Chapter 10: Measuring Exposure to Exchange Rate Fluctuations 343

MNCs should focus their energy on assessing the they may underestimate the value of the MNC. Even
exposure of their cash flows to exchange rate move- if the value is corrected in the future once the market
ments and should not be concerned with the exposure realizes how the earnings were distorted, some inves-
of their financial statements to exchange rate move- tors may have sold their stock by the time the correc-
ments. Value is about cash flows, and investors focus tion occurs. Investors should be concerned about an
on value. MNC’s translation exposure. They should recognize
Counterpoint Yes. Investors do not have sufficient that the earnings of MNCs with large translation
financial data to derive cash flows. They commonly exposure may be more distorted than the earnings of
use earnings as a base, and if earnings are distorted, MNCs with low translation exposure.
their estimates of cash flows will likewise be inac- Who Is Correct? Use the Internet to learn more
curate. If they underestimate cash flows because of about this issue. Which argument do you support?
how exchange rates affected the reported earnings, Offer your own opinion on this issue.

Self-Test
Answers are provided in Appendix A at the back of the are priced in pesos. Once material is received
text. from a source, it is quickly used to produce the
1. Given that shareholders can diversify away an product in the United States, and then the prod-
individual firm’s exchange rate risk by investing in uct is exported. Currently, your firm has no other
a variety of firms, why are firms concerned about ­exposure to exchange rate risk. You have a choice
exchange rate risk? of purchasing the material from Canada (denomi-
nated in C$), from Mexico (denominated in pesos),
2. Bradley, Inc., considers importing its supplies or from within the United States (denominated in
from either Canada (denominated in C$) or Mexico U.S. dollars). The quality and expected cost are
(denominated in pesos) on a monthly basis. The ­similar across the three sources. Which source is
quality of the goods obtained is the same from both preferable, given that you prefer minimal exchange
sources. Once the firm completes the agreement with rate risk?
a supplier, it will be obligated to continue using that
supplier for at least three years. Based on existing 4. Using the information in the previous question,
exchange rates, the dollar amount to be paid (includ- consider a proposal to price the exports to Mexico in
ing transportation costs) will be the same. The firm dollars and to use the U.S. source for material. Would
has no other exposure to exchange rate movements. this proposal eliminate the exchange rate risk?
Given that the firm prefers to have less exchange rate 5. Assume that the dollar is expected to strengthen
risk, which alternative is preferable? Explain. against the euro over the next several years. Explain
3. Assume that your U.S. firm currently exports how this will affect the consolidated earnings of U.S.-
products to Mexico on a monthly basis. The goods based MNCs with subsidiaries in Europe.

Questions and Applications

1. Transaction versus Economic Exposure British pound inflows equal £2,000,000, while out-
Compare and contrast transaction exposure and eco- flows equal £1,000,000. The spot rate of the krone is
nomic exposure. Why would an MNC consider exam- $0.15, and the spot rate of the pound is $1.50. Assume
ining only its “net” cash flows in each currency when that the movements in the Danish krone and the
assessing its transaction exposure? British pound are highly correlated. Provide your
2. Assessing Transaction Exposure Your assessment of your firm’s degree of transaction expo-
employer, a large MNC, has asked you to assess its sure (that is, whether the exposure is high or low).
transaction exposure. Its projected cash flows are as Substantiate your answer.
follows for the next year: Danish krone inflows equal 3. Factors That Affect a Firm’s Transaction
DK50,000,000, while outflows equal DK40,000,000; Exposure What factors affect a firm’s degree of

Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
344 Part 3: Exchange Rate Risk Management

transaction exposure in a particular currency? For think of any change that might occur in the global
each factor, explain the desirable characteristics that chemicals market?
would reduce transaction exposure. 12. Economic Exposure Longhorn Co. pro-
4. Currency Correlations Kopetsky Co. has net duces hospital equipment. Most of its revenues are in
receivables in several currencies that are highly cor- the United States. About half of its expenses require
related with each other. What does this imply about outflows in Philippine pesos (to pay for materials
the firm’s overall degree of transaction exposure? Are obtained in the Philippines). Most of Longhorn’s com-
currency correlations perfectly stable over time? What petition is from U.S. firms that have no international
does your answer imply about Kopetsky Co. or any business at all. How will Longhorn Co. be affected if
other firm using past data on correlations as an indi- the peso strengthens?
cator for the future? 13. Economic Exposure Lubbock, Inc., produces
5. Currency Effects on Cash Flows How furniture and has no international business. Its major
should appreciation of a firm’s home country currency competitors import most of their furniture from Brazil
generally affect its cash inflows? How should deprecia- and then sell it out of retail stores in the United States.
tion of a firm’s home country currency generally affect How will Lubbock be affected if Brazil’s currency (the
its cash outflows? real) strengthens over time?
6. Transaction Exposure Fischer, Inc., a U.S.- 14. Economic Exposure Sooner Co. is a U.S.
based MNC, exports products from Florida to Europe. wholesale company that imports expensive, high-
It obtains supplies and borrows funds locally. How quality luggage and sells it to retail stores around
would appreciation of the euro likely affect its net cash the United States. Its main competitors also import
flows? Why? high-quality luggage and sell it to retail stores. None
of these competitors hedges its exposure to exchange
7. Exposure of Domestic Firms Why are the
rate movements. Why might Sooner’s market share
cash flows of a purely domestic firm exposed to
be more volatile over time if the company hedges its
exchange rate fluctuations?
exposure?
8. Measuring Economic Exposure Memphis
15. PPP and Economic Exposure Boulder, Inc.,
Co. hires you as a consultant to assess its degree of
exports chairs to Europe (invoiced in U.S. dollars) and
economic exposure to exchange rate fluctuations. How
competes against local European companies. If pur-
would you handle this task? Be specific.
chasing power parity exists, why would Boulder not
9. Factors That Affect a Firm’s Translation benefit from a stronger euro?
Exposure What factors affect a firm’s degree of
16. Measuring Changes in Economic
translation exposure? Explain how each factor influ-
Exposure Toyota Motor Corp. measures the sensitiv-
ences translation exposure.
ity of its exports to the yen exchange rate (relative to
10. Translation Exposure Consider a period in the U.S. dollar). Explain how regression analysis could
which the U.S. dollar weakens against the euro. How be used for such a task. Identify the expected sign of
will this affect the reported earnings of a U.S.-based the regression coefficient if Toyota primarily exports
MNC with European subsidiaries? Consider a period its vehicles to the United States. If Toyota established
in which the U.S. dollar strengthens against most more plants in the United States, how might the regres-
foreign currencies. How will this affect the reported sion coefficient on the exchange rate variable change?
earnings of a U.S.-based MNC with subsidiaries all 17. Impact of Exchange Rates on Earnings
over the world? Cieplak, Inc., is a U.S.-based MNC that has expanded
11. Transaction Exposure Aggie Co. produces into Asia. Its U.S. parent exports goods to some Asian
chemicals. It is a major exporter to Europe, where its countries, with its exports denominated in the Asian
main competition is from other U.S. exporters. All of currencies. It also has a large subsidiary in Malaysia
these companies invoice their products in U.S. dollars. that serves that market. Offer at least two reasons
Is Aggie’s transaction exposure likely to be signifi- related to exposure to exchange rates that explain
cantly affected if the euro strengthens or weakens? why Cieplak’s earnings were reduced during the
Explain. If the euro weakens for several years, can you Asian crisis in 1997.

Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.