ECONOMIC EXPOSURE

AND
TRANSLATION EXPOSURE
We
1.
2.
3.
4.

are:
Phan Khanh Diu Linh (leader)
L Phng Mai
Nguyn Thi Mai Hng
Nguyn Thi Thu Ha

5.
6.
7.
8.

Nguyn Khanh Linh

Cao Vn Chinh
am Hng Hanh
L Phng Anh

Today we
are
talking
about

I. Economic Exposure
II. A Case Study in Hedging
Economic Exposure
III. Hedging Exposure to Fixed Assets

IV. Managing Translation Exposure

I.
Economic
Exposure

a. Definitions:
. Economic exposure represents any impact of exchange
rate fluctuations on a firms future cash flows.
. It includes transaction exposure and any exchange rate
movements in ways not directly associated with foreign
transactions.
. To manage economic exposure, a firm must both hedge
their foreign payables or receivables and determine how
all their cash flows will be affected by possible exchange
rate movements

I.
Economic
Exposure

b. Types of economic exposure:

There are 3 forms of economic exposure, each of which
affects:
-. Purchase and sale transactions in foreign currencies
-. Remitted earnings from foreign subsidiaries
-. Demand: A change in exchange rates that affects the
demand for a product of a company can indirectly affect
the demand for a similar product of another company.
c. Difficulties in hedging economic exposure:
- Future transactions are not completely predictable
- Effects of exchange rate movements on demand are not
easily determined:

I.
Economic
Exposure
1. Use of Projected Cash Flows
to Assess Economic Exposure
An MNC must determine its economic exposure before it
can manage its exposure. It can determine its exposure to
each currency in terms of its cash inflows and cash
outflows.

Example: Madison Co.

The US sales, US cost of materials
and US interest expense are
denominated in USD and thus not
sensitive
to
interest
rate
movements. The Canadian sales,
Canadian cost of materials and
Canadian
interest
expense,
however, are sensitive.
As the Canadian dollar inflows of
4 million are much smaller than
the outflows of 210 million,
which consist of both Canadian
cost of materials and Canadian
interest expense, the amount of
Madisons cash flows before taxes
is inversely related to the strength
of the Canadian dollar.
The company can therefore reduce
this
exposure
by
either
increasing Canadian sales or
reducing orders of Canadian
materials.

I.
Economic
Exposure
2. How Restructuring Can
Reduce Economic Exposure

Restructuring involves:
Shifting the SOURCES of cost and revenue to other
locations
balance cash inflows and outflows in foreign currencies.

Example: Madison Co.

Situation: cash outflows > cash inflows (in C$)
balance cash flows by increasing Canadian
sales (inflows)
To do this, Madison spends $2m in advertising,
which is believed to rise the Canadian sales to
C$20m.
Materials:
+ Increase materials cost from US. suppliers by
$10m+$80m=$90m.
+ Reduce cost of materials from Canadian
suppliers BY C$100m
Interest expenses:
+ Borrow more from US banks +$4m on
interest expenses to US banks.
+ Retire some existing loans from Canadian
banks
-->
-C$5m owed to Canadian banks.

Impacts of possible Exchange rate movements on

Earnings

Results:

Sensitivity between
Madison's proposed restructured
operations
and exchange rate movements
is REDUCED.

In conslusion:
Restructuring

firms

operations

to

reduce

economic

exposure depends on the form of exposure:

If in the future, the sensitivity of:
Expenses > Revenue to possible values of a foreign currency
Increasing sensitivity of Revenue and Reducing sensitivity of
Expenses to exchange rate movements.
And vice versa

II. A Case Study

in Hedging
Economic
Exposure
It's not easy to reduce economic exposure
because:
1. Economic exposure is not obvious.
2. Difficult to pinpoint the source of the
exposure hard to find a perfect hedge
against it.

Savor Co.s
Dilemma
Savor Co., a U.S. firm, is primarily concerned with its
exposure to the euro and want to hedge its exposure.
Savor has 3 units that conduct some business in Europe.
Because each unit has established a wide variety of business
arrangements, it is not obvious whether all 3 units have a
similar exposure.

? Whether it is exposed?
?

What is the source of exposure?

