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 operations is a long-term
solution to reducing economic exposure.
It is a much more complex task than
hedging any foreign currency transaction.

MNCs must be very confident about the

long-term potential benefits before they
proceed to restructure their operations,
because of the high reversal costs.
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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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A Case Study in
Hedging Economic Exposure
Savor Co., a U.S. firm, has three
independent units that conduct some
business in Europe. It is concerned about
its exposure to the euro.

To determine whether it is exposed and

the source of the exposure, Savor applies
a series of regression analysis to its cash
flows and the euros movements.
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Assessment of
Savor Co.s Cash Flows and the Euros Movements

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A Case Study in
Hedging Economic Exposure
Assessment of Savors Exposure:
% TotalCashFlowt =

a0 + a1% eurot + t

The slope coefficient, a1, is found by

regression analysis to be positive and
statistically significant.
Savor is exposed to the euros
movements.
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A Case Study in
Hedging Economic Exposure
Assessment of Each Units Exposure:
% UnitCashFlowt =
Unit
A
B
C

a0 + a1% eurot + t

Slope Coefficient
R-squared Statistic
Not significant
6.8%
Not significant
6.7%
Statistically significant
93%

Unit C is exposed to the euros movements.

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A Case Study in
Hedging Economic Exposure
Identifying the Source of Unit Cs Exposure:

Savor believes that Unit Cs cash flows are

mainly affected by income statement items.

Savor thus applies regression analysis to each

income statement item, and finds a significant
positive relationship between Unit Cs revenue
and the euros value.
Savors economic exposure could be due
to foreign competition.
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A Case Study in
Hedging Economic Exposure
Possible Hedging Strategies:

Pricing policy Reduce prices when the

euro depreciates.

Hedging with forward contracts Sell

euros forward to hedge against the
adverse effects of a weak euro.

Purchasing foreign supplies Costs will

be reduced during a weak-euro period.
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A Case Study in
Hedging Economic Exposure
Possible Hedging Strategies:

Financing with foreign funds Costs will

be reduced during a weak-euro period.

Revising the operations of other units So

as to offset the exposure of Unit C.

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Hedging Exposure to Fixed Assets

When an MNC has fixed assets (such as
buildings or machinery) in a foreign
country, the cash flows to be received
from the sale of these assets is subject to
exchange rate risk.

A sale of fixed assets can be hedged by

creating a liability that matches the
expected value of the assets at the point
in the future when they will be sold.
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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
Inaccurate earnings forecasts
Inadequate forward contracts for some
currencies

Accounting distortions

Translation gains/losses are based on the

average exchange rate (which is unlikely to
be the same as the forward rate).
Translation losses are also not tax deductible.

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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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