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 1. Any Topic from Chapters 9-12

2. APA format, minimum 4 sources 

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3. Explain the chosen international finance topic from chapter 9-12 AND cover how it is implemented in the student’s chosen pretend business. 

4. Paper will be a minimum of 750 and a maximum of 900 words. (This includes title section, content, and references…in other words the entire paper)

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The success of a nation’s commerce is heavily influenced by its exchange rate. Currency volatility and value can have an impact on overall economic growth, the balance of payments, and global finance, regardless of whether it is caused by policy prescriptions or extraneous events. The Department of Energy’s study on the revival of trade-restrictive policies and chronic currency devaluation has shed light on how currency values impact international commerce (Müllner, 2017). However, the actual impact of currency fluctuations on economic relations is a contentious issue, Müllner (2017) has detailed the empirical background on certain variables that might influence trade. However, analyzing the unpredictability of the currency value and the impact of consequent mismatch on global investment may be demonstrated by determining if distortion of the currency value affects trade policy changes on a regular basis. A weaker home currency encourages exporting by making imports comparable in price; on the other side, a strong national unit can stifle exports by rendering imports inexpensive (Engel et al., 2018).

The worldwide economic and commercial slump may have a range of consequences for global economies and business, including changes in international trade ties. This is because a decreasing exchange rate has the impact of making shipments from one country less expensive and, as a result, imports into the same country more costly. In a global economy, vertical industrial integration, on the other hand, indicates that outbound goods have a substantial proportion of components originating in other countries. A consequence of the ease with which such imported parts may be substituted with domestically made goods is that they may become too expensive for any exporter to utilize.

Following that, Lustig & Verdelhan, (2019), claims that currency value levels have an impact on the foreign capital inflows and debt payments. As a result, a deterioration of a nation’s currency entails a rise in the notional value of the bond financial assets in relation to the nation’s domestic currency resources. As a result, the debt based in domestic currency will have an effect on international lenders. As a result, the devaluation of currency will lower the cost of infrastructure investments made by international investors. This is a crucial factor, especially for large economies, because it will encourage capital spending. If, on the other hand, the devaluation of a nation’s currency is caused by key stakeholders losing faith in the industry, international investors will be hesitant to invest (Lustig & Verdelhan, 2019),

Now let us bring the homemade candle store, on board with international finance and exchange rate. It is crucial to note that, just like the fluctuating exchange rates of the dollar, there will be fluctuation of candle prices, not obvious, but as a business, it’s something that has to be anticipated at one time. When the prices change, the operations and operating income will change in the home candle store. Since we are aware of the inevitable fluctuating rates of the exchange rates, the homemade candle business can always keep in a tab, the demand, and supply of their products, so that in an instance of fluctuations, changes are made, and the business can continue.

The homemade candle business had a mission, and vision, just like many companies and businesses. No business wants to make losses, but rather maximize their profits always. As result, just like the exchange rates, the executives of the homemade candle business will have to think of operating exposures in the long term. Also, if the executives know the operating exposures can play a significant role in making a better judgment when it comes to looking for new markets and setting prices, as they keep their eyes on competition from other rival businesses. Also, it is crucial to bring one of the exchange rates concepts on board, since exchange rates impacts are outside the homemade candle business power, a very good reason why in the business segment leaders and management should take into consideration the exchange rate concepts in international finance.

In conclusion, the exchange rate plays a significant role in international finance and the business world. the exchange rates impact the business world, by helping in the planning of the operation costs, searching for new markets, and also can help in projecting risks in small businesses like that of the homemade candle store. The fluctuation of the exchange rates can help the business, to know if the prices have shifted, and if possible in the future, to export their products.

References

Engel, C., & Wu, S. P. Y. (2018). Liquidity and exchange rates: An empirical investigation (No. w25397). National Bureau of Economic Research.

Lustig, H., & Verdelhan, A. (2019). Does incomplete spanning in international financial markets help to explain exchange rates?. American Economic Review109(6), 2208-44.

Müllner, J. (2017). International project finance: Review and implications for international finance and international business. Management Review Quarterly67(2), 97-133.

