How do we measure the exchange rate risk facing an MNC? Foreign exchange exposure is defined as the degree to which a company is affected by exchange rate changes. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. Exposure is expressed in units of the underlying host currency, the exchange rate ppt the price of the host currency in units of home currency i. Although we shall see that economic exposure is most important measure, firms are concerned with all three. Translation exposure is currently defined for U. Hence, to determine the foreign exchange gain or loss, the net asset position assets minus liabilities is used as the measurement of exposure. Summary forex Translation Exposure. Transaction exposure is the degree to which cash and transactions denominated in a foreign currency and already entered into for settlement at a future date are affected by exchange rate changes. Translation or accounting measures of exposure are based on changes in book values of foreign currency assets and ppt. Currency changes - particularly those of high-inflation currencies - are usually preceded by or accompanied by changes in relative price levels between two countries. Hence, it is impossible to determine exposure to a given currency without considering simultaneously the offsetting effects of these price changes. Alternatively, exchange rates often affect firms most severely when the nominal exchange rate does not move exposure all - when relative price changes are not being offset by exchange rate adjustments. Cash flow exposure evaluates the ongoing cash flows of the firm. These cash flows are evaluated from a real standpoint - they are adjusted for inflation. The second component of economic exposure is net worth exposure - also know as economic balance sheet exposure. Non-Monetary Assets and Liabilities. Lets take the example of an Australian subsidiary facing a depreciation of the Australian dollar. Since the market value of non-monetary assets - such as property, plant, equipment, and inventory - will likely rise with local inflation, they will only be exposed to the extent that there is a real devaluation of the Australian dollar. Here the distinction between anticipated and unanticipated real exchange rate changes becomes important. Monetary Assets and Liabilities. Hence, any real depreciation will reduce the home-currency net asset position as long as the real depreciation is not offset ppt changes in the interest rate. A statistical measure of economic exposure can be obtained by applying linear forex analysis to cash flows or real net asset values. Hence, b will measure the sensitivity of cash flows to the level of the exchange rate - which is precisely exposure denominated in the foreign currency units. The R2 statistic from the regression will measure the fraction of cash flow variability that can be explained by changes in the exchange rate. He regressed the monthly price of American Airlines stock from January to December on:. The regression was run in log-scale - so coefficients can be interpreted as elasticities i. The regression equation of the price of AMR stock was as follows with standard errors in parentheses:. When the price of oil increases, the price of AMR stock falls. Design the evaluation criteria so that operating managers neither rewarded or penalized for unexpected exchange-rate changes. Summary of Economic Exposure. Economic exposure integrates 3 key aspects of exchange rate risk: Exchange rate risk can be highly pronounced in firms with purely domestic operations and firms operating in exposure with fixed nominal exchange rates. Microeconomic theory is useful in the analysis of cash flow exposure as it allows us to distinguish between price, volume, and margin effects on overall firm ppt. When there are no deviations from RPPP or when the subsidiary is operating in world markets for inputs and outputs, its cash flows are not exposed forex exchange rate fluctuations. If a subsidiary is entirely self-contained, only profits shrink or expand with real exchange rate changes - there are no volume or host-country price effects. When operating in a world output market in the currency of the parent, costs move with real exchange rate fluctuations, exposure marginal revenues remain constant. If the firm is a price-taker, output, margin, and profits expand with a real depreciation. When operating in a world input market in the currency of the parent, revenues will move with real exchange rate changes, while costs remain constant. If the firm is a price-taker, output, margin, and profits decline with a real depreciation. In world markets for inputs or outputs, a firm must worry about the currency habitat of price - the currency or basket of currencies in which the exposure of the input or output has the least variability. Ppt on the currency habitat of price allows the firm to distinguish between price risk which is a function of supply and demand conditions and exchange rate risk. Since prices for assets and liabilities are forward-looking, while prices for inputs or outputs are not, real exchange rate expectations are important. Non-monetary assets and liabilities will have expected real exchange rate changes built into prices. Monetary assets and liabilities will have real exchange rate expectations built into interest rates. Economic exposure can be measured using linear regression - regressing cash flows, net worth, or stock prices on exchange rates. If conducted in levels, the slope coefficient can be interpreted as the exposure measure. The regression must be run in real terms - real exchange rates and inflation-adjusted cash flows. The R-square can be interpreted as the fraction of cash flow, net worth, or stock price fluctuation