MindMap Gallery Measuring Exchange Rate Fluctuation Risk
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Measuring Exchange Rate Fluctuation Risk
Explore exchange rate fluctuation risk assessment with the "Measuring Exchange Rate Fluctuation Risk" mind map template, sourced from Edraw. This template encompasses branches such as "Exchange Rate Fluctuation Risk," "Correlation of Exchange Rate Fluctuation Risk," and "Economic Risks." Delve into understanding and quantifying the risks associated with exchange rate fluctuations and their correlation with economic risks. Tailored for financial analysts, risk managers, and economists, this mind map aids in evaluating and mitigating the impact of exchange rate fluctuations.
Edited at 2024-02-25 11:34:51
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Chapter 10: Measuring Exposure to Exchange Rate Fluctuations
Exposure to Exchange Rate Fluctuations
Financial managers of multinational corporations (MNCs) must understand how to measure their companies’ exposure to exchange rate fluctuations so that they can determine whether and how to protect their operations from that exposure.
In this way, they can reduce the sensitivity of their MNCs’ value to exchange rate movements.
1. Relevance of Exchange Rate Risk
Because exchange rate movements can affect an MNC’s cash flow, they can affect its performance and value.
- When an MNC is exposed to exchange rate risk, its cash flows (and therefore its performance and value) could be adversely affected by exchange rate movements. - In such an environment, MNCs that can reduce their exchange rate exposure may be able to stabilize their earnings and cash flows.
This can reduce the risk that the MNC’s stock valuation may decline.
It can also improve the MNC’s ability to repay its debt over the long run, thereby reducing the possibility of failure and enabling the MNC to borrow funds at a lower cost
- Some scholars argued that the exchange rate exposure of MNCs should not matter because the fluctuation of one currency may be offset by another. - Yet, for each argument as to why exchange rate risk might be irrelevant for MNCs (as briefly described in the first column of Exhibit 10.1), an argument can be made for why exchange rate risk is relevant for MNCs (as described in the second column of Exhibit 10.1).
In general, the assumptions used to argue for exchange rate irrelevance are not realistic.
Consequently, the arguments for exchange rate relevance are clearly superior
Furthermore, the relevance of exchange rate risk is well documented in the financial reports that MNCs distribute to investors.
Many financial statements (especially corporate annual reports) of MNCs acknowledge how their cash flows can be adversely affected by exchange rate movements:
- In general, we are a net receiver of currencies other than the U.S. dollar. - Accordingly, changes in exchange rates, and in particular a strengthening of the U.S. dollar, will negatively affect our revenue and other operating results as expressed in U.S. dollars — Facebook.
Because we manufacture and sell products in a number of countries throughout the world, we are exposed to the impact on revenue and expenses of movements in currency exchange rates — Procter & Gamble Co.
Increased volatility in foreign exchange rates . . . may have an adverse impact on our business results and financial condition — PepsiCo.
3. Economic Exposure
- The overall sensitivity of a firm’s cash flows to exchange rate movements is referred to as economic exposure (also sometimes referred to as operating exposure), which is a broader concept than transaction exposure. - Indeed, transaction exposure can be thought of as a subset of economic exposure.
Whereas transaction exposure focuses on the impact of exchange rate movements on an MNC’s contractual international transactions (as illustrated earlier in this chapter), economic exposure encompasses all of the ways that an MNC’s cash flows can be affected by exchange rate movements.
- E.g. , Intel (a U.S.-based MNC) invoices many of its computer chip exports in U.S. dollars, which avoids transaction exposure. - Yet if the euro weakens against the dollar, European importers will need more euros to pay for Intel’s chips and, therefore, might decide to purchase computer chips from European manufacturers instead. - While Intel’s decision to price exports in dollars can avoid transaction exposure, its cash flows could still be reduced when the euro weakens. - Thus, it is still subject to economic exposure.
- Although MNCs use a short-term perspective when assessing their transaction exposure, they tend to adopt a long-term perspective when assessing their economic exposure. - For example, U.S.-based MNCs may perform an assessment of their economic exposure to determine how their U.S. dollar cash flows are affected in general when foreign currencies appreciate against the U.S. dollar over time.
3.1 Exposure to Foreign Currency Depreciation
Exhibit 10.5 summarizes the means by which a U.S. firm’s cash inflows and outflows may be affected by exchange rate movements.
If the foreign currency depreciates:
With regard to the U.S. firm's cash inflows:
- 1. A U.S. firm’s local sales (in the United States) are expected to decrease if the foreign currency depreciates because the firm will face increased foreign competition. - That is, local customers (in the U.S.) will be able to obtain foreign substitute products cheaply if the foreign currency depreciates.
2. Cash inflows from the firm’s exports denominated in dollars will also likely be reduced as a result of depreciation in the foreign currency because foreign importers will likely demand fewer products when they need more of their own currency to pay for these products.
3. Cash inflows from the firm’s exports denominated in the foreign currency will convert to a reduced amount of dollars if the foreign currency has weakened.
4. Any interest or dividends received from foreign investments by the U.S. firm will also convert to a reduced amount of dollars if the foreign currency has weakened.
With regard to the U.S. firm's cash outflows:
1. The cost of imported supplies denominated in dollars will not be directly affected by changes in exchange rates. (no change)
2. If the imported supplies are denominated in the foreign currency, the cost will be reduced if the foreign currency depreciates.