Obstfeld, M., & Taylor, A. M. (2017). International monetary relations: Taking finance seriously. Journal of Economic Perspectives31(3), 3-28.

Running head: INTERNATIONAL FINANCE MARKETS 1

INTERNATIONAL FINANCE MARKETS 5

International Finance Markets.

The international finance market is a place where individuals as well as countries trade financial wealth amongst themselves. (Pilbeam, 2018) This market can also be viewed as a wide set of guidelines and organizations whereby wealth is merchandised between the business managers in overabundance and trustees in indebtedness and where organizations set the rules. (Mosley, 2000). This paper aims to give a clear explanation on what defines International Finance Markets and how these markets are implemented in a homemade candle store.

International finance markets are of various types. The first type is the international capital market. This is a type of market where investments and savings are herded between the people and or organizations with capital to lend or invest and the people who are in need. They bring vendors and vendees together to for the purpose of doing trade of stocks as well as other monetary valuables. (Mosley, 2001). International Capital markets are inclusive of both the stock market and the bond market. They greatly assist individuals with proposals on how to become entrepreneurs

Another type of international finance market is the international credit market. This is a market where there is exchange of debt securities as well as transitory commercial paper. Firms together with the countries’ leaderships are able to earn morning through granting the investors the consent to acquire these debt securities. (Pilbeam, 2018). The activities that are undertaken in credit markets are time and again used to measure the investor sentiment. These credit market have the aim of achieving the highest possible rate of profit as well as achieving political benefits.

International finance markets have key roles they play at the world level as far as markets are concerned. To start with, these markets allow for the determination of price of the financial assets being traded. This is made possible through the interactivity of vendees and the vendors. They offer a signal for the funds allocation in the economy according to the demand and to the supply. (Pilbeam, 2018). This is done via a mechanism well known as the process of price discovery.

Another responsibility played by these finance markets is mobilization of funds. In today’s world, the stock markets are a representation of a healthy economy. This is because these markets are the major way of mobilization for long term savings and investment and formation of fixed capital. (Lewis, 1995). Exchanges of stock permits and opens doors for businesses to raise kitty primarily through equitabness.

Taking an instance of a business like a homemade candle store, the international finance markets can be effectively implemented in various ways. The major reason for this is because a homemade candle store will include giving its products on credit to the customers. By the same token, international finance markets are with much efficiency implemented as this homemade candle store will act like the international credit market which is a type of the international finance market.

The international financial markets will also be implemented in the homemade candle business when it sells the products to the customers and profit is achieved. In the finance market, this is compared to the international capital market. (Lewis 1995). In both the homemade candle business and the international capital market, buyers will have together with an aim of bonding as well as to sell stocks and other financial assets. For this reason, the international financial market will be effectively implemented in a homemade candle store.

Just like the international finance markets, the homemade candle store will be a place where individuals trade their wealth but in this case in exchange of a specific product, the homemade candles. (Pilbeam, 2018). Just like the way the international financial market is, this homemade candle store can also be viewed as a wide set of guidelines and organizations whereby wealth is merchandised between the business managers in overabundance and trustees in indebtedness and where organizations set the rules. In that way, the international finance markets are implemented in the homemade candle store.

In conclusion, despite the fact that the International finance markets play a major role in the economic sector on a worldwide basis, they also play vital roles in implementing small scale businesses such as the homemade candle store discussed in the above essay. This is because in both, they form a basis where buyers and sellers can make great impacts in the world market hence balancing the economy of the world.

References

Buljevich, E. C., & Park, Y. S. (1999). Project financing and the international financial markets. Springer Science & Business Media.

Lewis, K. K. (1995). Puzzles in international financial markets. Handbook of international economics, 3, 1913-1971.

Levich, R. M. (2001). International financial markets. McGraw-Hill/Irwin.

Mosley, L. (2000). Room to move: International financial markets and national welfare states. International organization, 54(4), 737-773.

Pilbeam, K. (2018). Finance & financial markets. Macmillan International Higher Education.

