o Interest Rate Parity

- an equilibrium state when market forces cause interest rates and exchange rates to adjust
such that covered interest arbitrage is no longer feasible
- forward rate differs from the spot rate by a sufficient amount to offset interest rate
differential between two currencies

DERIVATION OF INTEREST RATE PARITY

CHAPTER 8: RELATIONSHIPS AMONG INFLATION, INTEREST RATES, AND EXCHANGE

RATES

o Purchasing Power Parity

- Recall: when a country’s inflation rate , the demand for its currency  as its exports 
(because of higher prices), also, consumer and firms in that country tend to increase their
importing, both of these places downward pressure on the high-inflation country’s currency.
- Attempts to quantify the relationship between inflation and exchange rate
- More specific about the degree by which a currency will weaken in response to high
inflation

TWO FORMS OF PPP:

 Absolute Form of PPP
- in absence of international barriers, consumers will shift their demand to wherever prices
are lowest
- prices of the same basket of goods in two different countries should be equal when
measured in a common currency, if there are discrepancies, then demand should shift so
that these prices converge.
- The existence of transportation costs, tariffs, and quotas render the absolute form of PPP
unrealistic. In this case, the discrepancy in price will continue.

 Relative Form of PPP

- accounts such market imperfections such as transportation costs, tariffs and quotas.
- Acknowledges that these imperfections make it unlikely for prices of the same basket of
goods in different countries to be the same when measured in a common currency.
- However, this form suggests that the rate of change in the prices of those baskets should
be comparable when measured in a common currency, all other things unchanged.

RATIONALE BEHIND RELATIVE PPP THEORY

- exchange rate adjustment is necessary for the relative purchasing power to be the same
whether buying products locally or from another country
- if not equal, then consumer will shift purchases to wherever products are cheaper until
purchasing power equalizes.

DERIVATION OF PURCHASING POWER PARITY

- if 𝐼ℎ >𝐼𝑓 , and if exchange rate does not change between two countries, then consumer’s
purchasing power is greater for foreign than for home goods, PPP does not hold
- if 𝐼ℎ <𝐼𝑓 , and if exchange rate does not change between two countries, then consumer’s
purchasing power is greater for home than for foreign good, PPP also does not hold
 - PPP theory suggests that the exchange rate will not remain constant but will adjust to
maintain the parity in purchasing power

- this expresses the relationsip between relative inflation and exchange rates
- if 𝐼ℎ >𝐼𝑓 , then 𝒆𝒇 should be positive, which implies that the foreign currency will appreciate
- this theory is more applicable when two countries engage in extensive international trade
with each other; if there is not much trade, then inflation differential will have little effect and
so exchange rate should not be expected to change

SUMMARY of PPP
S1: Local currency should
Relatively HIGH Local Inflation Imports will , exports will  depreciate by same degree as
inflation differential
S2: Local currency should
Relatively LOW Local Inflation Imports will , exports will  appreciate by same degree as
inflation differential
S3: Local currency’s value is not
Local and Foreign Inflation rate No impact of inflation on Import affected by inflation
are SIMILAR or Export volume

SIMPLIFIED PPP RELATIONSHIP

𝒆𝒇 = 𝑰 𝒉 − 𝑰 𝒇
- less precise
- percentage change in exchange rate should be approximately equal to the difference in
inflation rates between two countries
- appropriately only when inflation differential is small or when the value of 𝑰𝒇 is close to zero

STATISTICAL TESTS OF PPP

- high inflation can weaken a currency’s value, there are significant deviations from PPP
- these deviations are less pronounced when longer time periods are considered, but they
remain nonetheless
- relying on PPP to derive a forecast of exchange rates is subject to error, even long term
forecasts

LIMITATION OF PPP TESTS

- results will vary with the base period used

WHY PURCHASING POWER PARITY DOES NOT HOLD

- PPP doesn’t normally hold because:

 Confounding effects
- there are several factors affecting a currency’s spot rate
- Inflation, interes rates, income levels, government controls and expectations of future
exchange rates
- Since exchange rates are not driven by inflation alone, the relationship between the
inflation differential and exchange rate movement cannot be as simple as the PPP theory
suggests
  No substitutes for Traded Goods
- if substitutes are not available domestically, then consumers will probably not resist from
buying imported goods