3. In addition, any interest to be paid by the U.S. firm on financing in a foreign currency will be reduced if the foreign currency depreciates.
3.2 Exposure to Foreign Currency Appreciation
If the foreign currency appreciates, the U.S. firm’s sources of cash inflows or outflows will be affected in a manner opposite to how they are influenced by foreign currency depreciation
If the foreign currency appreciates:
With regard to the U.S. firm's cash inflows:
1. Local sales in the U.S. by the U.S. company should increase due to reduced foreign competition because prices denominated in the foreign currency will seem high to the U.S. customers
2. The U.S. company’s denominated in U.S. dollars will appear cheap to foreign imports, thereby increasing foreign demand for those products.
3. Exports denominated in the foreign currency will increase cash flows because foreign currency inflows will convert to a larger amount of dollars.
4. In addition, interest or dividends from foreign investments will convert to more dollars.
With regard to the U.S. firm's cash outflows:
1. The amount of the U.S. firm’s cash outflows due to imported supplies denominated in dollars will not be directly affected by the change in exchange rates.
2. The cost of imported supplies denominated in the foreign currency will increase in response to the appreciation of the foreign currency.
3. Any interest payments paid on financing in the foreign currency will also increase.
In general, appreciation of the foreign currency increases both cash inflows and outflows for the U.S. firm.
- If the firm concentrates on exporting and obtains supplies and borrows funds locally, it will likely benefit from the appreciation of the foreign currency. - This would be the case for U.S.-based MNCs such as Caterpillar, Ford, and DowDuPont during periods in which foreign currencies appreciate against the dollar. - Conversely, a U.S. firm that concentrates on local sales, has very little foreign competition, and obtains foreign supplies (denominated in foreign currencies) will likely suffer negative effects from appreciation of the foreign currency.
3.3 Measuring Economic Exposure
An MNC can estimate its economic exposure by determining how its cash flows in the following period (such as the following quarter) would be affected by possible exchange rate scenarios.
It applies sensitivity analysis to measure the sensitivity of its estimated net cash flows to the alternative exchange rate scenarios.
- If its estimated net cash flows are very similar regardless of the exchange rate scenario, this consistency implies that the firm’s net cash flows in the following quarter are not sensitive to possible exchange rate movements. - Thus, the firm may conclude that its economic exposure is low.
Conversely, if the firm’s sensitivity analysis determines that its estimated net cash flows for the following period are very sensitive to some possible exchange rate scenarios, this volatility implies that the firm has a high degree of economic exposure.
- E.g. The following example illustrates how an MNC could implement its sensitivity analysis to assess its degree of economic exposure. - The example is simplified in that the MNC is exposed to only one foreign currency. - In addition, the example focuses only on the next quarter. - In reality, an MNC would prefer to assess economic exposure for a period longer than one quarter.
- Madison Co. is a U.S.-based MNC that purchases most of its materials from Canada and generates a small portion of its sales from exporting to Canada. - The quarterly estimates of its cash flows, by country, are shown in Exhibit 10.6. - Madison wants to assess its economic exposure.
- Assume that Madison Co. expects three possible exchange rates for the Canadian dollar over the period of concern, all of which have an equal probability of occurring: $0.75, $0.80, or $0.85. - These scenarios are separately analyzed in (respectively) the second, third, and fourth columns of Exhibit 10.7.
Row (1) is constant across scenarios because the company’s sales to U.S. businesses are not affected by exchange rate movements.
In row (2), the estimated U.S. dollar sales to Canadian businesses are determined by converting the estimated Canadian dollar sales into U.S. dollars.
Row (3) is the sum of the U.S. dollar sales in rows (1 )and (2).
Row (4) is constant across scenarios because the cost of materials in the United States is not affected by exchange rate movements.
In row (5), the estimated U.S. dollar cost of materials purchased in Canada is determined by converting the estimated Canadian cost of materials into U.S. dollars.
Row (6) is the sum of the U.S. dollar cost of materials in rows (4) and (5).
Row (7) is constant across scenarios because U.S. operating expenses are not affected by exchange rate movements, and row (8) is constant across scenarios because the interest expense on U.S. debt is not affected by exchange rate movements.
In row (9), the estimated U.S. dollar interest expense from Canadian debt is determined by converting the estimated Canadian interest expenses into U.S. dollars.
Row (10) is the sum of the U.S. dollar interest expenses in rows (8) and (9).
The bottom row of Exhibit 10.7 illustrates that Madison’s dollar cash flows (before taxes) are much lower when the Canadian dollar is relatively strong.
Madison is highly exposed to exchange rate scenarios because its Canadian dollar cost of materials (C$200 million) is much greater than its Canadian dollar sales (C$4 million).
Whereas a strong Canadian dollar increases the firm’s U.S. dollar expenses and revenue, its expenses are affected to a much greater degree.
In addition, Madison’s U.S. dollar expense of making interest payments in Canadian dollars is higher when the Canadian dollar is stronger.
What is the degree of change (in terms of %) from the best to the worst scenario?
- Best scenario: US$52.50 - Worst scenario: US$31.90
The acceptable percentage is only about 20%
To the extent that the expenses and revenues shown in Exhibit 10.7 are typical for most quarters, Madison is subject to high economic exposure over the long run.
To reduce its economic exposure, it would need to restructure its operations to achieve more balance between its Canadian dollar cash inflows and outflows (as explained in Chapter 11).
