Lecture Multinational financial management: Lecture 12 - Dr. Umara Noreen

Lecture 12 - Managing economic exposure and translation exposure. In this chapter students will be able: to explain how an mnc’s economic exposure can be hedged; and to explain how an mnc’s translation exposure can be hedged.

Managing Economic Exposure

And Translation Exposure 12

LECTURE

Chapter Objectives

 To explain how an MNC’s economic

exposure can be hedged; and

 To explain how an MNC’s translation

exposure can be hedged.

• Economic exposure refers to the impact

exchange rate fluctuations can have on a

firm’s future cash flows.

• Recall that corporate cash flows can be

affected by exchange rate movements in

ways not directly associated with foreign

transactions.

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

Economic Exposure

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.

Original Impact of Exchange Rate Movements on Earnings:

Madison, Inc (In Millions)

Managing Madison Inc.’s Economic Exposure

• Madison’s earnings before taxes is

inversely related to the Canadian dollar’s

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.

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.

Impact of Possible Exchange Rate Movements on Earnings

under Two Alternative Operational Structures

(in Millions)

Economic Exposure Based on the Original

and Proposed Operating Structures

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.

• 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

Issues Involved in the Restructuring Decision

How to Restructure Operations

to Balance the Impact of Currency Movements

on Cash Inflows and Outflows

foreign currency foreign currency

Recommended Action When a Foreign Currency Has a Greater Impact on

Type of

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 euro’s movements.

Assessment of Savor Co.’s Cash Flows and the Euro’s Movements

Assessment of Savor’s 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 euro’s movements.

A Case Study in Hedging Economic Exposure

Assessment of Each Unit’s Exposure:

% UnitCashFlowt = a0 + a1% eurot + t

A Case Study in Hedging Economic Exposure

Unit C is exposed to the euro’s

A Case Study in Hedging Economic Exposure

Identifying the Source of Unit C’s Exposure:

• Savor believes that Unit C’s 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 C’s revenue and the euro’s value.

Savor’s economic exposure could be due to foreign competition.

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.

A Case Study in Hedging Economic Exposure

• 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.

A Case Study in Hedging Economic Exposure

Possible Hedging Strategies:

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.

• Translation exposure results when an

MNC translates each subsidiary’s 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.

Translation Exposure

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.

¤ 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

Use of Forward Contracts to Hedge

Translation Exposure

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

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.

• Source: Adopted from

South-Western/Thomson Learning © 2006