Lecture 09 - Managing Economic Exposure and Translation Exposure

Chapter Objectives
• Explain how an MNC’s economic exposure can be hedged.

• Explain how an MNC’s translation exposure can be hedged.
Lecture 09
Managing Economic Exposure and
Translation Exposure
Jeff Madura, International Financial Management, 14th Edition. © 2021 Cengage. All Rights Reserved. May not be scanned, Jeff Madura, International Financial Management, 14th Edition. © 2021 Cengage. All Rights Reserved. May not be scanned, 2
copied or duplicated, or posted to a publicly accessible website, in whole or in part. copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Managing Economic Exposure (1 of 3) Managing Economic Exposure (2 of 3)

Economic exposure represents the impact of exchange rate fluctuations on a Restructuring to reduce economic exposure (Continued)
firm’s future cash flows. (Exhibit 12.1) • How Restructuring Depends on the Form of Economic Exposure
Assessing economic exposure o The way a firm restructures its operations to reduce economic exposure to
• An MNC must determine how it is subject to exchange rate movements exchange rate risk depends on the form of exposure. Any restructuring of
before it can manage its economic exposure.(Exhibit 12.2) operations that can reduce the difference between a foreign currency’s inflows
and outflows can consistently reduce the firm’s economic exposure to that
Restructuring to reduce economic exposure: currency’s movements over several future quarters. (Exhibit 12.5)
• Restructuring involves shifting the sources of revenue or expenses to better
match cash inflows and outflows in foreign currencies.(Exhibit 12.3 & 12.4)
Jeff Madura, International Financial Management, 14th Edition. © 2021 Cengage. All Rights Reserved. May not be scanned, 3 Jeff Madura, International Financial Management, 14th Edition. © 2021 Cengage. All Rights Reserved. May not be scanned, 4
Exhibit 12.1 How Managing Exposure Can Increase Exhibit 12.2 Original Impact of Possible Exchange
an MNC’s Value Rates on Cash Flows of Madison Co. (in Millions)
Exhibit 12.3 Impact of Possible Exchange Rate Movements Exhibit 12.4 Economic Exposure Based on the
on Earnings under Two Alternative Operational Structures Original and Proposed Operating Structures
(in Millions)
Exhibit 12.5 Restructuring Operations to Balance the Impact Managing Economic Exposure (3 of 3)
of Currency Movements on Cash Inflows and Outflows
Limitations of Restructuring Intended to Reduce Economic Exposure
RECOMMENDED ACTION WHEN
A FOREIGN CURRENCY HAS A RECOMMENDED ACTION WHEN A • MNCs may desire to reduce their economic exposure to exchange rate
TYPE OF GREATER IMPACT ON CASH FOREIGN CURRENCY HAS A GREATER movements, their decisions should focus on maximizing their value. And to
OPERATION INFLOWS IMPACT ON CASH OUTFLOWS reduce their economic exposure, they could potentially reduce their foreign
Sales in foreign Consider pricing foreign sales in the Increase foreign sales. sales, but that would also reduce their cash flows.
currency units MNC's local currency.
• Movement of production facilities to foreign countries could prevent an MNC
Reliance on foreign Increase foreign supply orders. Reduce foreign supply orders.
supplies
from fully capitalizing on economies of scale.
Proportion of debt Restructure debt to increase debt Restructure debt to reduce debt payments
structure payments in foreign currency. in foreign currency.
representing foreign
debt
A Case on Hedging Economic Exposure (1 of 3) Exhibit 12.6 Assessment of Savor Co.’s Cash Flows and
the Euro’s Movements
Savor Co.’s Assessment of Economic Exposure
(1) (2) (3) (4) (5) (6)
U.S. firm with exposure to the euro
% CHANGE IN % CHANGE IN % CHANGE IN % CHANGE IN % CHANGE IN
• Process Used to Detect Economic Exposure UNIT A'S CASH UNIT B'S CASH UNIT C'S CASH TOTAL CASH VALUE OF THE
QUARTER FLOWS FLOWS FLOWS FLOWS EURO
o Since the exact nature of its economic exposure to the euro is unknown, Savor 1 −3 2 1 0 2
attempts to assess the relationship between the euro’s movements and each
2 0 1 3 4 5
unit’s cash flows over the last nine quarters.
3 6 −6 −1 −1 −3
o The quarterly cash flows and movements in the euro are shown in Exhibit 12.6
4 −1 1 −1 −1 0
o Savor applies regression analysis to determine whether the quarterly percentage 5 −4 0 −1 −5 −2
change in its total cash flow is related to the quarterly percentage change in the
6 −1 −2 −2 −5 −5
euro’s value over time:
7 1 −3 3 1 4
8 −3 2 1 0 2
PCFt  a0  a1  PCE   t 9 4 −1 0 3 −4
A Case on Hedging Economic Exposure (2 of 3) A Case on Hedging Economic Exposure (3 of 3)
Savor Co.’s Assessment of Economic Exposure (Continued) Using a Financing Strategy to Hedge Economic Exposure
• Assessment of Each Unit’s Exposure • Savor’s Unit C partially hedge its economic exposure by financing a portion
o Savor Co. wants to determine whether and how each of its business units is of its business with loans in euros rather than in dollars.
subject to movements in the euro, so that it can then consider how it might • If the euro weakens, Unit C will need fewer dollars to cover the loan
reduce that exposure. repayments. This favorable effect can partially offset the adverse effect of a
o Results suggest that the cash flows of Units A and B are not subject to economic weak euro on the unit’s revenue.
exposure. However, Unit C is subject to economic exposure. • If the euro strengthens, Unit C will need more dollars to cover the loan
repayments, but this adverse effect will be offset by the favorable effect of the
strong euro on the unit’s revenue.
Managing Exposure to Fixed Assets Managing Translation Exposure (1 of 2)