- The preceding example is based on a one-period time horizon. - A firm that has developed forecasts of sales, expenses, and exchange rates for several periods ahead can assess its economic exposure over time.
a. Use of Regression Analysis (for reference only)
4. Translation Exposure
- An MNC creates its financial statements by consolidating all of its individual subsidiaries’ financial statements. - A subsidiary’s financial statement is typically measured in its local currency.
To perform consolidation, each subsidiary’s financial statement must be translated into the home country currency of the MNC’s parent.
Of course, because exchange rates vary over time, the translation of the subsidiary’s financial statement into a different currency is affected by exchange rate movements.
- The exposure of the MNC’s consolidated financial statements to exchange rate fluctuations is known as translation exposure. - In particular, subsidiary earnings translated into the reporting currency on the consolidated income statement are subject to fluctuations in the exchange rates.
To translate earnings, MNCs use a process established by the Financial Accounting Standards Board (FASB).
The guidelines for translation are set by FASB 52.
4.1 Determinants of Translation Exposure
- Some MNCs have more translation exposure than others. - The extent of an MNC’s translation exposure depends mainly on three factors:
The proportion of its business conducted by foreign subsidiaries
The locations of its foreign subsidiaries
The accounting methods that it uses
a. Proportion of Business by Foreign Subsidiaries – Comparison of Two Companies
The greater the percentage of an MNC’s business conducted by its foreign subsidiaries, the larger the percentage of a given financial statement item that is susceptible to translation exposure.
- For example, Locus Co. and Zeuss Co. each generate approximately 30 percent of their sales from foreign countries. - However, Locus Co. generates all of its international business by exporting, whereas Zeuss Co. has a large Mexican subsidiary that generates all of its international business. - Locus Co. is NOT subject to translation exposure (although it is subject to economic exposure), while Zeuss has substantial translation exposure.
b. Locations of Foreign Subsidiaries
The countries in which subsidiaries are located can also influence the degree of translation exposure because the financial statement items of each subsidiary are typically measured by the respective subsidiary’s home country currency.
- For example, Zeuss Co. and Canton Co. each have one large foreign subsidiary that generates approximately 30 percent of their respective sales. - However, Zeuss Co. is subject to a much higher degree of translation exposure because its subsidiary is based in Mexico, and the peso’s value is subject to significant depreciation. - In contrast, Canton’s subsidiary is based in Canada, and the Canadian dollar is very stable against the U.S. dollar.
c. Accounting Methods (for reference only)
An MNC’s degree of translation exposure is strongly affected by the accounting procedures used to translate currencies when consolidating financial statement data.
Many important consolidated accounting rules for U.S.-based MNCs are based on FASB 52, which includes the following provisions:
For example, Providence, Inc., is a U.S.-based MNC whose British subsidiary earned £10 million in year 1and £10 million in year 2.
When these earnings are consolidated along with other subsidiary earnings, they are translated into U.S. dollars at the weighted average exchange rate for the year in question.
- Suppose the weighted average exchange rate is $1.70 in year 1 and $1.50 in year 2. - Then the translated earnings (in U.S. dollars) for each reporting period are determined as follows:
- Even though the subsidiary’s earnings in pounds were the same each year, the translated consolidated dollar earnings were reduced by $2 million in year 2. - This discrepancy reflects the change in the weighted average of the British pound exchange rate.
The drop in earnings is not the fault of the subsidiary but rather is attributable to the weakened British pound, which makes the subsidiary’s year 2 earnings look small (when measured in U.S. dollars).
The effect reported in the table occurs even if all of the earnings generated by the subsidiary are reinvested in the United Kingdom.
Translation exposure can explain some of the variations in earnings for any particular U.S.-based MNC over time, because the reported consolidated earnings are bolstered in periods when the currencies of foreign subsidiaries strengthen against the dollar, but decline in periods when these currencies weaken against the dollar.
For example, the consolidated earnings of Stanley Black & Decker, The Coca-Cola Co., and many other large U.S.-based MNCs are highly sensitive to exchange rates because more than one-third of their assets and sales are overseas.
In some quarters, more than half of the change in reported earnings by MNCs is due to the translation effect.
The potential impact of this effect on consolidated earnings is especially pronounced when foreign subsidiaries generate a relatively high proportion of the MNC’s total earnings and when the local currencies used by those subsidiaries have changed substantially in value over the quarter.
4.2 Exposure of an MNC’s Stock Price to Translation Effects
Many investors tend to use earnings when valuing the stock of MNCs, either by deriving estimates of expected cash flows from previous earnings or by applying an industry price to earnings (P/E) ratio to expected annual earnings to derive a value per share of stock.
- The price-to-earnings (P/E) ratio relates a company's share price to its earnings per share. - A high P/E ratio could mean that a company's stock is overvalued, or that investors are expecting high growth rates in the future. - Companies that have no earnings or that are losing money do not have a P/E ratio because there is nothing to put in the denominator. - Two kinds of P/E ratios—forward and trailing P/E—are used in practice. - A P/E ratio holds the most value to an analyst when compared against similar companies in the same industry or for a single company across a period of time.
Because the translation exposure of each MNC affects its consolidated earnings, that exposure can also affect the MNC’s valuation.
For example, recall the previous example, in which Providence earned consolidated earnings (translated to dollars) of $17 million in year 1 but only $15 million in year 2 (because of depreciation in the British pound during that year)
Providence has 10 million shares of stock outstanding.
