12
Chapter
Managing Economic Exposure
And Translation Exposure
J. Gaspar: Adapted from Jeff Madura, International Financial Management
12. 1
Chapter Objectives

To explain how an MNC’s economic exposure can
be managed/hedged; and

To explain how an MNC’s translation exposure
can be managed/hedged.
12. 2
Economic Exposure
• Economic exposure refers to the impact
exchange rate fluctuations can have on a firm’s
Present Value of future cash flows.
• Recall that corporate cash flows can be affected
by exchange rate movements in ways not directly
associated with foreign transactions, i.e., a purely
domestic firm that faces international competition.
12. 3
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
12. 4
Income Statement Analysis to
Assess Economic Exposure
• MNCs can determine the impact of FX exposure
by assessing the sensitivity of their cash inflows
and outflows to various possible exchange rate
scenarios.
• The MNC can then minimize its FX exposure by
restructuring its operations to reduce its “net”
exchange-rate-sensitive cash flows.
• Use spreadsheets to facilitate analysis.
12. 5
Base Case: Impact of Exchange Rate Movements on
Earnings of Madison, Inc. (In Millions)
12. 6
Managing
Madison Inc.’s Economic Exposure
• Madison Inc.’s Net FX Exposure: C$206 m outflow
• 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.
12. 7
How to Minimize Economic
Exposure
• Restructuring can reduce economic exposure by
shifting the sources of costs or revenue to other
locations in order to match cash inflows and
outflows in foreign currencies.
• The new structure is then evaluated by assessing
how the revised cash flows are sensitive to
various possible exchange rate scenarios.
12. 8
Impact of Possible Exchange Rate Movements on
Earnings: Before and After Corporate Restructuring
(in Millions)
12. 9
Economic Exposure Based on the Original
and Proposed Operating Structures
12. 10
Crucial Issues Involved in the
Restructuring Decisions
• 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.
12. 11
Strategies for Restructuring
• 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.
12. 12
12. 13
A Case Study in
Hedging Economic Exposure
• Savor Co., a U.S. firm, has three independent
units that conduct business in the Eurozone. 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.
12. 14
An Analysis of
Savor Co.’s Cash Flows and the Euro’s Movements
12. 15
A Case Study in
Hedging Economic Exposure
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.
12. 16
A Case Study in
Hedging Economic Exposure
Assessment of Each Unit’s Exposure:
%UnitCashFlowt = a0 + a1%eurot + t
 Unit C is exposed to the euro’s
movements.
12. 17
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.
12. 18
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.
12. 19
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.
12. 20
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.
12. 21
Translation Exposure
• Translation exposure results when an MNC
translates each subsidiary’s financial data from its
host country (operating) currency to home country
(reporting) currency for consolidated financial
reporting. MNCs like Coca Cola, GE, etc. deal with
over a hundred operating currencies.
• Translation exposure does not directly affect cash
flows, but some firms are concerned because of
its potential impact on reported consolidated
earnings.
12. 22
Translation Exposure Management
A simple example of earnings and balance sheet translation
Earnings Translation Management
Columbus, Inc., a US-based MNC has a subsidiary in France that is forecast to have an after tax earnings of €20 million during 2015.
2015 after tax earnings: €20 million Case#1: Repatriate earnings → Case of transactions exposure
Case#2: Reinvest earnings in France → Case of translation exposure
Exchange rate
Jan 1, 2015
Dec 31, 2015 rate
Ave. 2015
Forward Rate (sell €) quote provided on Jan 1, 2015
$1.30/€ spot
$1.40/€ spot
$1.35/€
$1.50/€ (Dec 31, 2015 delivery)
Case#2: Reinvest €20 million earnings in France
Strategy #1: No hedging of translation exposure
Per FASB-52, Translation of €20 French earning to $ (reporting currency) on Dec 31, 2015 = €20 × 1.35 = $27 million
Earnings after translation = $27 million
Strategy #2: Hedging translation exposure by selling euros forward at a stronger € rate than the actual future spot rate of $1.40/€
recorded on December 31, 2015.
Profit from executing forward contract
= Sell euros forward – buy euros spot on Dec 31, 2015
= €20 million (1.50 – 1.40) = €20 × 0.10 = $2 million
Earnings after translation = $27 million + $2*(1-French corporate tax rate) million
Strategy #3: Hedging translation exposure by selling euros forward at a weaker € rate than the actual future spot rate (say, $1.36/€
instead of the recorded $1.40/€ spot rate).
A loss will be incurred while executing the forward contract, since euros will need to be purchased at say, $1.40/€ (future spot rate on
December 31, 2015) and the euro sold at a lower forward rate of $1.36/€. Loss= €20 million (1.36 – 1.40) = €20 x -0.04 = -$0.8 mn
Earnings after translation = $27 million (1.35x20) – $0.8 million = $26.2 million
Balance Sheet Translation Management
Balance Sheet Translation Exposure relates to consolidation of Balance Sheet items in different currencies to reporting currency and
can be managed by minimizing Net Exposed Assets
Columbus’ Net exposed assets = € Assets – € Liabilities (i.e., net assets exposed to change in the value of € v. $, i.e. from operating
J. Gaspar 5/4/2015
currency to reporting currency).
12. 23
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.
12. 24