that can be accounted for by exchange rate changes. No Deviations from RPPP. If RPPP holds, nominal exchange rate changes correspond to inflation differentials and there are no real exchange rate changes. The depreciation of the host currency is solely the result of higher inflation in the host than in the home country. Since the host currency has depreciated against the home currency, the price will not rise as much when converted the home currency. No Deviations from RPPP cont. Since RPPP holds, the rise in the home currency price will exactly correspond to home currency inflation. Consider the case where the subsidiary is entirely self-contained - it services only the local market and undertakes all production in the local market. Recall from microeconomics the usual case of a firm functioning in a competitive local environment:. The marginal revenue from each unit of additional output will simply equal the price at which it is sold. Since costs are lower than revenues, their difference - the profit margin - must also fall proportionately. Now consider a subsidiary whose input costs are entirely denominated in the host currency, but whose output is priced according to world supply and demand conditions. For now, consider a product price is determined in the home currency and is invariant to changes in the value of the home currency. World Output Market cont. The subsidiary expands production - since the host country is now the low-cost producer of the product. The firm is unambiguously better off with the depreciation as output, margin, and total profits are higher. Now consider a subsidiary whose inputs are primarily imported and priced in the home currency, whereas the output market is priced in in the host currency. Now, the marginal revenue line will shift up or down with real fluctuations in the home currency, while home currency-based marginal costs remain constant. World Input and Output Markets. What will be the impact of exchange rate changes when the subsidiary is competing in a world market for its output and producing this output with factors supplied in a world input market? Marginal costs and marginal revenues are ppt shifting with real changes in the host currency. What if the Firm is not a Price-Taker? Specifically, if this firm increases its output, the price that it receives for its products will necessarily fall. In this case, the company will have some freedom to adjust its local price - via changes in output - in response to exchange rate changes. The Currency Habitat of Price. Our analysis requires determining which currency is important for the determination of the price for inputs or product. The issue essentially boils down to determining which currency the price for a particular input or product is most stable. This will generally be the currency in which much of production or sales of the product take place. For example, the price of wine will likely have the lowest variability in a basket which includes the Dollar, Franc, and Exposure. One point to keep in mind is that the preceding analysis of cash flow exposure considered for simplicity world markets for input and output to have a currency habitat of price in the home currency. This simplified the treatment since the parent company was based in the home country and therefore concerned with the value of cash flows in the home currency. If the currency habitat of price is actually in a third currency, shifts in marginal cost or revenue curves due to fluctuations in this currency must be recognized in the analysis. Browse Recent Presentations Presentation Topics Presentation Channels Featured Presentations. Presentation Creator new Upload Login. Home Users Business Fashion Health Science News More Topics. Forex Exchange Exposure PowerPoint Presentation. Email Presentation to Friend. Create Presentation Download Presentation. By benjamin Follow User. Description Statistics Report Foreign Exchange Exposure. Related searches for foreign exchange exposure Foreign Exchange Rate Exposure Foreign Exchange Exposure Definition Foreign Exchange Exposure Management Foreign Exchange Risk Exposure Foreign Exchange Risk PDF Types Foreign Exchange Exposure Foreign Currency Exposure Exchange Rate Risk. Copyright Complaint Adult Content Flag forex Inappropriate. Foreign Exchange Exposure How do we measure the exchange rate risk facing an MNC? The magnitude of the gain or loss that results from a particular exchange rate change is: Foreign Exchange Exposure There are three important kinds of exposure: Translation Exposure or Accounting Exposure Transaction Exposure or Contractual Exposure Economic Ppt or Operating Exposure Although we shall see that economic exposure is most important measure, firms are concerned with all three. Hence, each measure is worth understanding. Summary of Translation Exposure Step 1: Determine functional currency Host currency Step 2: Determine functional currency Host currency Home currency Step 2: Transaction Exposure Ppt exposure is the degree to which cash and transactions denominated in a foreign currency and already entered into for settlement at a future date are affected by exchange rate changes. Transaction exposure measures net cash and known cash inflows against known cash outflows. Economic Exposure Translation or accounting measures of exposure are based on changes in book values of foreign currency assets and liabilities. Economic Exposure Economic exposure integrates three key forex of exchange rate risk: Economic Exposure Why real exchange rate changes? Cash Flow Exposure Cash flow exposure evaluates the ongoing cash flows of the firm. Net Worth Exposure The second component of economic exposure is net worth exposure - also know as economic balance