Assume that all consolidated earnings for Providence come from its subsidiaries (the U.S. parent had no earnings).
Suppose the market valuation of Providence’s stock is usually near the mean P/E ratio in its industry multiplied by its prevailing earnings per share (EPS), and suppose the mean P/E ratio in its industry was 20 in both year 1and year 2.
- Earnings per share (EPS) is a company's net profit divided by the number of common shares it has outstanding. - EPS indicates how much money a company makes for each share of its stock and is a widely used metric for estimating corporate value. - A higher EPS indicates greater value because investors will pay more for a company's shares if they think the company has higher profits relative to its share price. - EPS can be arrived at in several forms, such as excluding extraordinary items or discontinued operations, or on a diluted basis. - Like other financial metrics, earnings per share is most valuable when compared against competitor metrics, companies of the same industry, or across a period of time.
Given this information, the translation effect on earnings per share and on the stock price of Providence is calculated as shown in Exhibit 10.8.
In year 1, its EPS is estimated to be $1.70; hence the stock valuation is $1.70 x 20 = $34 per share in that year.
In year 2, however, the company’s consolidated earnings (in dollars) are only $1.50 per share, which results in a stock value of only $30 per share.
Thus, Providence’s stock valuation declined over the last year because its consolidated earnings declined over that period, owing to a decline in the exchange rate used to translate the British pound earnings into dollar earnings.
These results hold regardless of whether the subsidiary earnings are remitted to the U.S. parent or reinvested by the subsidiary in the United Kingdom.
a. Signals That Complement Translation Effects (for reference only)
b. Exposure of Managerial Compensation to Translation Effects (for reference only)
2. Transaction Exposure
Perhaps the most obvious way in which most MNCs are exposed to exchange rate risk is through contractual transactions that are invoiced in foreign currencies
The sensitivity of the firm’s contractual transactions in foreign currencies to exchange rate movements is referred to as transaction exposure.
A U.S.-based MNC’s concern about transaction exposure is that any currencies that it will need in the future to cover international transactions could appreciate by the time it obtains them, while any currencies it will receive in the future could depreciate by the time it receives them.
Thus, the exchange rate movements of the currencies the MNC will need or receive in the near future for international transactions could adversely affect its dollar cash flows.
- Because many contractual international transactions tend to occur in the near future (such as within the next quarter), MNCs naturally focus on the near future when assessing their transaction exposure. - Therefore, the following discussion of transaction exposure emphasizes the short term period (the next quarter) when most contractual transactions occur.
If an MNC wanted to assess transaction exposure over a shorter time horizon (such as one month) or a longer time horizon (such as one year) in the future, the process described here for assessing transaction exposure could still be applied.
- For example: Sky Company is a U.S.-based MNC that wants to measure its transaction exposure over the next quarter. - The company just received an order from Spain for its products. It will deliver its products and receive 1 million euros in one quarter (90 days). - The euro’s spot rate is currently US$1.35 per euro, Sky Company is more worried about the spot rate that will exist when it exchanges 1 million euros for US dollars at the end of the next quarter.
- Sky Company’s financial manager measures the transaction exposure by forecasting a set of possible exchange rates. - The financial manager forecasts the exchange would fall between US$1.60 = €1 and US$0.90 = €1.
Sky Company is to receive € 1 million in 90 days. How much US$ will Sky Company deliver to the bank given value of one euro being: US$0.9 US$1.0 US$1.1 US$1.2 US$1.3 US$1.4 US$1.5 US$1.6
Answer to question: What is the percentage difference between the highest and lowest possible amounts received by Sky Company?
This is an extreme case, but you can see how exchange rate fluctuation may affect a company’s receivables.
If you were the financial manager of Sky Company, would you be worried?
Sky Company is subject to transaction exposure, because the US dollar cash flows it will receive is uncertain, and dependent on the future exchange rate when the international transaction is completed.
The greater the uncertainty surrounding the future exchange rate of the currency, the greater the Sky Company’s transaction exposure (potential adverse effects of its international transactions that could be caused by the future exchange rate movements).
Now that Sky Company has assessed its transaction exposure, it can decide whether to hedge this exposure.
If Sky Company believes that the euro will appreciate to US$1.50 per euro in one quarter, it will not hedge because it will benefit from the appreciation of the euro.
Conversely, if it believes that the euro will depreciate to US$1.00 per euro over the next quarter, it may consider hedging its transaction exposure.
For most MNCs’ the assessment of transaction exposure is not as simple as in the previous example.
A typical MNC will have multiple orders for its products, for which it will receive euros from multiple customers at the end of the quarter.
It may also have made multiple purchases of supplies for which it will owe multiple vendors euros at the end of the quarter.
- Another factor complicating an MNC’s assessment of its exposure is that a typical MNC will have international transactions in more than one currency over the next quarter. - Thus, an MNC should (1) estimate the expected net cash flows for each currency over the next quarter, and then (2) assess its exposure to all these currencies as a portfolio over the next quarter.
2.1 Estimating “Net” Cash Flows in Each Currency
To measure transaction exposure over the next quarter, an MNC should identify all transactions denominated in a foreign currency that will occur during the quarter and categorize the transactions by whether they are cash inflows or cash outflows.