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1

12 Managing Economic Exposure and Translation Exposure

 Explain how an MNC’s economic exposure can be

hedged

 Explain how an MNC’s translation exposure can be

hedged

1

Chapter Objectives

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2

Managing Economic Exposure

 Economic exposure represents the impact of exchange rate fluctuations on a firm’s future cash flows. (Exhibit 12.1)

 Assessing economic exposure An MNC must measure its exposure to each currency in terms of its cash inflows and cash outflows. (Exhibit 12.2)

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Managing Economic Exposure

 Restructuring to reduce economic exposure, e.g.: a. Increase sensitivity of revenues to exchange rate

movements. b.Decrease sensitivity of expenses to exchange rate

movements. (Exhibit 12.3 & 12.4)

 Expediting the Analysis with Computer Spreadsheets Determining the sensitivity of cash flows (ignoring tax effects) to alternative exchange rate scenarios can be expedited by using a computer to create a spreadsheet similar to Exhibit 12.3.

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Exhibit 12.1 How Managing Exposure Can Increase an MNC’s Value

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Exhibit 12.2 Original Impact of Possible Exchange Rates on Cash Flows of Madison Co. (in Millions)

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Exhibit 12.3 Impact of Possible Exchange Rate Movements on Earnings under Two Alternative Operational Structures (in Millions)

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Exhibit 12.4 Economic Exposure Based on the Original and Proposed Operating Structures

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Issues Involved in the Restructuring Decision

 Should the firm attempt to increase or reduce sales in new or existing foreign markets?

 Should the firm increase or reduce its dependency on foreign suppliers?

 Should the firm establish or eliminate production facilities in foreign markets?

 Should the firm increase or reduce its level of debt denominated in foreign currencies?

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Exhibit 12.5 How to Restructure Operations to Balance the Impact of Currency Movements on Cash Inflows and Outflows

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A Case on Hedging Economic Exposure: Savor Co., a U.S. firm with exposure to the Euro

 Assessment of economic exposure: assess the relationship between the euro’s movement and each unit’s cash flows over last 9 quarters.  Assessment of each unit’s exposure using

regression analysis  Identifying the source of each unit’s exposure  See Exhibit 12.6

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A Case on Hedging Economic Exposure: Savor Co., a U.S. firm with exposure to the Euro

 Possible strategies to hedge economic exposure:  Pricing policy  Hedging with forward contracts  Purchasing foreign supplies  Financing with foreign funds  Revising operations of other units

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12

A Case on Hedging Economic Exposure: Savor Co., a U.S. firm with exposure to the Euro

1. Savor’s Hedging Strategy: instruct other units to do their financing in Euros as well

2. Limitations of Savor’s Optimal Hedging Strategy: impact of Euro’s movements on Savor’s cash outflows is known with certainty but impact on cash inflows is uncertain.

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Hedging Exposure to Fixed Assets

1. Hedging the sale of fixed assets by: a. Selling the currency forward in long-term forward

contract

b. Creating a liability in that currency that matches the expected value of the assets in the future.

2. Limitations of hedging the sale of fixed assets: a. MNC may not know the date when it will sell the assets

b. MNC may not know the price in the local currency at which it will sell them.

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Managing Translation Exposure

 Translation exposure occurs when each subsidiary’s financial data is translated to its home currency for consolidated financial statements.

 Translation exposure can be hedged with forward or futures contracts.

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Managing Translation Exposure

 Limitations of hedging translation exposure:  Inaccurate earnings forecasts – earnings in a future period

are uncertain.

 Inadequate forward contracts for some currencies – forward contracts are not available for all currencies.

 Accounting distortions – the forward rate gain or loss reflects the difference between the forward rate and the future spot rate, whereas the translation gain or loss is caused by the change in the average exchange rate over the period in which the earnings are generated.

