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Chapter 10 Measuring Exposure to Exchange Rate Fluctuations Lecture Outline Is Exchange Rate Risk Relevant? Transaction Exposure 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 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 141 142 International Financial Management 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. 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? POINT/COUNTER-POINT: Should Investors Care about an MNCs Translation Exposure? POINT: No. The present value of an MNCs 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 MNCs 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. than the earnings of MNCs with low translation exposure.... View Full Document

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