How Savor defines economic exposure

01

Assessment of
Economic
Exposure

Whether it is
exposed or not?

02

Assessment of
Each Units
Exposure

Which Units are

exposed?

03

Identifying the Source

of the Units Exposure
Which characteristics of the
Unit that cause exposure?

Because the economic exposure to the euro is not

1. Assessment of
Economic Exposure

obvious, Savor attempts to assess the

relationship between the euros movements
and each units cash flows

Savor applies regression analysis to

determine whether the percentage
change in its total flow (5) is related to
the percentage change in the euro (6)
over time:

over the last nine quarters.

PCFt = a0 + a1(%euro)t + t
a0: the constant
a1: the slope coefficient which represents the
sensitivity of PCFt to movements in the euro.
Based on this analysis, the slope
coefficient is positive, which implies
that the cash flows are positively
related to the percentage changes in
the euro Savor is exposed to the
exchange rate movements of the
euro.

Textbook, p.352

2. Assessment of Each
Units Exposure

Which Units are exposed?

To determine the source of the exposure, Savor applies the regression model separately
to each individual units cash flows. The results are shown here:

The results suggest that the cash flows of Units A and B are not subject to economic
exposure. However, Unit C is subject to economic exposure.

Coefficient = .45 for 1% decrease in the euros value, the units cash flows will decline
by about .45%
R-squared = .80 about 80% of Unit Cs cash flows can be explained by movements in

3. Identifying the
Source of the Units
Exposure

Which characteristics of the

Unit that cause exposure?

The key components that affect Unit Cs cash flows are:

Income statement items such as its U.S. revenue;
Its cost of goods sold;
Its operating expenses.

3. Identifying the
Source of the Units
Exposure

Which characteristics of the

Unit that cause exposure?

Savor first determines the value of each income statement item that affected the
units cash flows in every of the last nine quarter. Then, it applies regression analysis to
determine the relationship between the percentage change in the euro and each
income statement item over those quarters. Assume that it finds:

A significant positive relationship between Unit Cs revenue and the euros value
No relationship between the units cost of goods sold and the euros value
No relationship between the units operating expenses and the euros value.
When the euro weakens, the units revenue from U.S. customers declines
substantially.
(When euro weakens price of goods from Europe is relatively cheaper US. Customers

Possible
Strategies to
Hedge
Economic
Exposure

1. Pricing policy

2. Hedging with Forward Contracts

3. Purchasing Foreign Supplies

4. Financing with Foreign Funds

5. Revising Operations of Other Units

1. Pricing policy

Anticipation: Euro will depreciate against

dollar in the future
Unit C attempt to be more competitive by
reducing its prices

For example:
When euro's value declines by 10% prices of foreign products that US customers pay
reduces 10% Unit C has to discount its prices by 10%.
Positive: Retain market share thanks to its competitive prices.
Negative: Lower prices less revenue less cash flows.
This policy cannot completely eliminate economic exposure.
Solution:
Unit C may charge relatively high prices when euro is strong then reduce the prices when
euro weakens.
Unit C can receive high revenue in a strong-euro period to offset the low revenue in a
weak-euro period.

2. Hedging with
Forward Contracts
Description :
Unit C could sell euros forward at a fixed rate:

Unit C and a financial institution sign a forward contract at the quote of $1/1
in 6 months. This allows unit C to exchange euros for dollars at the rate of
$1/1.

In six-month time, assume that the rate is $.95/1(euro depreciates against

the dollar)
Cash flow from normal operations will decrease
Generate a gain (profit) from forward contract offset the lost in the
cash flows.

2. Hedging with
Forward Contracts
Advantage:

The weaker the euro is, the more pronounced the gains from forward
contract will be.

Limitation:

The forward contract hedges only for the period of the contract, it does not
serve as a appropriate long-term solution.

3. Purchasing
Foreign Supplies
When euro weakens, Unit C may buy materials from Europe
at a lower price to reduce costs. (Because it conducts all of its
productions in the US)

However, the cost of buying materials from Europe maybe

higher than that of buying from local supplies when the
transportation expenses are included.

4. Financing with
Foreign Funds

How? -

Finance a part of its business with

loans in euros. Then convert the loans
proceeds to dollars and use this dollars to
support its business.
- But it still needs to periodically pay loans in
euros.

