Foreign exchange exposure is a measure of the potential for a firm’s profitability, net cash flow, and market value to change because of a change in exchange rates.
Types of Foreign Exchange Exposure
Transaction exposure measures changes in the value of outstanding financial obligations due to a change in exchange rates.
Translation exposure deals with changes in cash flows that result from existing contractual obligations.
Operating (economic, competitive, or strategic) exposure measures the change in the present value of the firm resulting from any changes in future operating cash flows of the firm caused by an unexpected change in exchange rates [via changes in sales volume, prices and costs.]
Impact of Hedging
MNEs possess a multitude of cash flows that are sensitive to changes in exchange rates, interest rates, and commodity prices. These three financial price risks are the subject of the growing field of financial risk management. Many firms attempt to manage their currency exposures through hedging.
Hedging is the taking of a position that will rise (fall) in value and offset a fall (rise) in the value of an existing position. While hedging can protect the owner of an asset from a loss, it also eliminates any gain from an increase in the value of the asset hedged against.
The value of a firm, according to financial theory, is the net present value of all expected future cash flows. Currency risk is defined roughly as the variance in expected cash flows arising from unexpected exchange rate changes. A firm that hedges these exposures reduces some of the variance in the value of its future expected cash flows.
However, is a reduction in the variability of cash flows sufficient reason for currency risk management?
Opponents of hedging state (among other things):
- Shareholders are much more capable of diversifying currency risk than the management of the firm.
- Currency risk management reduces the variance of the cash flows of the firm, but also uses valuable resources.
- Management often conducts hedging activities that benefit management at the expense of the shareholders (agency conflict), i.e., large FX loss are more embarrassing than the large cost of hedging.
Proponents of hedging cite:
- Reduction in risk in future cash flows improves the planning capability of the firm.
- Reduction of risk in future cash flows reduces the likelihood that the firm’s cash flows will fall below a necessary minimum (the point of financial distress)
- Management has a comparative advantage over the individual shareholder in knowing the actual currency risk of the firm
- Management is in better position to take advantage of disequilibrium conditions in the market.
Transaction exposure arises when a firm faces contractual cash flows that are fixed in a foreign currency.
Whenever a firm has foreign-currency-denominated receivables or payables, it is subject to transaction exposure, and the eventual settlements have the potential to affect the firm’s cash flow position. Since modern firms are often involved in commercial and financial contracts denominated in foreign currencies, management of transaction exposure has become an important function of international financial management.
Measurement of Transaction Exposure
Transaction exposure is simply the amount of foreign currency that is receivable or payable.
Since MNCs commonly have foreign subsidiaries spread around the world, they need an information system around the world, they need an information system that can track their currency positions .
Identifying Net Transaction Exposure
Before an MNC makes any decisions related to hedging, it should identify the individual net transaction exposure on a currency-by-currency basis. The term ‘net’ here refers to the consolidation of all expected inflows and outflows for a particular time and currency.
The management at each subsidiary plays a vital role in reporting its expected inflows and outflows. Then a centralised group consolidates the subsidiary reports to identify, for the MNC as a whole, the expected net positions in each foreign currency during several upcoming periods.
The MNC can identify its exposure by reviewing this consolidation of subsidiary positions.
One subsidiary may have net receivables in Mexican Pesos three months from now, while a different subsidiary has net payables in Pesos. If the Peso appreciates, this will be favourable to the first subsidiary and unfavourable to the second. However, the impact on the MNC as a whole is at least partially offset. Each subsidiary may desire to hedge its net currency position in order to avoid the possible adverse impacts on its performance due to fluctuations in the currency’s value. The overall performance of the MNC, however, may already be insulated by the offsetting positions between subsidiaries. Therefore, hedging the position of each individual subsidiary may not be necessary.
Although it is difficult to predict future currency value with much accuracy, MNCs can evaluate historical data to at least assess the potential degree of movement for each currency
The standard deviation statistic is one such possible way to measure the degree of movement for each currency. Notice that within each period, some currencies clearly fluctuate much more than others.
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