sheet exposure. We will consider non-monetary assets and forex first. Non-Monetary Assets and Liabilities Lets take the example ppt an Australian subsidiary facing a depreciation of the Australian dollar. Non-Monetary Assets and Liabilities Here the distinction between anticipated and unanticipated real exchange rate changes becomes important. Monetary Assets and Liabilities Monetary assets and liabilities will be exposed to real exchange rate changes as well. Monetary assets and liabilities carry nominal returns determined by the relevant interest rate. Again, any real depreciations that are anticipated will be reflected in the interest rates. Measuring Economic Exposure A statistical measure of economic exposure can be obtained by applying linear regression analysis to cash flows or real net asset values. For cash flow exposure, a regression of the following type can be estimated: The estimated coefficient b, will be: The regression should be run in real terms. Measuring Economic Exposure What happens if the regression is run in nominal terms? As an example, consider exposure case where the Pound-Dollar real exchange rate is constant. Measuring Economic Exposure This measurement technique can be applied in many different ways: American Airlines Bilson ran a regression to determine the economic exposure of American Airlines. He regressed the monthly price of American Airlines stock from January to December on: American Airlines The regression equation of the price of Ppt stock was as follows with standard errors in parentheses: A one percent increase in the Mark is associated with a 0. Exposure OPERATING EXPOSURE Operating exposure management requires long-term operating adjustments. Proactive Marketing and Production Initiatives 1. Market selection -- 3Ps 2. Product Management Adjustments Product sourcing and plant location are the main variables that can be manipulated. Shift production among plants C. Provide local manager with forecasts of inflation and exchange-rate changes. Identify and focus on competitive exposure. Estimate and hedge the operating exposure after adjustments made. Summary of Economic Exposure 1. Summary of Economic Exposure 5. Summary of Economic Exposure 9. Summary of Economic Exposure Hence, net worth is only exposed to unanticipated changes in real exchange rates. No deviations from RPPP. Real exchange rate changes and a self-contained subsidiary. Real exchange rate changes and a world output market. Real exchange rate changes and a world input market. Real forex rate changes and world output and input markets. No Deviations from RPPP If RPPP holds, nominal exchange rate changes correspond to inflation differentials and there are no real exchange rate changes. The host price of the exposure will rise with inflation. Hence, the real home currency ppt of the product will remain unchanged. If RPPP holds, the depreciation has no real effect on the subsidiary home currency revenues. The same analysis will hold for production costs. Self-Contained Subsidiary Consider the case where the subsidiary is entirely self-contained - it services only the local market and undertakes all production in the local market. Now, however, we allow there to be changes in the real value of the host currency. Recall from microeconomics the usual case of a firm functioning in a competitive local environment: Self-Contained Subsidiary Ppt from microeconomics the usual case of a firm functioning in a forex local environment: Self-Contained Subsidiary How is the self-contained subsidiary affected by changes in the real exchange rate? If the host currency depreciates in real terms: All curves shift downward by the same proportion. Output volume remains unchanged. Real dollar costs and revenues are reduced proportionately. World Output Market Now consider a subsidiary whose input costs are entirely denominated in the host currency, but whose output is priced according to world supply and demand conditions. The changes will, however, affect the marginal exposure schedule as before. The profit margin has also increased, since the average costs shift down. World Input Market Now consider a forex whose inputs are primarily imported and priced in the home currency, whereas the output market is priced in in the host currency. The profit margin declines. The firm cuts back production in order to reduce costs. The reduction of margin and output results in exposure reduction in firm profits. World Input and Output Markets What will be the impact of exchange rate changes when the subsidiary is competing in a world market for its output forex producing this output with factors supplied in a world input market? How does the analysis change if the firm is not operating in a competitive market? Exposure Rate Pass-Through When a firm operates in an environment that is not competitive: Margin is the difference between sale price and average cost. If the subsidiary is self-contained? If the subsidiary is in a world output market? Exchange Rate Pass-Through If the subsidiary is in a world input market? The Currency Habitat of Price Our analysis requires determining which currency is important for the determination of the price for inputs or product. The Currency Habitat of Price What is the currency habitat of: The Currency Habitat of Price One point to keep in mind is that the preceding analysis of cash flow exposure considered for simplicity world markets for input and output to have a currency habitat of price in the home currency. Previous Presentation diapositiva 1. Next Presentation from tycoon. Foreign Exchange Exposure -Two methods of exposure quotation. Foreign Exchange Exposure -What is foreign exchange exposure?. 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