1,Chapter 4,Measuring Exposure To Exchange Rate Fluctuations,2,Objectives,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. The specific objectives are to:,3,Objectives,discuss the relevance of an MNCs exposure to exchange rate risk; explain how transaction exposure can be measured; explain how economic exposure can be measured; explain how translation exposure can be measured.,4,Is Exchange Rate Risk Relevant?,Purchasing Power Parity Argument Exchange rate movements will be matched by price movements. PPP does not necessarily hold.,5,Is Exchange Rate Risk Relevant?,The Investor Hedge Argument MNC shareholders can hedge against exchange rate fluctuations on their own. The investors may not have complete information on corporate exposure. They may not have the capabilities to correctly insulate their individual exposure too.,6,Is Exchange Rate Risk Relevant?,Currency Diversification Argument An MNC that is well diversified should not be affected by exchange rate movements because of offsetting effects. This is a naive presumption.,7,Is Exchange Rate Risk Relevant?,Stakeholder Diversification Argument Well diversified stakeholders will be somewhat insulated against losses experienced by an MNC due to exchange rate risk. MNCs may be affected in the same way because of exchange rate risk.,8,Is Exchange Rate Risk Relevant?,Response from MNCs Many MNCs have attempted to stabilize their earnings with hedging strategies, which confirms the view that exchange rate risk is relevant.,9,Types of Exposure,Although exchange rates cannot be forecasted with perfect accuracy, firms can at leastmeasure their exposure to exchange rate fluctuations. Exposure to exchange rate fluctuations comes in three forms: Transaction exposure Economic exposure Translation exposure,10,Transaction Exposure,The degree to which the value of future cash transactions can be affected byexchange rate fluctuations is referred to as transaction exposure. To measure transaction exposure: project the net amount of inflows or outflowsin each foreign currency, and determine the overall risk of exposure tothose currencies.,11,Transaction Exposure,MNCs can usually anticipate foreign cash flows for an upcoming short-term period with reasonable accuracy. After the consolidated net currency flows for the entire MNC has been determined, each net flow is converted into either a point estimate or a range of a chosen currency, so as to standardize the exposure assessment for each currency. (Example：P248),12,Transaction Exposure,An MNCs overall exposure can be assessed by considering each currency position together with the currencys variability and the correlations among the currencies. The standard deviation statistic on historical data serves as one measure of currency variability. Note that currency variability levels may change over time.,13,Transaction Exposure,The correlations among currency movements can be measured by their correlation coefficients, which indicate the degree to which two currencies move in relation to each other.coefficient perfect positive correlation 1.00 no correlation 0.00 perfect negative correlation -1.00,14,Transaction Exposure,The point in considering correlations is to detect positions that could somewhat offset each other. For example, if currency X and Y are highly correlated, the exposures of a net X inflow and a net Y outflow will offset each other to a certain degree. Note that the correlations among currencies may change over time.,15,Transaction Exposure,A related method, the value-at-risk (VAR) method, incorporates currency volatility and correlations to determine the potential maximum one-day loss. Historical data is used to determine the potential one-day decline in a particular currency. This decline is then applied to the net cash flows in that currency.,16,Transaction Exposure,Example: Pitt, Inc., a U.S.-based MNC, typically has receivables in Japanese yen. It first determines the maximum potential one-day decline in the yen that would be likely using a recent historical period such as 90 days. Pitt then applies that potential decline to its receivables to determine the potential loss in the dollar value of its receivables if that decline in the yen does occur.,