INTERNATIONAL FISHER EFFECT

- uses the difference in interest rates to explain why exchange rates shift over time
- uses PPP to support argument

FISHER EFFECT
- named from economist Irving Fisher
- presumes that the nominal interest rate consists of two components: the expected
inflation rate & real rate of interest
- real rate of interest: return on investment to savers after accounting for expected inflation,
measured as 𝑛𝑜𝑚𝑖𝑛𝑎𝑙 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 – 𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒

USING THE IFE TO PREDICT EXCHANGE RATE MOVEMENTS

 Apply the Fisher effect to derive expected inflation per country
- difference in expected inflation is equal to the difference in nominal interest rates between
two countries, which means that expected inflation is higher in the country whose interest
rate is higher
 Rely on PPP to estimate the exchange rate movement
- determine via PPP how the exchange rate would change in response to the two countries’
expected inflation rates

IMPLICATIONS OF IFE
- high interest rates will exhibit high expected inflation (because of IFE) and that this
relatively high inflation will cause those currencies to depreciate (because of PPP)
- this explains why MNCs and investors bases in the US may refrain from investments in the
interest-bearing securities of those countries; the exchange rate effect could offset the
interest rate advantage

IMPLICATIONS OF THE IFE FOR TWO NON US CURRENCIES

- the expected return after considering the exchange rate effect is the same irrespective of
where the investors of a given country invest their funds

DERIVATION OF THE IFE

- if 𝐼ℎ >𝐼𝑓 , then exchange rate changes will be positive because relatively low foreign interest
rate reflects low inflationary expectations in the foreign country
- foreign currency will appreciate when foreign interest rate is lower than the home interest
rate
- if 𝐼ℎ <𝐼𝑓 , then ef will be negative, foreign currency will depreciate when foreign interest rate
exceeds the home interest rate
- this depreciation will reduce the return on foreign securities from the perspective of
investors in the home country, making returns on foreign securities no higher than returns
on home securities

SIMPLIFIED RELATIONSHIP
 - simple but less precise
- reasonable only when interest rate differential is small
LIMITATIONS OF THE IFE
 Limitations of the fisher effect
- expected inflation derived is subject to error
 Limitations of PPP
- there are other characteristics besides inflation that can affect exchange movements

THEORY KEY VARIABLES SUMMARY

Interest rate parity Forward rate discount/
premium
Interest rate differential
Purchasing power Percentage change in spot
parity exchange rate/
Inflation rate differential
International Fisher Percentage change in spot
Effect exchange rate/ Interest
rate differential
Forward rate of one currency with respect to
another will contain a premium or discount that
is determined by the differential in interest rates
between the two countries. As a result, covered
interest arbitrage will provide a retun that is no
higher than a domestic return.
The spot rate of one currency with respect to
another will change in reaction to the differential
in inflation rates between two countires.
Consequently, the purchasing power for
consumers when purchasing goods in their own
country will be similar to their purchasing power
when importing goods from foreign countries.
The spot rate of one currency with respect to
another will change in accordance with the
differential in interest rates between the two
countries. Consequently, the return on
uncovered foreign money market securities will,
on average, be no higher than the return on
domestic money market securities from the
perspective of investors in the home country.

Chapter 10: Measuring Exposure to Exchange Rate Fluctuations

 Exchange rate risk: risk that a company’s performance will be affected by exchange rate
movements

Relevance of Exchange Rate Risk

- exchange rates are extremely volatile
- dollar value of an MNC’s future payables or receivables position in a foreign currency can change
substantially in response to movements

The Investor Hedge Argument

- one argument for exchange rate irrelevance is that investors in MNCs can hedge exchange rate risk
on their own
- this assumes that investors have complete info on corporate exposure to exchange rate
fluctuations as well as the ability to insulate their individual exposure
- an MNC may be able to hedge at a lower cost than individual investors

Currency Diversification Argument

- if a firm is well diversified across numerous countries, then its value will not be affected by
exchange rate movements because of offsetting effects
 - however, it would be naïve to suppose that exchange rate will offset one another