Because cash outflows that must be paid in a particular currency at the end of the quarter partially offset the cash inflows that will be received in that same currency at the end of the quarter, the MNC’s transaction exposure focuses only on the “net” cash flows, measured as cash inflows minus cash outflows for aparticular currency. Net Cash Flows = Cash Inflows – Cash Outflows
For example 1:
- For example 2: Miami Company is a U.S company and conducts its international business in four currencies: British pound, Canadian dollar, Euro, and Australian dollar. - The Company wants to measure its exposure in each currency over the next quarter, so that it can decide whether to hedge that exposure. - Miami should measure the US$ dollar value of net cash flows for each currency over the next quarter, so that it can compare the exposure per currency using a standardized measurement.
Miami Company forecasts the future cash inflow and outflow in four currencies in 90 days as follows:
1. Miami Company expects British pound inflows of £17 million and outflows of £7 million over the next quarter. The net cash inflows is £10 million.
2. Miami Company expects Canadian dollar inflows of C$12,000,000 and outflows of C$2,000,000, with net inflow of C$10,000,000.
3. Miami Company expects Euro inflows of €10,000,000 and outflows of €$22,500,000, with net outflow of C$€12,500,000.
4. Miami Company expects Australian dollar inflows of A$23,333,333 and outflows of A$10,000,000, with net inflow of A$13,333,333.
Miami Company also forecasts the exchange rate in 90 days.
Miami’s exposure to each foreign currency cannot be directly compared to that of the other three foreign currencies, because the values of the currencies differ.
Transaction exposure of 1 million British pounds is not the same as transaction exposure of 1 million Australian dollar because the value of the British pound is higher than the value of Australian dollar against the U.S. dollar.
For this reason, Miami determines its U.S. dollar value of exposure to each foreign currency in column 6 measured as the net inflow or outflow in foreign currency for the quarter (shown in Column 4) multiplied by the spot exchange rate expected at the end of the quarter (shown in column 5).
Because Miami Company has net cash inflows of £10 million over the next quarter (first row of column 4), and given that Miami expects the British pound’s spot rate to be US$1.50 at the end of the quarter (first row of column 5), the U.S. dollar value of the British pound exposure is £10,000,000 x US$1.50 per £ = US$15,000,000 (first row of column 6).
- The U.S. dollar value of Miami’s exposure to transactions denominated in Canadian dollars is estimated in a similar manner. - Because Miami has net inflows of C$10 million (second row of column 4) over the next quarter, and it expects that the Canadian dollar’s spot rate will be US$0.80 at the end of the quarter (second row of column 5), the U.S. dollar value of this exposure is C$100,000,000 x US$0.80 per C$ = US$8,000,000 (shown in the second row of column 6).
The U.S. dollar value of the exposure to the Euro and Australian dollar are derived in the same manner.
Notice that Miami Company has a negative cash flow from its Euro business.
Miami expects net cash flows in three of the currencies are positive (British pound, Canadian dollar, Australian dollar) but that the net cash flows in the euro are negative (reflecting cash outflows). (column 4 of table).
- Answers to the Questions: - When British pound appreciates, does it have a positive or negative effect on Miami? Positive - When Canadian dollar appreciates, does it have positive or negative effect on Miami? Positive - When Euro appreciates, does it have a positive or negative effect on Miami? Negative - When Australian dollar appreciates, does it have a positive or negative effect on Miami? Positive
2.2 Transaction Exposure of an MNC’s Portfolio
After estimating net U.S. dollar cash flows per currency for the next period (quarter in Miami’s case), an MNC can assess the degree of transaction exposure of its portfolio of currencies (a set of currencies).
To measure that exposure, the MNC can determine whether the U.S. dollar value of the portfolio has a relatively high standard deviation, this value may be more volatile over the next quarter.
If a currency portfolio has a relatively high standard deviation, its value may be more volatile over time, suggesting that it is more susceptible to a pronounced reduction in value over the next quarter.
How do you determine if this MNC has a higher degree of transaction exposure?
By knowing the volatility of each currency.
Or whether the two currencies are highly correlated (move in the same direction).
- The volatility of a portfolio containing more than two currencies is more difficult to estimate. - Nevertheless, it is also positively related to the volatility of each individual currency, and to the degree of correlation between each pair of currencies in the portfolio:
a. Measurement of Currency Volatility
To estimate the volatility of a currency’s movements against the dollar, first access quarterly exchange rates for that currency against the dollar over the past several quarters, using a source such as a Federal Reserve website.
Second, derive the percentage change in the exchange rate of the currency from one quarter to the next (use a different period than a quarter if you are interested in a different time horizon).
- Third, compute the standard deviation of the quarterly percentage changes. - Spreadsheets such as Excel can easily compute the percentage changes in the currency’s value and the standard deviation.
The volatility (as measured by the standard deviation) of any currency depends on the time horizon that is used to measure the exchange rate movements.
- In general, the longer the time horizon, the more volatile a currency’s exchange rate movements. - Thus, a currency’s exchange rate movements generally will be more volatile (have a higher standard deviation) on a quarterly basis than on a daily basis, and that currency’s exchange rate movements will be more volatile on an annual basis than on a quarterly basis.
b. Currency Volatility over Time
The volatility of a currency usually will not remain constant over time.
That is, if you measure the standard deviation of quarterly movements in the euro against the dollar this year, it will not be equal to the standard deviation of quarterly movements in the euro against the dollar next year.
However, an MNC can at least attempt to compare volatility levels among currencies in recent periods to anticipate which currencies will have a relatively high or low level of volatility in the future.
