workshop 7

Question 1

what is the definition of transaction exposure

Answer 1

impact of exchange rate changes on a firms contractual cash flows, such as receivables and payables denominated in foreign currencies

Exposure to exchange rate changes on contractual cash flows (e.g. receivables, payables)

Question 2

what’s the definition of economic exposure

Answer 2

impact of exchange rate changes on a firms overall future cash flows and value, including both contractual and non contractural effects

Exposure of a firm’s overall future cash flows and value to exchange rate changes

Question 3

differences in transaction and economic exposure

Answer 3

Transaction = existing contracts only
Economic = all future cash flows e.g. changes in competitiveness due to exchange rate movements

Question 4

example in the difference of transaction vs economic exposure

Answer 4

For example, a depreciation of a currency may increase foreign competition, reducing a firm’s future sales. This affects the firm’s cash flows and represents economic exposure, but it does not affect any existing contractual transactions, so it is not transaction exposure.

Question 5

Which is broader: transaction or economic exposure?

Answer 5

economic exposure

Question 6

why would a MNC focus on net cash flow

Answer 6

An MNC focuses on net cash flows in each currency because inflows and outflows in the same currency may offset each other.

Question 7

what’s the relationship between transactional and economic exposure

Answer 7

Transaction exposure is a subset of economic exposure

Question 8

Give an example of transaction exposure

Answer 8

A firm expecting to receive €1m from a sale

Question 9

Give an example of economic exposure

Answer 9

Currency changes increase foreign competition → reduces future sales

Question 10

Why is foreign competition an economic exposure but not transaction exposure?

Answer 10

It affects future cash flows, not existing contracts

Question 11

What is net exposure?

Answer 11

The remaining amount after offsetting inflows and outflows

Question 12

Example of net exposure?

Answer 12

Receive €1m, pay €800k → net exposure = €200k

Question 13

Why is net exposure important?

Answer 13

Only the net amount is at risk from exchange rate changes

Question 14

Why is economic exposure harder to measure?

Answer 14

It involves uncertain future cash flows and market effects compared to being based on contractual amounts

Question 15

Summarise transaction vs economic exposure

Answer 15

Transaction = contractual, short-term
Economic = total, long-term
Net flows = actual exposure

Question 16

What does a negative net exposure mean?

Answer 16

The firm expects to pay more than it receives (net short)

Question 17

What does a positive net exposure mean?

Answer 17

The firm expects to receive more foreign currency than it pays (net long)

Question 17

how do you calculate net exposure

Answer 17

Net Exposure= inflow- outflow

Question 18

How do you convert exposure into pounds?

Answer 18

Multiply by exchange rate

Exposure (£)=Net foreign currency × Exchange rate

Question 19

What is the effect of correlation between currencies- for transaction exposure

Answer 19

High correlation → little risk reduction
Low/negative correlation → more diversification

Question 20

Which currency is more important- for transaction exposure

Answer 20

the currency with the most exposure

Question 21

How do you answer transaction exposure questions?

Answer 21

Net flows (inflow − outflow)
Convert to home currency
Compare sizes
Comment on risk (correlation + volatility)

Question 22

impact of CIA

Answer 22

Covered Interest Arbitrage forces markets toward Interest Rate Parity (IRP) by eliminating riskless profit opportunities. Its main impacts are:

Market Realignment: Arbitrage activity pushes exchange rates and interest rates back into equilibrium (IRP condition).
Forward Rate Adjustment: The forward exchange rate typically adjusts to reflect interest rate differentials.
Co-determination of Variables: In reality, spot rates, forward rates, and interest rates can all adjust simultaneously due to expectations.
Neutralisation of Returns: Higher interest rates in one country do not lead to higher returns because they are offset by forward rate discounts.
No-Arbitrage Condition: Ensures equal returns between domestic and foreign investments when exchange rate risk is hedged.
Market Efficiency: CIA enforces efficiency by removing arbitrage opportunities quickly.
Imperfect Real-World Application: IRP may not hold exactly due to transaction costs, capital controls, taxes, and liquidity constraints.

Question 23

How do you calculate net transaction exposure in a foreign currency?

Answer 23

Net exposure = Total inflows − Total outflows

Positive → net receipt (long position)
Negative → net payment (short position)

Question 24

How do you convert foreign currency exposure into pounds (£)?

Answer 24

Multiply net exposure by the current exchange rate Exposure in £=Net foreign currency ×Exchange rate

Question 25

What does a positive (long) exposure mean?

Answer 25

Firm will benefit if the currency appreciates Firm will lose if the currency depreciates

Question 26

How does correlation between currencies affect exposure?

Answer 26

High correlation → currencies move together → Little diversification benefit → Small offsetting effect

Question 27

How do you assess and interpret transaction exposure for an MNC?

Answer 27

Calculate Net Exposure (per currency) Net exposure = Inflows − Outflows Net exposure=Inflows−Outflows Positive → net receipt (long position) Negative → net payment (short position) 2. Convert into Home Currency (£) Exposure (£) = Net foreign currency × Exchange rate Exposure (£)=Net foreign currency×Exchange rate 3. Compare Exposure Sizes Larger exposure → greater impact on firm value Focus on biggest currency position 4. Consider Correlation High correlation → little diversification Low/negative correlation → natural hedging possible 5. Assess Risk (Volatility) Currency with highest exposure × highest volatility (standard deviation) = most important risk driver 6. Interpretation Long position → gains if currency appreciates, losses if depreciates Overall exposure depends on: Size Direction Correlation The firm has a net transaction exposure in each currency, with the largest exposure posing the greatest risk, and limited risk reduction where currencies are highly correlated.

Question 28

How do exchange rate movements affect a firm’s cash inflows?

Answer 28

Appreciation of Home Currency (£ ↑) Exports become more expensive to foreign buyers Foreign demand falls Foreign competitors become cheaper 👉 Cash inflows decrease Depreciation of Home Currency (£ ↓) Exports become cheaper to foreign buyers Foreign demand rises Foreign competitors become less competitive 👉 Cash inflows increase Core Logic Exchange rate changes affect price competitiveness, which drives foreign demand and revenues

Question 29

How does appreciation of the home currency affect cash flows?

Answer 29

Inflows ↓ (exports become expensive → demand falls) Outflows ↓ (imports become cheaper)

Question 30

How does depreciation of the home currency affect cash flows?

Answer 30

Inflows ↑ (exports become cheaper → demand rises) Outflows ↑ (imports become more expensive)

Question 31

How does home currency appreciation affect a foreign firm’s cash flows?

Answer 31

Inflows ↑ (they become more competitive) Outflows ↑ (imports become more expensive for them)

Question 32

How does home currency depreciation affect a foreign firm’s cash flows? A:

Answer 32

Inflows ↓ (they become less competitive) Outflows ↓ (imports become cheaper for them)

Question 33

Why do exchange rate changes affect cash flows?

Answer 33

Because they change price competitiveness, affecting foreign demand and import costs

Question 34

What is the key rule when switching from home to foreign perspective?

Answer 34

everything is the opposite effect