Stakeholder Diversification Argument

- if stakeholders are diversified then they will be sufficiently insulated against losses due to
exchange rate risk
- but MNCs are similarly affected by exchange rate movements, so it is difficult to construct a
diversified portfolio of stocks

Response from MNCs

- hedging can reduce the uncertainty surrounding future cash flows
- a creditor that provides loans to MNCs may prefer low exposure to exchange rate risk
- MNCs that hedge may be able to borrow funds at a lower cost
- Colgate palmolive, eastman kodak, merck have hedging strategies

Firms are subject to the following forms of exchange rate exposure:

 Transaction exposure
 Economic exposure
 Translation exposure

TRANSACTION EXPOSURE
- the sensitivity of the firm’s contractual transactions in foreign currencies to exchange rate
movements
- to assess transaction exposure:
 MNC must estimate its net cash flows in each currency
 Measure the possible effects of its exposure to those currencies

Estimating “Net” Cash flows in Each Currency

- MNCs tend to focus on transaction exposure over an upcoming short term period, for which
they can anticipate foreign currency cash flows with reasonable accuracy
- The further into the future an MNC attempts to measure its transaction exposure, the less
accurate the measurement will be because of the greater uncertainty about future inflows from
and outflows to each foreign currency

Exposure of an MNCs Portfolio

- the exposure of the portfolio of currencies can be measured by the standard deviation of the
portfolio, which indicates how the portfolio’s value may deviate from what is expected

𝜎𝑝 = √𝑊 2𝑋 𝜎 2𝑋 + 𝑊 2 𝑌 𝜎 2 𝑌 + 2𝑊𝑥 𝑊𝑌 𝜎𝑥 𝜎𝑌 𝐶𝑂𝑅𝑅𝑋𝑌
where:
W= proportion of total portfolio value that is currency x and Y

𝜎= standard deviation of monthly percentage changes in currencies X and Y

CORR= correlation coefficient of monthly percentage changes between currencies X and Y

Measurement of Currency Volatility

- standard deviation measures the degree of movement for each currency
- standard deviations of currencies in emerging countries tend to be higher than deviations in the
currencies of developed countries

Currency Volatility over Time

 - volatility of a currency need not remain consistent from one period to another

Measurement of Currency Correlations

- correlations among currencies are measured by their correlation coefficients, which indicate the
extent to which two currencies move in tandem with each other
- a negative correlation reflect an inverse relationship between the currencies

Impact of Cash Flow and Correlation Conditions

IF THE MNC’S EXPECTED CASH FLOW AND IF THE THEN THE MNC’S EXPOSURE IS
SITUATION IS CURRENCIES ARE RELATIVELY
Equal amounts of net inflows in two currencies Highly correlated High
Equal amounts of net inflows in two currencies Slightly positively Moderate
correlated
Equal amounts of net inflows in two currencies Negatively Low
correlated
A net inflow in one currency and net outflow of Highly correlated Low
about the same amount in another
A net inflow in one currency and net outflow of Slightly positively Moderate
about the same amount in another correlated
A net inflow in one currency and net outflow of Negatively High
about the same amount in another correlated

Currency correlations over Time

- previous correlations are not perfect predictors of future correlations
- but some general relationships tend to hold over time
Transaction Exposure Based on Value at Risk
- value at risk (VaR) method: measures maximum possible (one day) loss on the value of
positions held by an MNC that is exposed to exchange rate movements

𝑀𝑎𝑥𝑖𝑚𝑢𝑚 1 − 𝑑𝑎𝑦 𝑙𝑜𝑠𝑠 = 𝐸(𝑒𝑡 ) − (1.65 𝑥 𝜎𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦 )

𝐶𝑢𝑟𝑟𝑒𝑛𝑐𝑦 𝑣𝑎𝑙𝑢𝑒 𝑏𝑎𝑠𝑒𝑑 𝑜𝑛 𝑚𝑎𝑥𝑖𝑚𝑢𝑚 1 − 𝑑𝑎𝑦 𝑙𝑜𝑠𝑠 = 𝑆 𝑥 (1 + max 1 − 𝑑𝑎𝑦 𝑙𝑜𝑠𝑠)