 Increased transaction exposure – the MNC may be increasing its transaction exposure

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SUMMARY

 Economic exposure can be managed by balancing the sensitivity of revenue and expenses to exchange rate fluctuations. The firm must first recognize how its revenue and expenses are affected by exchange rate fluctuations. For some firms, revenue is more susceptible. These firms are most concerned that their home currency will appreciate against foreign currencies since the unfavorable effects on revenue will more than offset the favorable effects on expenses. Conversely, firms whose expenses are more sensitive to exchange rates than their revenue are most concerned that their home currency will depreciate against foreign currencies. When firms reduce their economic exposure, they reduce not only these unfavorable effects but also the favorable effects if the home currency value moves in the opposite direction.

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SUMMARY (Cont.)

 Translation exposure can be reduced by selling forward the foreign currency used to measure a subsidiary’s income. If the foreign currency depreciates against the home currency, the adverse impact on the consolidated income statement can be offset by the gain on the forward sale in that currency. If the foreign currency appreciates over the time period of concern, there will be a loss on the forward sale that is offset by a favorable effect on the reported consolidated earnings. However, many MNCs would not be satisfied with a “paper gain” that offsets a “cash loss.”

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

International Financial Management 11th Edition

by Jeff Madura

1

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2

Part 3 Exchange Rate Risk Management

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3

9 Forecasting Exchange Rates

 Explain how firms can benefit from forecasting exchange rates

 Describe the common techniques used for forecasting

 Explain how forecasting performance can be evaluated

 explain how interval forecasts can be applied

3

Chapter Objectives

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4

Why Firms Forecast Exchange Rates

1. Hedging decisions Whether a firm hedges may be determined by its forecasts of foreign currency values.

2. Short-term investment decisions Corporations sometimes have a substantial amount of excess cash available for a short time period. Large deposits can be established in several currencies.

3. Capital budgeting decisions When an MNC’s parent assesses whether to invest funds in a foreign project, the firm takes into account that the project may periodically require the exchange of currencies.

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5

Why Firms Forecast Exchange Rates (Cont.)

4. Earnings assessment The parent’s decision about whether a foreign subsidiary should reinvest earnings in a foreign country or remit earnings back to the parent may be influenced by exchange rate forecasts.

5. Long-term financing decisions MNCs that issue bonds to secure long-term funds may consider denominating the bonds in foreign currencies.

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6

Exhibit 9.1 Corporate Motives for Forecasting Exchange Rates

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7

Forecasting Techniques

1. Technical Forecasting

2. Fundamental Forecasting

3. Market-Based Forecasting

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8

Technical Forecasting

1. Involves the use of historical exchange rate data to predict future values

2. Limitations of technical forecasting: a. Focuses on the near future

b. Rarely provides point estimates or range of possible future values

c. Technical forecasting model that worked well in one period may not work well in another

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9

Fundamental Forecasting

1. Based on fundamental relationships between economic variables and exchange rates

2. Use of sensitivity analysis Considers more than one possible outcome for the factors exhibiting uncertainty.

3. Use of PPP While the inflation differential by itself is not sufficient to accurately forecast exchange rate movements, it should be included in any fundamental forecasting model.

4. Limitations of fundamental forecasting include: a. Unknown timing of the impact of some factors b. Forecasts of some factors may be difficult to obtain c. Some factors are not easily quantified d. Regression coefficients may not remain constant

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10

Market-Based Forecasting

 Use of the spot rate to forecast the future spot rate.

 Use of the forward rate to forecast the future spot rate.

 The forward rate should serve as a reasonable forecast for the future spot rate because otherwise speculators would trade forward contracts (or futures contracts) to capitalize on the difference between the forward rate and the expected future spot rate.

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S FeE

peE

ratespot theexceeds

rate forward heby which t percentage

rate exchange in the change percentage expected

where

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11

Market-Based Forecasting (Cont.)

 Long-Term Forecasting with Forward Rates Long-term exchange rate forecasts can be derived from long-term forward rates. Like any method of forecasting exchange rates, the forward rate is typically more accurate when forecasting exchange rates for short-term horizons than for long-term horizons.

 Implications of the IFE for Forecasts Since the forward rate captures the interest rate differential (and therefore the expected inflation rate differential) between two countries, it should provide more accurate forecasts for currencies in high-inflation countries than the spot rate.

