Question

Briefly describe the following items:

1.Transaction exposure, economic exposure and translation exposure. Which exposure is more relevant to multinational corporation? Please explain

2.Purchasing power parity and Interest rate parity, and their linkage.

Answer 1

Transaction Exposure: It is a level of uncertainity or risk for international business transactions. It is the risk that the exchange rate fluctuations that can happen once 2 international firms has agreed to do business. If these 2 companies have not agreed on a fixed exchange rate during contract, if the exchange rate fluctuate during the time of payment, one company will loose and the other will gain due to the risk.

Economic Exposure; Foreigh exchange rate exposure which is caused by unexpected currency fluctuation that can affect the companies cashflows, investments, earnings etc. This can severely affect in the valuaton of the company and its profitability.

Translation Exposure; If a firm has foreign assets and liabilities, if there are exchange rate changes the value of these liabilities can increase significantly or asset alue can reduce significantly. Translation exposure is the uncertainity of a company's assets, liabilities, equity etc can change in value due to exchange rate changes.

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Purchasing Power Parity: PPP compares the purchasing power of consumers in different countries for buying a standardised basket of goods in these countries. Ideally the basket of goods should be priced same in both the countries after considering exchange rate;

S=P2/​P1​​ where:S= Currency 1 to 2 exchange rate ; P1​= Cost of basket of goods in currency 1 ;

P2​= Cost of basket of goods in currency 2​

Interest rate parity: IRP is a theory which describes that in ideal scenarios, the interest rate differential between 2 countries should be equal to differential between their spot rate and forward rate of currency. It is a relation between spot rate, forward rate and interest rates.

F=S×(1+ia)/(​1+ib)

where:F=Forward Rate ; S​=Spot Rate ia=Interest rate in country a ; ib​=Interest rate in country b​

; When PPP and IRP holds in a market, they shows a relationship among the real interest rates in the market and changes in expected real interest rate relates expected change in the value of real exchnge rate.