Example:
Celia Co. will receive 10 million MXP tomorrow as a result of providing services to a mexican firm. It
wants to determine the maximum one day loss due to a potential decline in the peso value. Celia
estimates the 𝜎 of daily percentage changes of MXP to be 1.2% over the last 100 days. Assuming an
expected % change of 0% during the next day, then the maximum one day loss is: (Suppose the spot rate
of peso is $0.09

𝑀𝑎𝑥𝑖𝑚𝑢𝑚 1 − 𝑑𝑎𝑦 𝑙𝑜𝑠𝑠 = 0% − (1.65 𝑥 1.2%) = −𝟏. 𝟗𝟖%

𝐶𝑢𝑟𝑟𝑒𝑛𝑐𝑦 𝑣𝑎𝑙𝑢𝑒 𝑏𝑎𝑠𝑒𝑑 𝑜𝑛 𝑚𝑎𝑥𝑖𝑚𝑢𝑚 1 − 𝑑𝑎𝑦 𝑙𝑜𝑠𝑠 = 0.09 𝑥 (1 − 1.98%) = $. 𝟎𝟎𝟖𝟖𝟐𝟏𝟖
10,000,000 x .09= $900,000
Hence, a decline of -1.98% will result to a loss of: 900,000 x -1.98%= -$17,820

Factors that affect the Maximum one day loss

- it depends on three factors:
 depends on the expected percentage change in the currency the next day, if expected
change were -.2% instead of 0%
𝑀𝑎𝑥𝑖𝑚𝑢𝑚 1 − 𝑑𝑎𝑦 𝑙𝑜𝑠𝑠 = −.2% − (1.65 𝑥 1.2%) = −𝟐. 𝟏𝟖%
  depends on confidence level used: a higher confidence level will lead to greater
maximum one day loss (all other things constant)
 depends on 𝜎 of the daily percentage changes in the currency over a previous period
(lower 𝝈, 𝒍𝒐𝒘𝒆𝒓 𝒍𝒐𝒔𝒔)

Applying VaR to Longer Time Horizons

- can be used to assess exposure over longer time horizons
- standard deviation should be estimated over the time horizon for which max loss is measured
- instead of daily, use monthly percentage changes

Applying VaR to the Transaction Exposure of a Portfolio

Example:
Benou, Inc., a US exporting firm, expects to receive substantial payments denominated in Indonesian
rupiah and Thai baht in one month. Based on today’s spot rate, the dollar value of the funds to be
received is estimated at $600,000 for the rupiah and $400,000 for the baht. Thus, Benouh is exposed to a
currency portfolio weighted 60% in rupiah, 40% in baht. Benou estimates the standard deviation of
monthly percentage changes to be 7% for the rupiah and 8% for baht; it also estimates a correlation
coefficient of .50 between these two currencies. The portfolio’s 𝜎 is:

𝜎𝑝 = √(. 60)2 (. 07)2 + (. 40)2 (. 08)2 + 2(. 60)(. 40)(. 07)(. 08)(. 50)
= 𝒂𝒃𝒐𝒖𝒕 𝟔. 𝟒𝟑%
Assuming a 0% change for each currency next month, the maximum one month loss is:
𝑀𝑎𝑥𝑖𝑚𝑢𝑚 1 − 𝑚𝑜𝑛𝑡ℎ 𝑙𝑜𝑠𝑠 = 0% − (1.65 𝑥 6.43%) = −𝟏𝟎. 𝟔𝟏%

Now, compare this maximum one month loss to that of the rupiah or baht individually:
𝑀𝑎𝑥𝑖𝑚𝑢𝑚 1 − 𝑚𝑜𝑛𝑡ℎ 𝑙𝑜𝑠𝑠 𝑜𝑓 𝑟𝑢𝑝𝑖𝑎ℎ = 0% − (1.65 𝑥 7%) = −𝟏𝟏. 𝟓𝟓%
𝑀𝑎𝑥𝑖𝑚𝑢𝑚 1 − 𝑚𝑜𝑛𝑡ℎ 𝑙𝑜𝑠𝑠 𝑜𝑓 𝑏𝑎ℎ𝑡 = 0% − (1.65 𝑥 8%) = −𝟏𝟑. 𝟐%

