Foreign Exchange

Exposure
What is it and How it Affects
the Multinational Firm?

What is Foreign Exchange

Exposure?
Simply put, foreign exchange exposure is

the risk associated with activities that

involve a global firm in currencies other
than its home currency.
Essentially, it is the risk that a foreign
currency may move in a direction which
is financially detrimental to the global
firm.
Given our observed potential for adverse
exchange rate movements, firms must:
Assess and Manage their foreign exchange
exposures.

Does Foreign Exchange

Exposure Matter? What do
Global Firms Say
Nike: Our international operations and sources
of supply are subject to the usual risks of doing
business abroad, such as possible revaluation of
currencies (2005).
Starbucks: In fiscal 2004, international company
revenue [in US dollars] increased 32%, [in part]
because of the weakening U.S. dollar against
both the Canadian dollar and the British pound.
(2005).
McDonalds: In 2000, the weak euro, British
pound and Australian dollar had a negative
impact upon reported [US dollar] results. (2000).

FX Exposure and the

Valuation of a MNC
E CF$,t
V
t
1 k
t 1
n

where E(CF$,t) represents expected cash flows

to be received at the end of period t,
n represents the number of periods into the
future in which cash flows are received, and
k represents the required rate of return by
investors.
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Impact of Foreign Exchange

Exposure

E CF$,t E CF j ,t E S j ,t
m

j 1

where CFj,t represents the amount of cash flow

denominated in a particular foreign currency j at
the end of period t,

Sj,t represents the exchange rate at which the

foreign currency (measured in dollars per unit of
the foreign currency) can be converted to dollars
at the end of period t.
5

Global Companies and FX

Exposure
What are the specific
risks to a global firm
from foreign exchange exposure?

Cash inflows and outflows, as measured in

home currency equivalents, associated with
foreign operations can be adversely affected.
Revenues (profits) and Costs

Settlement value of foreign currency

denominated contracts, in home currency
equivalents, can be adversely affected.
For Example: Loans in foreign currencies.

The global competitive position of the firm

can be affected by adverse changes in
exchange rates.
Influence on required return.

End Result: The value (market price) of the

firm can be adversely affected.

Types of Foreign Exchange

Exposure

There are three distinct types of foreign

exchange exposures that global firms may face
as a result of their international activities.
These foreign exchange exposures are:
Transaction exposure

Any MNC engaged in current transactions involving

foreign currencies.

Economic exposure

Results for future and unknown transactions in foreign

currencies resulting from a MNC long term involvement
in a particular market.

Translation exposure (sometimes called

accounting exposure).

Important for MNCs with a physical presence in a foreign

country.

We will develop each of these in the slides

which follow.

Transaction Exposure

Transaction Exposure: Results from a

firm taking on fixed cash flow foreign
currency denominated contractual
agreements.
Examples of translation exposure:
An Account Receivable denominate in a foreign
currency.
A maturing financial asset (e.g., a bond)
denominated in a foreign currency.
An Account Payable denominate in a foreign
currency.
A maturing financial liability (e.g., a loan)
denominated in a foreign currency.

Economic Exposure

Economic Exposure: Results from the physical

entry (and on-going presence) of a global firm into
a foreign market.
This is a long term foreign exchange exposure resulting
from a previous FDI location decision.

Over time, the firm will acquire foreign currency

denominated assets and liabilities in the foreign
country.
The firm will also have operating income and
operating costs in the foreign country.
Economic exposure impacts the firm through contracts
and transactions which have yet to occur, but will, in the
future, because of the firms location.

These are really future transaction exposures

which are unknown today.
Economic exposure can have profound impacts on a
global firms competitive position and on the market
value of that firm.

The Two Channels of

Economic Exposure
Foreign currency
denominated asset &
liability exposure

Exchange
Rate
Fluctuations
Operating exposure
(Revenues and Costs)

Impact on the home

currency value of
foreign assets and
liabilities

MNCs
Competitive
Position and Value
Impact on home
currency amount of
future operating
cash flows

Translation Exposure
Translation Exposure: Results from the
need of a global firm to consolidated its
financial statements to include results
from foreign operations.
Consolidation involves translating
subsidiary financial statements from local
currencies (in the foreign markets where the
firm is located) to the home currency of the
firm (i.e., the parent).
Consolidation can result in either translation
gains or translation losses.
These are essentially the accounting systems
attempt to measure foreign exchange ex post
exposure.

Assessing Foreign Exchange

All global firms Exposure
are faced with the need to
analyze their foreign exchange exposures.

In some cases, the analysis of foreign exchange

exposure is fairly straight forward and known.
For example: Transaction exposure.
There is a fixed (and thus known) contractual
obligation (in some foreign currency) .
While in other cases, the analysis of the foreign
exchange exposure is complex and less certain.
For example: Economic exposure
There is great uncertainty as to what the
firms exposures will look like over the long
term.
Specifically when they will take place and
what the amounts will be.

Using a Hedge to Deal with

Exposures
In using a hedge,
a firm establishes a situation
opposite to its initial foreign exchange exposure.
A firm with a long position: i.e., it expects to
receive foreign currency in the future, will:
Offset that position with a short position (i.e., a
payment in the future) in the same currency.
A firm with a short position: i.e., it expects to pay
foreign currency in the future, will:
Offset that position with a long position in the
same currency.
In essence, the firm is covering (offsetting) the
original foreign exchange position.

Since the firm has two opposite foreign

exchange positions, they will cancel each other
out.

To Hedge or Not to Hedge?

What are some of the factors that would influence a
global firms decision to hedge its exposures?
Perhaps the firms assessment of the future strength or
weakness of the foreign currency it is exposed in.
This involves forecasting and how comfortable the firm is with
the results of the forecast.
For example; If the firm has a long position in what they think will
be a strong currency they may decide not to hedge, or do a
partial hedge.
Under these assumptions, a firm might accept an open
position.

On the other hand, firms may decide not have any currency
exposures and simply focus on their core business.
Does Starbucks want to sell coffee overseas or speculate on
currency moves?
Obviously, this is different from a company managing a hedge
fund, or a currency trading floor?

Hedging Strategies
It appears that most MNC firms (except for
those involved in currency-trading) would
prefer to hedge their foreign exchange
exposures.
But, how can firms hedge?
(1) Financial Contracts
Forward contracts (also futures contracts)
Options contracts (puts and calls)
Borrowing or investing in local markets.
(2) Operational Techniques
Geographic diversification (spreading the
risk)