Explain the chosen international finance topic in general terms AND cover how it is implemented in the students chosen pretend business
1. Any Topic from Chapters 9-12
2. APA format, minimum 4 sources
3. Explain the chosen international finance topic in general terms AND cover how it is implemented in the student’s chosen pretend business.
5. 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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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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3
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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4
Exhibit 12.1 How Managing Exposure Can Increase an MNC’s Value
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5
Exhibit 12.2 Original Impact of Possible Exchange Rates on Cash Flows of Madison Co. (in Millions)
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6
Exhibit 12.3 Impact of Possible Exchange Rate Movements on Earnings under Two Alternative Operational Structures (in Millions)
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7
Exhibit 12.4 Economic Exposure Based on the Original and Proposed Operating Structures
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8
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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9
Exhibit 12.5 How to Restructure Operations to Balance the Impact of Currency Movements on Cash Inflows and Outflows
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10
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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11
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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13
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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14
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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15
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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16
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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17
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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(F) p
E(e)
S FeE
peE
ratespot theexceeds
rate forward heby which t percentage
rate exchange in the change percentage expected
where
1)(
)(
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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.
,
© 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
© 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.
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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7
Exhibit 10.2 Consolidated Net Cash Flow Assessment of Miami Co.
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