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12

Chapter

Managing Economic Exposure


And Translation Exposure

South-Western/Thomson Learning 2006

Chapter Objectives

To explain how an MNCs economic


exposure can be hedged; and

To explain how an MNCs translation


exposure can be hedged.

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Economic Exposure
Economic exposure refers to the impact
exchange rate fluctuations can have on a
firms future cash flows.

Recall that corporate cash flows can be


affected by exchange rate movements in
ways not directly associated with foreign
transactions.

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Economic Exposure
The economic impact of currency exchange
rates on us is complex because such
changes are often linked to variability in real
growth, inflation, interest rates,
governmental actions, and other factors.
These changes, if material, can cause us to
adjust our financing and operating
strategies.
PepsiCo
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Use of the Income Statement to


Assess Economic Exposure
An MNC can determine its exposure by
assessing the sensitivity of its cash
inflows and outflows to various possible
exchange rate scenarios.

The MNC can then reduce its exposure by


restructuring its operations to balance its
exchange-rate-sensitive cash flows.

Note that computer spreadsheets are


often used to expedite the analysis.
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Original Impact of Exchange Rate Movements on Earnings:


Madison, Inc. (In Millions)

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Managing
Madison Inc.s Economic Exposure
Madisons earnings before taxes is
inversely related to the Canadian dollars
strength, since the higher expenses more
than offset the higher revenue when the
Canadian dollar strengthens.

Madison may reduce its exposure by


increasing Canadian sales, reducing
orders of Canadian materials, and
borrowing less in Canadian dollars.
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How Restructuring Can Reduce


Economic Exposure
Restructuring to reduce economic
exposure involves shifting the sources of
costs or revenue to other locations in
order to match cash inflows and outflows
in foreign currencies.

The proposed structure is then evaluated


by assessing the sensitivity of its cash
inflows and outflows to various possible
exchange rate scenarios.
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Impact of Possible Exchange Rate Movements on Earnings


under Two Alternative Operational Structures
(in Millions)

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Economic Exposure Based on the Original


and Proposed Operating Structures

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Issues Involved in the


Restructuring Decision
Restructuring may involve:
increasing/reducing sales in new or

existing foreign markets,


increasing/reducing dependency on
foreign suppliers,
establishing/eliminating production
facilities in foreign markets, and/or
increasing/reducing the level of debt
denominated in foreign currencies.
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How to Restructure Operations


to Balance the Impact of Currency Movements
on Cash Inflows and Outflows
Type of
Operation

Recommended Action When a Foreign


Currency Has a Greater Impact on
Cash Inflows
Cash Outflows

Sales in foreign
currency units

Reduce foreign
sales

Increase foreign
sales

Reliance on
foreign supplies

Increase foreign
supply orders

Reduce foreign
supply orders

Proportion of
foreign debt

Restructure debt
to increase debt
payments in
foreign currency

Restructure debt
to reduce debt
payments in
foreign currency
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Translation Exposure
Translation exposure results when an
MNC translates each subsidiarys financial
data to its home currency for consolidated
financial reporting.

Translation exposure does not directly


affect cash flows, but some firms are
concerned about it because of its potential
impact on reported consolidated earnings.

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Use of Forward Contracts to Hedge


Translation Exposure
To hedge translation exposure, forward or
futures contracts can be used.
Specifically, an MNC may sell the currency
that its foreign subsidiary receive as
earnings forward, thus creating an
offsetting cash outflow in that currency.

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Use of Forward Contracts to Hedge


Translation Exposure
Example:
A U.S.-based MNC has a British subsidiary.
The forecasted British earnings of 20 million
(to be entirely reinvested) will be translated at
the weighted average value over the year.
To hedge this expected earnings, the MNC
sells 20 million one year forward.
If the depreciates, the gain generated from
the forward contract position will help to
offset the translation loss.
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Limitations of
Hedging Translation Exposure

Increased transaction exposure


If the foreign currency appreciates during
the fiscal year, the transaction loss
generated by a forward contract position
will somewhat offset the translation gain.
The translation gain is simply a paper gain,
while the loss resulting from the hedge is a
real loss.

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