- observe that portfolio max loss is lower than the maximum loss for either individual currency,
which can be attributed to diversification effects
- the lower the correlation between currencies movements, the greater diversification benefits

Limitations of VaR
- presumes that the distribution of exchange rate movements is normal
- if distribution of exchange rate movements is not normal, then estimating the maximum expected
loss is subject to error
- also, VaR assumes that the volatility of exchange rate movements is stable over time, if past
exchange rate movements are less volatile than future movements, then the estimated max
expected loss derived will be underestimated

ECONOMIC EXPOSURE (operating exposure)

- the sensitivity of the firm’s cash flows to exchange rate movement
- an MNC’s transaction exposure is a subset of its economic exposure but the latter includes other
ways, besides transaction exposure, that a firm’s cash flows can be affected by exchange rate
movements

A US FIRM… THE US FIRM’S CASH FLOW WILL BE

ADVERSELY AFFECTED IF
1. Has a contract to export products in which it Euro depreciates
agreed to accept euros
2. Has a contract to import materials that are Peso appreciates
priced in Mexican pesos
3. Exports products to UK that are priced in Pound depreciates (cause some customers to
dollars, and competitors located in UK switch to the competitors)
4. Sells products to local customers, and its Euro depreciates (causing some customers to swith
main competitor is based on Belgium to competitors)

Exposure to Local Currency Appreciation

Transactions that influence the Impact of Local Currency Impact of Local Currency
Firm’s Local Currency APPRECIATION on DEPRECIATION on
INFLOWS Transactions Transactions
Local sales Decrease Increase
Firm’s exports denominated in Decrease Increase
local currency
Firm’s exports denominated in Decrease Increase
foreign currency
Interest received from Foreign Decrease Increase
investments

Transactions that influence the Impact of Local Currency Impact of Local Currency
Firm’s Local Currency APPRECIATION on DEPRECIATION on
OUTFLOWS Transactions Transactions
Firm’s imported supplies No change No change
denominated in local currency
Firm’s imported supplies Decrease Increase
denominated in foreign
currency
Interest owed on foreign funds Decrease Increase
borrowed

Economic Exposure of Domestic Firms

- even purely domestic firms are affected by economic exposure because it faces foreign
competition in its local markets

TRANSLATION EXPOSURE
- exposure of the MNC’s consolidated financial statements to exchange rate fluctuations
- MNCs used a process established by the FASB 52.

Determinants of Translation Exposure

 The proportion of its business conducted by foreign subsidiaries
 The locations of its foreign subsidiaries
 The accounting methods that it uses

Proportion of its business conducted by foreign subsidiaries

- the greater the percentage of an MNC’s business conducted by its foreign subsidiaries, the larger
the percentage of a given financial statement item that is susceptible to translation exposure
Locations of Foreign Subsidiaries
- countries in which subsidiaries are located can influence the degree of translation exposure
because the financial statement items of each subsidiary are typically measured by the respective
subsidiary’s home currency

Accounting Methods

CHAPTER 11: Managing Transaction Exposure

- Transaction exposure exists when there are contractual transactions that cause an MNC to
either need or receive a specified amount of a foreign currency at a specified time in the
future

 Hedging most of the Exposure

- some MNCs most of their exposure so that their value is not strongly influenced by
exchange rates
- most MNCs do not necessarily expect that hedging will always be beneficial; some even
use hedges that results to slightly worse outcomes than no hedges at all
- hedging transaction exposure allows MNC to accurately forecast future cash flows (in their
home currency) so that they can make better decisions regarding the amount of financing
they will need
 Selective hedging
- consider each type of transaction separately
- MNCs that are well diversified across many countries may forgo hedging their exposure
except in rare circumstances

HEDGING EXPOSURE TO PAYABLES

 Forward or Futures Hedge
- lock in a specific exchange rate at which it can purchase a specific currency, thereby
hedging payables denominated in that currency.
- Forward contract is negotiated between a firm and a financial institution such as a
commercial bank, so it can be tailored to meet the firm’s specific needs.

