,Measuring Exposure To Exchange Rate Fluctuations,10,Chapter,South-Western/Thomson Learning 2003,See c10.xls for spreadsheets to accompany this chapter.,Chapter Objectives,To discuss the relevance of an MNCs exposure to exchange rate risk; To explain how transaction exposure can be measured; To explain how economic exposure can be measured; and To explain how translation exposure can be measured.,Is Exchange Rate Risk Relevant?,Purchasing Power Parity Argument Exchange rate movements will be matched by price movements. PPP does not necessarily hold.,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.,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.,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.,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.,Is Exchange Rate Risk Relevant?,For current and historic exchange rates, as well as implied currency volatilities, visit http:/www.ny.frb.org/pihome/statistics/.,Online Application,11/30/01 Implied Vols 1 Week 1 Month 2 Month 3 Month 6 Month 12 Month 2 Year 3 Year EUR 10.9 9.9 10.9 11.2 11.7 11.9 11.9 11.8 JPY 9.1 8.9 9.5 9.9 10.4 10.6 10.7 10.7 CHF 11.2 10.3 11.2 11.5 11.9 12.1 12.0 12.0 GBP 9.0 8.1 8.8 9.1 9.4 9.5 9.6 9.7 CAD 6.2 5.9 6.0 6.1 6.1 6.1 6.2 6.1 AUD 10.4 10.3 11.0 11.4 11.8 12.0 12.0 12.0 GBPEUR 8.1 6.9 7.4 7.7 8.4 8.7 8.6 8.5 EURJPY 9.3 9.0 9.7 10.3 10.8 11.3 11.4 11.4,Types of Exposure,Although exchange rates cannot be forecasted with perfect accuracy, firms can at least measure their exposure to exchange rate fluctuations. Exposure to exchange rate fluctuations comes in three forms: Transaction exposure Economic exposure Translation exposure,Transaction Exposure,The degree to which the value of future cash transactions can be affected by exchange rate fluctuations is referred to as transaction exposure. To measure transaction exposure: project the net amount of inflows or outflows in each foreign currency, and determine the overall risk of exposure to those currencies.,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.,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.,Transaction Exposure,Currency 1981-1993 1994-1998 British pound 0.0309 0.0148 Canadian dollar 0.0100 0.0110 Indian rupee 0.0219 0.0168 Japanese yen 0.0279 0.0298 New Zealand dollar 0.0289 0.0190 Swedish krona 0.0287 0.0195 Swiss franc 0.0330 0.0246 Singapore dollar 0.0111 0.0174,Transaction Exposure,Standard Deviations of Exchange Rate Movements Based on Monthly Data,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,Transaction Exposure, Can$ NZ$ Sk SwF British pound () 1.00 Canadian dollar (Can$) .18 1.00 Japanese yen () .45 .06 1.00 New Zealand dollar (NZ$) .39 .20 .33 1.00 Swedish krona (Sk) .62 .16 .46 .33 1.00 Swiss franc (SwF) .63 .12 .61 .37 .70 1.00,Transaction Exposure,Correlations Among Exchange Rate Movements,The point in considering correlations is to detect positions that could somewhat offset each other. For example, if currencies 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 corrrelations among currencies may change over time.,Transaction Exposure,Movements of Selected Currencies Against the Dollar,A related method, the value-at-risk (VAR) method, incorporates currency volatility and correlations to determine the potentia