ$ earnings will be remitted to the U.S. parent at the end of the period.
Chapter 10: Measuring Exposure to Exchange Rate Fluctuations 149
Revenue and Cost Estimates: DeKalb Inc.
(in millions of U.S. dollars and New Zealand dollars)
U.S. Business Business
Sales $800 NZ$800
Cost of Goods Sold 500 100
Gross Profit $300 NZ$700
Operating Expenses 300 0
Earnings Before Interest and Taxes $ 0 NZ$700
Interest Expense 100 0
Earnings Before Taxes –$100 NZ$700
(Figures are in millions)
NZ$=$.50 NZ$=$.55 NZ$=$.60
U.S. $ 800 $ 800 $ 800
New Zealand NZ$800 = 400 NZ$800 = 440 NZ$800 = 480
Total $ 1,200 $ 1,240 $ 1,280
Cost of Goods Sold
U.S. $ 500 $ 500 $ 500
New Zealand NZ$100 = 50 NZ$100 = 55 NZ$100 = 60
Total $ 550 $ 555 $ 560
Gross profit $650 $685 $720
Operating expenses $300 $300 $300
EBIT $350 $385 $420
Interest expenses $100 $100 $100
Earnings after taxes $250 $285 $320
The preceding table shows that DeKalb Inc. is adversely affected by a weaker New Zealand dollar
value. This should not be surprising since the New Zealand business has relatively high
NZ$ revenue compared to NZ$ expenses. This analysis assumes that the NZ$ received are
converted to U.S. dollars at the end of the period.
23. Changes in Economic Exposure. Walt Disney World built an amusement park in France that
opened in 1992. How do you think this project has affected Disney’s economic exposure to
exchange rate movements? Think carefully before you give your final answer. There is more than
one way in which Disney’s cash flows may be affected. Explain.
150 International Financial Management
ANSWER: This is a good question for class discussion. The typical first reaction is that Walt
Disney Company’s exposure may increase, since this new park would generate revenue in French
francs (now euros), which may someday be converted to dollars. If the French currency weakens
against the dollar, the revenue will be converted to fewer dollars.
However, keep in mind that Walt Disney was already affected by movements in the French franc
and other major currencies before this park was built. When European currencies (or the euro)
weakens against the dollar, tourism by Europeans decreases and Walt Disney’s business in the U.S.
declines. By having a European amusement park, it may be able to offset the declining U.S.
business during strong dollar cycles, since more European tourists may go to the Disney park in
France during the periods. Overall, Disney may be less exposed to exchange rate movements
because of the park.
24. Lagged Effects of Exchange Rate Movements. Cornhusker Co. is an exporter of products to
Singapore. It wants to know how its stock price is affected by changes in the Singapore dollar’s
exchange rate. It believes that the impact may occur with a lag of one to three quarters. How could
regression analysis be used to assess the impact?
ANSWER: A possible regression model for this task is to regress percentage change in its stock
price over quarter t (PSP) against the percentage change in the Singapore dollar (PSD) in the three t
previous quarters, shown as follows.
PSP = a + aPSD + aPSD + aPSD + u t01t–12t–23t–3t
where u is an error term. t
25. Potential Effects if the United Kingdom Adopted the Euro. The U.K. still has its own currency,
the pound. The pound’s interest rate has historically been higher than the euros interest rate. The
U.K. has considered adopting the euro as its currency. There have been many arguments about
whether it should do so.
Use your knowledge and intuition to discuss the likely effects if the United Kingdom adopts the euro.
For each of the 10 statements below, insert either INCREASE or DECREASE and complete the
statement by adding a clear short explanation (perhaps one to three sentences) of why the U.K.’s
adoption of the euro would have that effect.
To help you narrow your focus, follow these guidelines. Do not base your answer on whether the
pound would have been stronger than the euro in the future. Also, do not base your answer on an
unusual change in economic growth in the U.K. or in the euro zone if the euro is adopted.
a. The economic exposure of British firms that are heavy exporters to the euro zone would
ANSWER: The economic exposure of British firms that are heavy exporters to the euro zone would
decrease because no exchange of currencies would be needed.
b. The translation exposure of firms based in the euro zone that have British subsidiaries would