From a U.S. perspective, currencies of developed countries such as the Canadian dollar, the euro, and the Swiss franc tend to have relatively low volatility, whereas currencies of developing countries such as the Argentine peso, Brazilian real, and Mexican peso tend to have relatively high volatility.
c. Measurement of Currency Correlations
The correlations among currency movements can be measured by their correlation coefficients, which indicate the extent to which two currencies move in tandem with each other.
The extreme case is perfect positive correlation, which is represented by a correlation coefficient equal to 1.
A negative correlation coefficient suggests an inverse relationship between the exchange rate movements of two currencies.
A MNC’s two-currency portfolio is subject to a higher degree of transaction exposure when:
Each currency is very volatile.
The movements of the two currencies against the U.S. dollar are highly correlated.
- Currency correlation is defined as the relationship between one currency pair and another. - For example, the quarterly movements in the euro and other currencies of European countries not in the eurozone against the U.S. dollar are highly positively correlated (the correlation coefficient between any pair of these currencies is commonly 0.80 or higher).
- Because currency correlations change over time, previous correlations are not perfect predictors of future correlations. - Nevertheless, some general relationships tend to hold over time.
From a U.S. perspective, currency correlations are generally positive; this implies that currencies tend to move in the same direction against the U.S. dollar.
For example: the quarterly movements in the euro and other currencies of European countries not in the eurozone against the U.S. dollar are highly positively correlated (the correlation coefficient between any pair of these currencies is commonly 0.80 or higher).
When euro appreciates against the U.S. dollar, British pound also appreciates against the U.S. dollar.
When euro depreciates against the U.S. dollar, British pound also depreciates against the U.S. dollar
For example, the Canadian dollar’s quarterly movements against the U.S. dollar are typically positively correlated with quarterly movements of European currencies against the U.S. dollar, but the correlation is not as high as that of any pair of European currencies against the dollar.
For example, The Australian dollar’s quarterly movements against the U.S. dollar are also typically positively correlated with quarterly movements of European currencies against the U.S. dollar, but the correlation is not as high as that of any pair of European currencies against the U.S. dollar.
d. Applying Currency Correlations to Net Cash Flow Positions
The implications of currency correlations for a particular MNC depend on its cash flow characteristics, i.e. net cash inflow or net cash outflow.
- If an MNC has positive net cash flows over the next quarter in various currencies that are highly correlated, it may be subject to a higher degree of transaction exposure in that quarter. - If the values of these currencies move in the same direction, and by similar degrees, they could all depreciate against the dollar in the quarter without any offsetting effects.
- For example, an MNC has: - A positive net cash inflows in Euro (+) - A positive net cash inflows in British pound (+) - We have two scenarios:
When Euro appreciates against the U.S. dollar, will this MNC receive more US dollars from the two currencies?
Answer: Yes!
- When Euro appreciates, British pound is likely to appreciate too. - Therefore, the MNC will receive more US$ from its euro business segment and British business segment.
When Euro depreciates against the U.S. dollar, will this MNC receive more US dollars from the two currencies?
Answer: NO!
- When Euro depreciates , British pound is likely to depreciate too. - Therefore, the MNC will receive less US$ from both the euro business segment and the British business segment.
However, many MNCs have negative net cash flow positions (meaning that their cash outflows exceed their cash inflows) in one or more currencies.
An MNC’s transaction exposure is reduced if its negative net cash flow currencies are highly correlated with its positive net cash flow currencies.
While depreciation of currencies has an adverse effect on the positive net cash flows (the inflows will convert to fewer dollars), it will favorably affect the negative net cash flow positions because the MNC will need fewer dollars to obtain these currencies.
Conversely, whereas currency appreciation would adversely affect the MNC’s negative net cash flows (more dollars would be needed to obtain those currencies), it would favorably affect the MNC’s positive net cash flows (the inflows will convert to more dollars).
- For example, if a MNC has: - A positive net cash inflows in Euro (+) - A negative net cash inflows in British pound (—) - We know that Euro and British pound are positively correlated. - If Euro appreciates against the U.S. dollar, what would happen to its US$ cash flows from Euro and British pound?
- Answer: - When euro appreciates against the U.S. dollar, the MNC receives more U.S. dollars.
When euro appreciates against the U.S. dollar, pound is likely to appreciate against the U.S. dollar as well, the MNC pays out more U.S dollars from pounds.
Therefore, the positive effect of euro appreciation (cash inflow) could be offset by the negative effect of pound appreciation (cash outflow).
- For example, if a MNC has: - A positive net cash inflows in Euro (+) - A negative net cash inflows in British pound (—) - We know that Euro and British pound are positively correlated. - If Euro depreciates against the U.S. dollar, what would happen to its US$ cash flows from Euro and British pound?
- Answer: - When euro depreciates against the U.S. dollar, the MNC receives fewer U.S. dollars
When euro depreciates against the U.S. dollar, pound is likely to depreciate against the U.S. dollar as well, the MNC pays out fewer U.S dollars
Therefore, the negative effect of euro depreciation (cash inflow) is offset by the positive effect of pound appreciation (cash outflow).
From example (2) & (3) above, we realize that if an MNC has positive net cash flows over the next quarter in one currency and negative net cash flows in another currency:
When the two currencies are highly correlated, the MNC may be subject to a lower degree of transaction exposure in that quarter.