Cost of contract = Payables x Forward rate

- same thing would apply if futures contract were used
- futures rate is normally close to the forward rate
- forward contracts are frequently used by large corporations
 Money Market Hedge on Payables
- involves taking a money position to cover a future payables position
- 1) borrowed funds in the home currency
- 2) a short term investment in the foreign currency
𝑃𝑎𝑦𝑎𝑏𝑙𝑒𝑠
1. 𝐷𝑒𝑝𝑜𝑠𝑖𝑡 𝑎𝑚𝑜𝑢𝑛𝑡 𝑡𝑜 ℎ𝑒𝑑𝑔𝑒 𝑝𝑎𝑦𝑎𝑏𝑙𝑒𝑠 = (1+𝑓𝑜𝑟𝑒𝑖𝑔𝑛 𝑙𝑒𝑛𝑑𝑖𝑛𝑔 𝑟𝑎𝑡𝑒) = 𝑥
2. 𝐷𝑒𝑝𝑜𝑠𝑖𝑡 𝑎𝑚𝑜𝑢𝑛𝑡 𝑖𝑛 𝑑𝑜𝑙𝑙𝑎𝑟𝑠 = 𝑥 (𝑠𝑝𝑜𝑡 𝑟𝑎𝑡𝑒 𝑡𝑜𝑑𝑎𝑦) = 𝑦

3. 𝐷𝑜𝑙𝑙𝑎𝑟 𝑎𝑚𝑜𝑢𝑛𝑡 𝑜𝑓 𝑙𝑜𝑎𝑛 𝑟𝑒𝑝𝑎𝑦𝑚𝑒𝑛𝑡 = 𝑦 ∗ (1 + ℎ𝑜𝑚𝑒 𝑏𝑜𝑟𝑟𝑜𝑤𝑖𝑛𝑔 𝑟𝑎𝑡𝑒)

 Call Option Hedge on Payables

- currency call option provides the right to buy a specified amount of a particular currency at
a specified price within a given period of time
HEDGING EXPOSURE TO RECEIVABLES

 Forward or Futures Hedge on Receivables

Cash inflow = Receivables x Forward rate

 Money Market Hedge on Receivables
𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠
1. 𝐴𝑚𝑜𝑢𝑛𝑡 𝑡𝑜 𝑏𝑜𝑟𝑟𝑜𝑤 = =𝑥
(1 + 𝐹𝑜𝑟𝑒𝑖𝑔𝑛 𝑏𝑜𝑟𝑟𝑜𝑤𝑖𝑛𝑔 𝑟𝑎𝑡𝑒)
2. 𝐴𝑚𝑜𝑢𝑛𝑡 𝑜𝑓 𝑑𝑜𝑙𝑙𝑎𝑟𝑠 𝑟𝑒𝑐𝑒𝑖𝑣𝑒𝑑 𝑓𝑟𝑜𝑚 𝑙𝑜𝑎𝑛 = 𝑥(𝑠𝑝𝑜𝑡 𝑟𝑎𝑡𝑒) = 𝑦

3. 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑤𝑜𝑟𝑡ℎ = 𝑦 ∗ (1 + ℎ𝑜𝑚𝑒 𝑙𝑒𝑛𝑑𝑖𝑛𝑔 𝑟𝑎𝑡𝑒)

 Put Option Hedge on Receivables

- put option allows MNC to sell specific amount of currency at a specified exercise price by a
specified expiration date
- not exercise if currency is higher than the exercise price

CHAPTER 12: MANAGING ECONOMIC EXPOSURE AND TRANSLATION EXPOSURE

- it is more difficult to hedge economic or translation exposure than to hedge transaction
exposures

MANAGING ECONOMIC EXPOSURE

- economic exposure represents any impact of exchange rate fluctuations on a firm’s future
cash flows
- balancing the sensitivity of revenue and expenses to exchange rate fluctuations
- one can be subject to economic exposure but not transaction exposure
- one that is subject to transaction exposure will always be subject to economic exposure
- comes in various forms:
 numerous purchases purchase and sale transactions
 any remitted earnings from foreign subsidiaries to the US parent also reflect transaction and
economic exposure
 a change in exchange rates may affect demand for the product for other companies can indirectly
affect the demand for Nike’s athletic shoes