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12

Mixed Forecasting

 Use a combination of forecasting techniques. (Exhibit 9.2)

 Mixed forecast is then a weighted average of the various forecasts developed.

 Guidelines for Implementing a Forecast  All managers of an MNC should rely on the same exchange

rate forecasts.

 MNCs may complement their forecast by hiring forecasting services to obtain exchange rate forecasts.

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13

Exhibit 9.2 Forecasts of the Mexican Peso Drawn from Each Forecasting Technique

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14

Forecast Error

Measurement of forecast error Absolute forecast error as a percentage of the realized value = (forecasted value – realized value) / realized value

Forecast error among time horizons The potential forecast error for a particular currency depends on the forecast horizon.

Forecast error over time periods

The forecast error for a given currency changes over time.

Forecast errors among currencies The ability to forecast currency values may vary with the currency of concern.

Forecast bias When a forecast error is measured as the forecasted value minus the realized value, negative errors indicate underestimating, while positive errors indicate overestimating.

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15

SUMMARY

 Multinational corporations need exchange rate forecasts to make decisions on hedging payables and receivables, short- term financing and investment, capital budgeting, and long- term financing.

 The most common forecasting techniques can be classified as (1) technical, (2) fundamental, (3) market based, and (4) mixed. Each technique has limitations, and the quality of the forecasts produced varies. Yet due to the high variability in exchange rates, each technique has limited accuracy.

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16

SUMMARY (Cont.)

 Forecasting methods can be evaluated by comparing the actual values of currencies to the values predicted by the forecasting method. To be meaningful, this comparison should be conducted over several periods. Two criteria used to evaluate performance of a forecast method are bias and accuracy. When comparing the accuracy of forecasts for two currencies, the absolute forecast error should be divided by the realized value of the currency to control for differences in the relative values of currencies.

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International Financial Management 11th Edition

by Jeff Madura

1

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2

Relevance of Exchange Rate Risk

 Exchange rates are very volatile.

 The dollar value of an MNC’s future payables or receivables in a foreign currency can change substantially in response to exchange rate movements.

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3

Relevance of Exchange Rate Risk

1. Investor Hedge Argument: exchange rate risk is irrelevant because investors can hedge exchange rate risk on their own.

2. Currency Diversification Argument: if U.S.- based MNC is well diversified across numerous currencies, its value will not be affected by exchange rate risk

3. Stakeholder Diversification Argument: if stakeholders are well diversified, they will be somewhat insulated against losses due to MNC exchange rate risk.

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4

Response from MNCs

Many MNCs attempt to stabilize their earnings with hedging strategies because they believe exchange rate risk is relevant.

Because we manufacture and sell products in a number of countries throughout the world, we are expossed to the impact on revenues and expenses of movements in currency exchange rates.

—Proctor & Gamble Co.

Increased volatility in foreign exchange rates … may have an adverse impact on our business results and financial condition.

—PepsiCo

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5

Forms of Exchange Rate Exposure

1. Transaction exposure

2. Economic exposure

3. Translation exposure

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6

Transaction Exposure

 Definition: sensitivity of the firm’s contractual transactions in foreign currencies to exchange rate movements.

 To assess transaction exposure, the MNC must:  Estimate net cash flows in each currency (See Exhibits

10.2 & 10.3)

 Measure potential impact of the currency exposure

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yor currency xin changes percentage ofdeviation standard

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  

 

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7

Exhibit 10.2 Consolidated Net Cash Flow Assessment of Miami Co.

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8

Exposure of an MNC’s Portfolio

 Measurement of currency volatility The standard deviation statistic measures the degree of movement for each currency. In any given period, some currencies clearly fluctuate much more than others.

 Currency volatility over time The volatility of a currency may not remain consistent from one time period to another. An MNC can identify currencies whose values are most likely to be stable or highly volatile in the future.

 Measurement of currency correlations The correlations coefficients indicate the degree to which two currencies move in relation to each other.

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9

Exposure of an MNC’s Portfolio Affected by:

 Applying currency correlations to net cash flows  If a MNC has positive net cash flows in various currencies

that are highly correlated, it may be exposed to exchange rate risk. However, many MNCs have some negative net cash flow positions in some currencies to complement their positive net cash flows in other currencies.

