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Lecture 8 Currency/Foreign Exchange Exposure
Learning Objectives
Gain knowledge of the types of exposure to exchange rate fluctuations
Understand the different types of exposure that Multinational corporations face
Learn how different types of exposure are measured
Reading: Madura and Fox, Ch 10
Wang, Peijie, Ch 15-16
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Types of Exposure
Transaction exposure
Economic exposure
Accounting/translation exposure
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Transaction Exposure
Transaction exposure
Measures how the home currency value
Of a firm’s foreign currency denominated cash flows
Would be affected by exchange rate fluctuations.
Transaction exposure
Arises from the possibility of incurring exchange gains
Or losses
On transactions already entered into
Which are denominated in a foreign currency.
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Economic Exposure
Economic exposure
Measures how the value of a firm,
The present value of all future cash flows,
Would be affected by changes in exchange rates
So economic exposure
Is not just about existing contracts
But also about the effect on future activities as well
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Economic Exposure
Firms with economic exposure
Do not necessarily have transaction exposure.
Domestic cash flows can also be affected by foreign exchange risk,
Due to the effect on foreign competition
In the domestic market
Of foreign exchange rate changes
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Difference between Economic and Transaction Exposure
| Transaction exposure | Economic exposure |
| Foreign currency receivables/payables Foreign exchange market uncertainties affect home currency value of foreign cash flows | Cash inflows/ outflows Broader effect of exchange rate changes |
| Individual and specific They reference established contracts | The collective effect of the transaction exposures Encompasses transaction exposure, but usually much larger |
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Accounting Exposure
Accounting/translation exposure
measures how a MNC’s consolidated financial statements
would be affected by exchange rate fluctuations
Translating foreign exchange figures
for reporting consolidated financial statements
does not directly affect cash flows
So is regarded as less relevant or irrelevant in some cases
Accounting Exposure
It has a potential impact
Stock market implications
Of consolidated financial reports
Arising from translation exposure.
These occur because accounting systems and rules
May differ from country to country
Difficult to reflect in consolidated accounts
Summary
Have seen that there are different forms of foreign exchange exposure
Transactions exposure might be the most obvious
However economic exposure is important to consider
Note that foreign exchange exposure can affect firms
That are not active internationally
Accounting exposure is typically much less significant
But important to note its existence
Later sessions will discuss how the tools we have discussed
Might be used to address these risks
Business School