Page 278 - DMGT514_MANAGEMENT_CONTROL_SYSTEMS

Unit 14: Management Control of MNC’s

We have seen that exchange rates, interest rates and inflation rates are intimately interrelated Notes
and in turn relate to a whole complex of macroeconomic variables. In many cases, it is difficult
to locate the effect of changes in any of them on the firm’s assets, liabilities and cash flow.
The terms exposure and risk though often used interchangeably are not identical. Exposure is a
measure of the sensitivity of the firm’s performance, however, measured to fluctuation in the
relevant risk factor. While risk is a measure of the extent of variability of the performance
measure attributable to the risk factor.

Following are the important points about the definition of exposure and risk:
Notes

1. Value of assets and liabilities or operating income is denominated in the functional
currency of the firm. This is the primary currency of the firm in which its financial
statements are published. For most firms, it is the domestic currency of the firm.
2. Exposure is defined with regard to the real values i.e., values adjusted for inflation.
While theoretically, this is the correct way of assessing exposure, in practice, due to
the difficulty of dealing with an uncertain inflation rate, this adjustment is often
ignored i.e., exposure is estimated with reference to changes in nominal value.

3. The definition stresses that only anticipated changes in the relevant risk factor are to
be considered. The reason is that markets have already considered allowance for
anticipated changes. For example, an exporter invoicing a foreign buyer in the
buyer’s currency will build an allowance for the expected depreciation of that currency
into the price. A lender will adjust the rate of interest charged in the loan to incorporate
an allowance for the expected depreciation.
4. From the operational point of view, how do we separate given change in exchange
rate or interest rate into anticipated and unanticipated components since only the
actual change can be observed? One possible option of estimating what will be the
exchange rate after 3 months from the transaction date is to consider a firm which
has a 90 day payable amounting to US$ 500,000, arising out of a raw material import
transaction. The current spot rate is ` 43.60 per dollar and the three months forward
rate is ` 43.80. Three months later, the spot rate turns out to be ` 44.00. Thus, the
unanticipated depreciation of the rupee is 44-43.80 or ` 0.20 per dollar. The loss on
account of the increase in the rupee value of the payable is ` 100,000.

Now let us introduce the concept of risk:
Suppose a financial consulting firm gives the following “forecast” of the value of spot exchange
3 months from now. In our view, the most likely value of the spot rate three months from now
is ` 44.0, but it could be shooting as high as ` 44.50. There is a very small probability that the
dollar could fall to ` 43.40.

Given this view, the best scenario for the firm would be dollar falling to ` 43.40 (since the
company has to pay in US$ after 3 months) and the worst case would be dollar shooting up to
` 44.50. The rupee outlay on settling the payable could be as high as ` 24.75 million or as low as
` 24.20 million. Exchange rate risk is a measure of variability of the value of an item attributable
to the fluctuations in the underlying exchange rate. It depends upon the size of the exposure
(transaction) and the extent of fluctuation expected in the underlying exchange rate. Exchange
rate risk can be captured by analysing the “best case” and “the worst case” scenarios to gauge the
maximum possible variation in the value of the item under consideration.

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