Advantages:
If the euro depreciates, the unit will need fewer dollars to repay the loans
in euros offset the negative effect of a weak euro on its revenue.
If the euro appreciates, the unit will need more dollars for repayment,
which will be offset by the positive effect of a strong euro on the units
revenue.
This type of hedge is more effective than the pricing policy as it can offset the
adverse effects of a weak euro in the same period.

Limitations:

If the euro has a high interest rate, the MNC has to deal with high interest
expenses.
The MNC must attempt to determine the amount of debt financing for
hedging (sometimes exceeding the necessary amount ).

5. Revising
Operations of Other
Units

Description: Modifying the operations of other

units to offset the economic exposure of unit C.
Beside unit C, Unit A and B also finance their
business with loans in euros.

Advantage:
In case of euros depreciation, the combined favourable effect on financing
for the MNC could offset the negative one on Unit Cs revenue. (recall that
unit A and B are not subject to economic exposure)

Limitations:
If the euro strengthens, unit A and Bs interest expenses increase, resulting
to weaker performance, less compensation Managers of the two units are
reluctant to obtain their finances.
Solution: Reward the managers of those units based on the units
performance that excludes the effect of euro on financing costs.

Savors Hedging
Solution

What is the optimal hedging strategy for

Savor?

Of those hedging solutions mentioned, the most optimal one seems to

be Revising operations of other units. By doing this other units
may their exposure, but in the opposite manner of Unit Cs In
general, the overall economic exposure of the MNC is reduced.
However, it is clear that an MNCs economic exposure can change over
time in response to shifts in foreign competition or other global
conditions. Therefore, it is essential that the MNC continually assess
and manage its economic exposure.

III. Hedging
Exposure to
Fixed
Assets

When a MNC has fixed assets (building, machinery) in a

foreign country, the dollar cash flows to be received
from the ultimate sale of these assets is subject to
exchange rate risk.
Example:

Wagner, a US firm, pursued a 6-year project in Russia.

At

the

time

of

investment,

it

purchased

manufacturing plant from the Russian government for

500m rubles, spot rate $.16 cost $80m.

The Russian government promised to repurchase the

plant for 500 rubes when the project completed, spot
rate at that time is $.034 worth only $17m.

US company suffer a 79% loss of money.

How to hedge?
MNCs need to consider hedging against the possible sale of assets in the distant future
by creating a liability that matches the expected value of the fixed asset at the time it will be
sold in the future.
Example:
US Company could borrow rubles from a local bank, with the loan structured to have zero
interest payments and a lump-sum repayment equal to the final sale price of the
product.
The loan could be a lump-sum repayment of 500 rubes in 6 years.
We can use the money from selling fixed asset to pay off the liability.

Limitations
The MNCs, however, may not know:
+ The future date to sell fixed assets;
+ How much they will sell the assets in local currency.
Unable to create a liability that perfectly match the date and price of the fixed assets.

Note: Long-term forward contracts may also be a possible way to hedge the distant sale

a. Definition:
Translation exposure occurs when an MNC
translates each subsidiarys financial data

IV.
Managing
Translation
Exposure

to its home currency for consolidated

financial statements.
Translation exposure can reduce an MNCs
consolidated earnings and thereby cause
a decline in its stock price.

b. Hedging
translation exposure

The subsidiarys earnings will be

translated as follows:

At the exchange rate of $1.60 (unchanged) translated earnings = $32 million

The exchange rate movements caused the reported earnings to be reduced by $2
million.
If we assume that the spot rate is worth $1.50 at the end of the year, then the gain
on the forward contract would be:

b. Hedging
translation exposure
The subsidiary forecasts that its earnings next year will be 20
million. It can implement a forward hedge on the expected
earnings by selling 20 million one year forward. Assume the
forward rate at that time is $1.60, the same as the spot rate.
If the pound depreciates over the year such that the average
weighted exchange rate is $1.50 over the year, the subsidiarys
earnings will be translated as follows:

c. Limitations of
Hedging Translation
Exposure

Inaccurate earnings forecasts;

Inadequate forward contract for some currencies (forward contracts are

not available to all currencies);

Accounting distortions;

Increased transaction exposure.

Thank you for listening!