- The US$ cash inflow in one currency could be offset by the US$ cash outflow in the other currency. - There is an offsetting effect.
For example: Recall from Exhibit 10.3 that Miami Co. anticipates net cash inflows in British pounds equivalent to $15 million and net cash outflows in Swedish krona equivalent to $15 million at the end of the quarter. - These currencies are highly positively correlated against the dollar. Thus, one possible scenario is that these two currencies will appreciate against the U.S. dollar over the next quarter, such that Miami would be adversely affected by its exposure to the krona but favorably affected by its pounds exposure. - An alternative scenario is that these two currencies might depreciate against the dollar over the next quarter, in which case Miami would be adversely affected by its pounds exposure but favorably affected by its krona exposure. - Thus, although Miami does not know which of the two scenarios will play out, it has determined that offsetting effects would occur with either scenario. - Given these offsetting effects, Miami is not concerned about its transaction exposure to the British pound or the Swedish krona over the next quarter. However, it is somewhat concerned about its exposure to the Canadian dollar and the Mexican peso. - Therefore, Miami decides to conduct some additional analysis to determine its transaction exposure to these two currencies, as described shortly.
- Exhibit 10.4 offers some insight into the transaction exposure of an MNC over the next period (such as the next quarter) based on some specific scenarios. - Or in simple terms, Applying Currency Correlations to Net Cash Flow Positions - Currency A and B are highly correlated
In Case 3 and 4:
MNCs have negative net cash flow positions in one or more currencies.
An MNC’s transaction exposure is reduced if its negative net cash flow currencies are highly correlated with its positive net cash flow currencies.
While depreciation of currencies has an adverse effect on the positive net cash flows, it will favorably affect the negative net cash flow positions because the MNC will need fewer U.S. dollars to obtain these currencies. (4)
Conversely, whereas currency appreciation would adversely affect the MNC’s negative net cash flows, it would favorably affect the MNC’s positive net cash flows. (3)
2.3 Transaction Exposure Based on Value at Risk (VaR)
A related method for assessing exposure is the value-at-risk (VaR) method, which can estimate the maximum possible loss on the value of currency positions that are exposed to exchange rate movements.
- Value at risk (VaR) is a way to quantify the risk of potential losses for a firm or an investment. - This metric can be computed in three ways: the historical, variance-covariance, and Monte Carlo methods. - Investment banks commonly apply VaR modeling to firm-wide risk due to the potential for independent trading desks to unintentionally expose the firm to highly correlated assets.
For example, recall that Miami Co. (from the earlier example 1) has determined that its exposures to British pounds and Swedish krona are offsetting, so that it needs to be concerned only about the exposure of its net cash flows in Canadian dollars and Mexican pesos.
- Assume for the moment that Miami needs to worry about just its transaction exposure to Canadian dollar net cash flows. - It can use the VaR method to estimate the maximum expected loss.
Assume that Miami estimates the standard deviation of quarterly percentage changes of the Canadian dollar to be 4 percent over the last 40 quarters.
- If these quarterly percentage changes are normally distributed, then the maximum one-quarter loss is determined by the lower boundary (the left tail) of the probability distribution, which, based on a 95 percent confidence level, is approximately 1.65 standard deviations away from the expected percentage change in the Canadian dollar. - Building upon this saying, let's take an example:
- Suppose you are a currency trader or a financial institution that holds a significant position in Canadian dollars. - You want to estimate the maximum one-quarter loss in the value of the Canadian dollar with 95 percent confidence.
You analyze historical data and find that the quarterly percentage changes in the Canadian dollar exchange rate are approximately normally distributed with a mean (expected value) of 0.5 percent and a standard deviation of 2 percent.
- To estimate the maximum one-quarter loss at a 95 percent confidence level: - You calculate the distance from the mean in terms of standard deviations: 1.65 standard deviations x 2 percent = 3.3 percent. - You interpret this as follows: With 95 percent confidence, you expect that the Canadian dollar's quarterly percentage change will not fall below approximately -3.3 percent (a loss) over a quarter.
- Assume that Miami expects that the Canadian dollar will depreciate by 1 percent against the U.S. dollar over the next quarter. - Based on this forecast, along with the estimated standard deviation of 4 percent, the maximum expected loss due to Miami’s transaction exposure in Canadian dollars over the next quarter is: , where E(et) is a mean or the expected perfectage change , and σ(C$) is standard deviation of a currency.
- Recall from Exhibit 10.3 that the U.S. dollar value of Miami’s net cash flow position in Canadian dollars over the next quarter is$8 million. - Therefore, a decline of 7.6 percent in the Canadian dollar’s value over the next quarter would cause Miami’s Canadian dollar position to experience a loss of $8,000,000 x -0.076 = - $608,000. - This is called Value at Risk (VAR).
For example (cont.), now assume that Miami is only concerned about the maximum one-quarter loss due to a potential decline in the Mexican peso’s value.
Assume that the company believes the expected percentage change in the Mexican peso is -1 percent during the next quarter, and that Miami estimated the standard deviation of exchange rate movements of the Mexican peso to be 6 percent over the past 40 quarters.