 Currency correlations over time Because currency correlations change over time, an MNC cannot use previous correlations to predict future correlations with perfect accuracy.

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Exhibit 10.5 Shift In Currency Volatility During The Financial Crisis

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Transaction Exposure Based on Value at Risk (VaR)

 Measures the potential maximum 1-day loss on the value of positions of an MNC that is exposed to exchange rate movements.

 Factors that affect the maximum 1-day loss:  Expected percentage change in the currency rate for the

next day

 Confidence level used

 Standard deviation of the daily percentage changes in the currency

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Limitations of VaR

1. If the distribution of exchange rate movements is not normal, the estimate of the maximum expected loss is subject to error.

2. The VaR method assumes that the volatility (standard deviation) of exchange rate movements is stable over time. If exchange rate movements are less volatile in the past than in the future, the estimated maximum expected loss derived from the VaR method will be underestimated.

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Economic Exposure

 Definition: The sensitivity of the firm’s cash flows to exchange rate movements, sometimes referred to as operating exposure. (Exhibits 10.9 & 10.10)

 Economic exposure arises from:  Exposure to local currency appreciation

Appreciation in the firm’s local currency causes a reduction in both cash inflows and outflows. The impact on a firm’s net cash flows will depend on whether the inflow transactions are affected more or less than the outflow transactions.

 Exposure to local currency depreciation

Depreciation of the firm’s local currency causes an increase in both cash inflows and outflows.

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Exhibit 10.9 Examples That Subject a Firm to Economic Exposure

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Exhibit 10.10 Economic Exposure to Exchange Rate Fluctuations

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Exhibit 10.12 Impact of Possible Exchange Rates on Cash Flows of Madison Co. (in Millions)

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Translation Exposure

 Definition: The exposure of the MNC’s consolidated financial statements to exchange rate fluctuations.

 Determinants of translation exposure:  The proportion of business conducted by foreign

subsidiaries

 The locations of foreign subsidiaries

 The accounting methods used

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Accounting Methods

MNC translation exposure is affected by accounting procedures, many of which are based on FASB 52:

1. The functional currency of an entity is the currency of the economic environment in which the entity operates.

2. The current exchange rate as of the reporting date is used to translate the assets and liabilities of a foreign entity from its functional currency into the reporting currency.

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Accounting Methods

3. The weighted average exchange rate over the relevant period is used to translate revenue, expenses, and gains and losses of a foreign entity from its functional currency into the reporting currency.

4. Translated income gains or losses due to changes in foreign currency values are not recognized in current net income but are reported as a second component of stockholder’s equity; an exception to this rule is a foreign entity located in a country with high inflation.

5. Realized income gains or losses due to foreign currency transactions are recorded in current net income, although there are some exceptions.

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Exposure of an MNC’s Stock Price to Translation Effects

Because an MNC’s translation exposure affects its consolidated earnings, it can affect the MNC’s valuation.

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SUMMARY

 MNCs with less risk can obtain funds at lower financing costs. Since they may experience more volatile cash flows because of exchange rate movements, exchange rate risk can affect their financing costs. Thus, MNCs recognize the relevance of exchange rate risk, and may benefit from hedging their exposure.

 Transaction exposure is the exposure of an MNC’s contractual transactions to exchange rate movements. MNCs can measure their transaction exposure by determining their future payables and receivables positions in various currencies, along with the volatility levels and correlations of these currencies. From this information, they can assess how their revenue and costs may change in response to various exchange rate scenarios.

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SUMMARY (Cont.)

 Economic exposure is any exposure of an MNC’s cash flows (direct or indirect) to exchange rate movements. MNCs can attempt to measure their economic exposure by determining the extent to which their cash flows will be affected by their exposure to each foreign currency.

 Translation exposure is the exposure of an MNC’s consolidated financial statements to exchange rate movements. To measure translation exposure, MNCs can forecast their earnings in each foreign currency and then determine how their earnings could be affected by the potential exchange rate movements of each currency.

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