Hedging the sale of fixed assets by: Translation exposure occurs when each subsidiary’s financial data is translated
• Selling the currency forward in long-term forward contract to its home currency for consolidated financial statements.
• Creating a liability in that currency that matches the expected value of the Hedging Translation Exposure with Forward Contracts
assets in the future. • Translation exposure can be hedged with forward or futures contracts.
Limitations of hedging the sale of fixed assets:
• MNC may not know the date when it will sell the assets.
• MNC may not know the price in the local currency at which it will sell them.
Managing Translation Exposure (2 of 2) Summary (1 of 2)
Limitations of hedging translation exposure: • Economic exposure can be managed by balancing the sensitivity of revenue
• Inaccurate earnings forecasts — Earnings in a future period are uncertain. and expenses to exchange rate fluctuations. To accomplish this, however,
the firm must first recognize how its revenue and expenses are affected by
• Inadequate forward contracts for some currencies — Forward contracts exchange rate fluctuations. For some firms, revenue is more susceptible.
are not available for all currencies. These firms are most concerned that their home currency will appreciate
• Accounting distortions — The forward rate gain or loss reflects the against foreign currencies since the unfavorable effects on revenue will more
difference between the forward rate and the future spot rate, whereas the than offset the favorable effects on expenses. Conversely, firms whose
translation gain or loss is caused by the change in the average exchange expenses are more sensitive to exchange rates than their revenue are most
rate over the period in which the earnings are generated. concerned that their home currency will depreciate against foreign
currencies. When firms reduce their economic exposure, they reduce not
• Increased transaction exposure — The MNC may be increasing its only these unfavorable effects but also the favorable effects if the home
transaction exposure. currency value moves in the opposite direction.
Summary (2 of 2)
• Translation exposure can be reduced by selling forward the foreign currency
used to measure a subsidiary’s income. If the foreign currency depreciates
against the home currency, the adverse impact on the consolidated income
statement can be offset by the gain on the forward sale in that currency. If the
foreign currency appreciates over the time period of concern, there will be a
loss on the forward sale that is offset by a favorable effect on the reported
consolidated earnings. However, many MNCs would not be satisfied with a
“paper gain” that offsets a “cash loss.”
Jeff Madura, International Financial Management, 14th Edition. © 2021 Cengage. All Rights Reserved. May not be scanned, 19
copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Chapter Objectives

• Explain how an MNC’s economic exposure can be hedged.

Managing Economic Exposure (1 of 3) Managing Economic Exposure (2 of 3)

Managing Exposure to Fixed Assets Managing Translation Exposure (1 of 2)

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