Based on these assumptions, Miami’s maximum expected one-quarter loss due to its transaction exposure in Mexican pesos over the next quarter is:
- Recall that the dollar value of Miami’s net cash flows in Mexican pesos is estimated to be $8 million. - Therefore, a decline of 10.9 percent in the Mexican peso’s value over the next quarter would result in a loss of $8,000,000 x -10.9% = - $872,000. - This is called Value at Risk (VAR).
a. Factors That Affect the Maximum One-Day Loss
The maximum expected loss on a currency over the next quarter depends on three factors:
- First, it depends on the expected percentage change in the currency for the next quarter. - If the expected percentage change in the currency’s value was more pronounced than the 1 percent depreciation assumed in the previous example, the maximum expected loss would be more pronounced.
Second, a higher confidence level (such as 99 percent confidence instead of 95 percent confidence) will lead to a greater maximum expected loss (when all other factors are held constant).
- Third, the maximum expected loss over the next quarter depends on the standard deviation of the currency’s quarterly exchange rate movements over a previous period. - For example, notice that Miami Co.’s maximum expected loss in Mexican pesos is more pronounced than its loss in Canadian dollars. - This is due to the higher volatility (larger standard deviation) of the Mexican peso’s quarterly exchange rate movements in the past, which makes Miami believe that the Mexican peso could possibly depreciate to a greater degree than the Canadian dollar in the following quarter.
Because the VaR method provides Miami with a specific estimate of the maximum expected loss, it offers additional information to supplement the MNC’s previous assessment of its transaction exposure over the next quarter.
If Miami is uncomfortable with the magnitude of its possible maximum loss for either currency over the next quarter, it can hedge its position as explained in Chapter 11.
However, it should also use VaR to assess the maximum loss of the portfolio (Canadian dollars and Mexican pesos) in the event that it does not hedge either currency’s net cash flows, as described in the next section.
b. Applying VaR to the Transaction Exposure of a Portfolio
Because MNCs are commonly exposed to more than one currency, they may wish to apply the VaR method to a portfolio of currencies.
When considering multiple currencies, software packages can be used to perform the computations.
An example of applying VaR to a two-currency portfolio is given next:
- Recall that Miami Co. is expecting net cash flows in Canadian dollars at the end of the quarter valued at $8 million, and net cash flows in Mexican pesos valued at $8 million. - Thus, Miami is exposed to a currency portfolio weighted 50 percent $(8 mil divided by $16 mil) in Canadian dollars and 50 percent in Mexican pesos.
Miami wants to determine the maximum expected one-quarter loss in its portfolio of these two currencies (based on a 95 percent confidence level)
Recall from previous examples that Miami estimates the standard deviation of quarterly percentage changes to be 4 percent for the Canadian dollar and 6 percent for the Mexican peso.
Also assume that Miami estimates a correlation coefficient (CORR) of 0.20 (often provided in a situation) between these two currencies.
The portfolio’s standard deviation σ(p) is estimated as follows:
Based on the assumptions, σ(p) standard deviation of quarterly percentage changes of the portfolio between Canadian dollar and Mexian peso is:
If the quarterly percentage changes of each currency are normally distributed, then the quarterly percentage changes of the portfolio should be normally distributed.
- The maximum one-quarter loss of the currency portfolio is determined by the lower boundary (the left tail) of the probability distribution, which, based on a 95 percent confidence level, is approximately 1.65 standard deviations away from the expected percentage change in the currency portfolio. - Assuming an expected percentage change of -1 percent for the currency portfolio, the maximum expected one-quarter loss is:
- Notice that the maximum one-quarter loss for the portfolio is much smaller than the maximum loss for the Mexican peso by itself, which can be attributed to the low correlation between the Mexican peso’s movements and the Canadian dollar’s movements (diversification effects). - In other words, because the two currencies do not move in perfect tandem, it is unlikely that both currencies would experience a maximum loss at the same time.
- Diversification is a strategy that mixes a wide variety of investments within a portfolio in an attempt to reduce portfolio risk. - Diversification is most often done by investing in different asset classes such as stocks, bonds, real estate, or cryptocurrency. - Diversification can also be achieved by purchasing investments in different countries, industries, sizes of companies, or term lengths for income-generating investments. - The quality of diversification in a portfolio is most often measured by analyzing the correlation coefficient of pairs of assets. - Investors can diversify on their own by investing in select investments or can hold diversified funds.
- Given the maximum losses calculated here for individual currency positions and for the portfolio, Miami Co. may decide to hedge its transaction exposure in Canadian dollars, its transaction exposure in Mexican pesos, neither position, or both positions. - An MNC’s decision of whether to hedge and how to hedge is discussed in Chapter 11.
c. Estimating VaR with a Spreadsheet (for reference only)
d. Limitations of VaR (for reference only)
- The VaR method presumes that the distribution of exchange rate movements is normal. - If the distribution of exchange rate movements is not normal, then the estimate of the maximum expected loss is subject to error.
- In addition, the VaR method typically relies on an estimate of volatility (standard deviation) of exchange rate movements based on historical data. - If past exchange rate movements are less volatile than future movements are, then the estimated maximum expected loss derived from the VaR method will be underestimated. - For example, in this scenario, historical data indicated that the USD-EUR exchange rate had been relatively stable with small daily fluctuations. - The company used a 1% VaR model, estimating a 1% chance of losing $100,000 over the next month based on this historical data. - However, a sudden geopolitical event led to increased volatility in the currency markets, causing the USD-EUR exchange rate to swing dramatically. - The VaR estimate, relying on historical data, failed to account for this increased volatility, resulting in a significantly greater loss than the model had predicted.