The means by which an MNC’s management of its exposure to exchange rate movements can
increase its value:

1) Increase cash flows or reduce its cash flow by properly managing exposure
2) Reduce financing costs, which lowers its cost of capital
3) Stabilize earnings, which can reduce risk, and therefore, reduce cost of capital

ASSESSING ECONOMIC EXPOSURE

- must determine how it is subject to economic exposure before managing
- measure its exposure to each currency in terms of its cash inflows and outflows

RESTRUCTURING TO REDUCE ECONOMIC EXPOSURE

- restructuring involves shifting the sources of costs or revenue to other locations in order to
match cash inflows and outflows in foreign currencies
- restructuring to reduce economic exposure depends on the form of exposure
ISSUES INVOLVED IN THE RESTRUCTURING DECISION
- more complex task than hedging any single foreign currency transaction
- managing economic exposure is more difficult than managing transaction exposure
- MNCs must be confident about the potential benefits before they decide to restructure their
operations

When deciding to restructure operations, one must address the ff:

 Increase or reduce sales in new or existing foreign markets (cash inflow)
 Increase or reduce its dependency on foreign suppliers (cash outflow)
 Establish or eliminate production facilities in foreign markets(cash outflow)
 Increase or reduce its level of debt denominated in foreign currencies(cash outflow)

Type of Operation
Sales in foreign currency units
Reliance on foreign supplies
Proportion of debt structure
representing foreign debt
When a foreign currency has
a greater impact on cash
inflows
Reduce foreign sales
Increase foreign supply orders
Restructure debt to increase
debt payments in foreign
currency
When a foreign currency has
a greater impact on cash
outflows
Increase foreign sales
Reduce foreign supply orders
Restructure debt to reduce debt
payments in foreign currency

MANAGING TRANSLATION EXPOSURE

- translation exposure occurs when an MNC translates each subsidiary’s financial data to its
home currency for consolidated financial statements
- translation exposure can reduce a company’s earnings and can cause decline in its stock
price

HEDGING WITH FORWARD CONTRACTS

𝑇𝑟𝑎𝑛𝑠𝑙𝑎𝑡𝑒𝑑 𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠 = 𝑆𝑢𝑏𝑠𝑖𝑑𝑖𝑎𝑟𝑦 𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑥 𝑊𝑒𝑖𝑔ℎ𝑡𝑒𝑑 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑒𝑥𝑐ℎ𝑎𝑛𝑔𝑒 𝑟𝑎𝑡𝑒
𝐺𝑎𝑖𝑛 𝑜𝑛 𝑓𝑜𝑟𝑤𝑎𝑟𝑑 𝑐𝑜𝑛𝑡𝑟𝑎𝑐𝑡
= (𝐴𝑚𝑜𝑢𝑛𝑡 𝑟𝑒𝑐𝑒𝑖𝑣𝑒 𝑓𝑟𝑜𝑚 𝐹𝑜𝑟𝑤𝑎𝑟𝑑 𝑠𝑎𝑙𝑒
− 𝐴𝑚𝑜𝑢𝑛𝑡 𝑝𝑎𝑖𝑑 𝑡𝑜 𝑓𝑢𝑙𝑓𝑖𝑙𝑙 𝑓𝑜𝑟𝑤𝑎𝑟𝑑 𝑐𝑜𝑛𝑡𝑟𝑎𝑐𝑡 𝑜𝑏𝑙𝑖𝑔𝑎𝑡𝑖𝑜𝑛)
LIMITATIONS OF HEDGING TRANSLATION EXPOSURE
 Inaccurate Earnings Forecasts
- it actual earnings turned out differed, there would likely be a loss
 Inadequate Forward Contracts for Some Currencies
- forward contracts are not available for all currencies
 Accounting Distortions
- forward rate gain or loss reflects difference between forward rate and future spot rate,
whereas the translation gain or loss is caused by change in the average exchange rate
over the period
- translation losses are not tax deductible, whereas gains on forward contracts used are
taxed
 Increased Transaction Exposure
- hedging might increase a company’s transaction exposure