Exam 10: Measuring Exposure to Exchange Rate Fluctuations

One argument why exchange rate risk is irrelevant to corporations is that shareholders can deal with this risk individually.

Assume that the British pound and Swiss franc are highly correlated. A U.S. firm anticipates the equivalent of $1 million cash outflows in francs and the equivalent of $1 million cash outflows in pounds. During a ____ cycle, the firm is ____ affected by its exposure.

Because creditors may prefer that firms maintain low exposure to exchange rate risk, exchange rate movements may cause earnings to be more volatile, and because investors may prefer corporations to perform hedging for them, exchange rate risk is probably relevant.

Consider an MNC that is exposed to the Taiwan dollar (TWD) and the Egyptian pound (EGP). 25% of the MNC's funds are Taiwan dollars and 75% are pounds. The standard deviation of exchange movements is 7% for Taiwan dollars and 5% for pounds. The correlation coefficient between movements in the value of the Taiwan dollar and the pound is .7. Based on this information, the standard deviation of this two-currency portfolio is approximately:

Regression analysis cannot be used to assess the sensitivity of a company's performance to economic conditions because economic conditions are unpredictable.

The following regression model was run by a U.S.-based MNC to determine its degree of economic exposure as it relates to the Australian dollar and Sudanese dinar (SDD): PCF_t = a₀ + a₁e_t + $\mu$ _t Where the term on the left-hand side is the percentage change in inflation-adjusted cash flows measured in the firm's home currency over period t, and et is the percentage change in the exchange rate of the currency over period t. The regression was run over two subperiods for each of the two currencies, with the following results: \begin{array}{llcc} \text { } &\text { Regression Coefficient \left(a_{1}\right) }&\text {Regression Coefficient \( \left(a_{1}\right) \)}\\ \text { Currency} &\text { Earlier Subperiod }&\text {Recent Subperiod}\\ \text {Australian dollar (AS) } &-.80&.10\\ \text { Sudanese dinar (SDD) } &.20&.25\\\end{array} Based on these results, which of the following statements is probably not true?

Some MNCs are subject to economic exposure without being subject to transaction exposure.

A purely domestic firm is never exposed to exchange rate fluctuations.

Generally, MNCs with less foreign costs than foreign revenues will be ____ affected by a ____ foreign currency.

The maximum one-day loss estimated using the value-at-risk (VAR) method is independent of the confidence level used.

Translation exposure affects an MNC's cash flows.

Exhibit 10-2 Volusia, Inc. is a U.S.-based exporting firm that expects to receive payments denominated in both euros and Canadian dollars in one month. Based on today's spot rates, the dollar value of the funds to be received is estimated at $500,000 for the euros and $300,000 for the Canadian dollars. Based on data for the last fifty months, Volusia estimates the standard deviation of monthly percentage changes to be 8 percent for the euro and 3 percent for the Canadian dollar. The correlation coefficient between the euro and the Canadian dollar is 0.30. -Refer to Exhibit 10-2. Assuming an expected percentage change of 0 percent for each currency during the next month, what is the maximum one-month loss of the currency portfolio? Use a 95 percent confidence level and assume the monthly percentage changes for each currency are normally distributed.

Since earnings can affect stock prices, many MNCs are concerned about translation exposure.

Vermont Co. has one foreign subsidiary. Its translation exposure is directly affected by each of the following, except:

If the net inflow of one currency is about the same amount as a net outflow in another currency, the firm will benefit if these two currencies are negatively correlated because the transaction exposure is offset.

Economic exposure can affect:

Generally, MNCs with less foreign revenues than foreign costs will be ____ affected by a ____ foreign currency.

Magent Co. is a U.S. company that has exposure to the Swiss francs (SF) and Danish kroner (DK). It has net inflows of SF200 million and net outflows of DK500 million. The present exchange rate of the SF is about $.40 while the present exchange rate of the DK is $.10. Magent Co. has not hedged these positions. The SF and DK are highly correlated in their movements against the dollar. If the dollar weakens, then Magent Co. will:

A company may become more exposed or sensitive to an individual currency's movements over time for several reasons, including a reduction in hedging, a greater involvement in the foreign country, or an increased use of the foreign currency.

Exhibit 10-2 Volusia, Inc. is a U.S.-based exporting firm that expects to receive payments denominated in both euros and Canadian dollars in one month. Based on today's spot rates, the dollar value of the funds to be received is estimated at $500,000 for the euros and $300,000 for the Canadian dollars. Based on data for the last fifty months, Volusia estimates the standard deviation of monthly percentage changes to be 8 percent for the euro and 3 percent for the Canadian dollar. The correlation coefficient between the euro and the Canadian dollar is 0.30. -Refer to Exhibit 10-2. What is the portfolio standard deviation?