Translation and Transaction Exposure

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Translation and Transaction Exposure

• International Corporate Finance
• P.V. Viswanath
• For use with Alan Shapiro Multinational
  Financial Management

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Learning Objectives

• To define translation and transaction exposure
• To describe the four principal currency
  translation methods.
• To describe and apply the FASB-52 currency
  translation method
• Different Hedging Strategies

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Exchange Risk

• Definition A gain/loss that results due to an
  exchange rate change.
• Only unanticipated exchange rate changes
  constitute risk.
• Question Whose gain or loss?
• Ans The subsidiarys? The parents? No, the
  shareholders.
• However, the link between exchange risk and
  shareholder value is weak.
• If a shareholder has a diversified portfolio,
  then the negative effect of exchange rate changes
  on one firm might be offset by the positive
  effect on another firm.
• Also, even if there is no offset, let the
  shareholder do the hedging.

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Justifications for Corporate Hedging

• Assessment of exposure to exchange rate risk
  requires estimates of susceptibility of net
  cashflows to unexpected exchange rate changes.
  Operating managers can make these estimates more
  precisely.
• The firm can hedge cheaper.
• Nominal exchange rate changes should not
  translate into real exchange rate changes if PPP
  holds however, deviations from PPP can persist.
• Increased firm level exposure to exchange risk
  can lead to bankruptcy and its attendant costs
  hence it may be optimal for firms to hedge
  against exchange rate risk.

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Translation Exposure

• There are three kinds of exposure.
• Translation (accounting) exposure, arises from
  the need for purposes of reporting and
  consolidation to convert the financial statements
  of foreign subsidiaries from local currencies
  (LC) to the home currency (HC).
• If exchange rates have changed since the previous
  reporting period, translation/restatement of
  those assets/liabilities, revenues/expenses that
  are denominated in foreign currencies will result
  in foreign exchange gains or losses.

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Transaction Exposure

• Transaction exposure results from transactions
  that give rise to known, contractually binding
  future foreign-currency-denominated cash flows.
  As exchange rages change between now and when
  these transactions settle, so does the value of
  their associated foreign currency cashflows,
  leading to currency gains and losses
• For example, accounts receivable associated with
  a sale denominated in euros or the obligation to
  repay a Japanese yen debt.

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Operating Exposure

• The extent to which currency fluctuations can
  alter a companys future operating cash flows,
  i.e. its future revenues and costs.
• Any company whose revenues or costs are affected
  by currency changes has operating exposure, even
  if it is a purely domestic corporation and has
  all of its cashflows denominated in the home
  currency.
• Operating and Transactions Exposure together are
  referred to as Economic Exposure

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Types of Exposure Accounting, Operating and
Transaction
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Comparison of Exposure Types
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Translation Methods

• Income statements of foreign affiliates are
  usually translated according to the following
  rules
• Sales revenue and interest are translated at the
  average historical exchange rate that prevailed
  during the period
• Depreciation is translated at the appropriate
  historical exchange rate.
• Some of the general and administrative expenses
  as well as cost-of-goods-sold are translated at
  historical exchange rates, others at current
  rates.
• This is based on when the expenses were incurred.
• However, there are different methods for
  translating assets and liabilities.
• The various methods differ in terms of how
  exchange rate changes are presumed to impact the
  value of individual categories of assets and
  liabilities.

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Current/Noncurrent Currency Translation Method

• Maturity is used to divided assets into two
  categories. Not in general use at the moment.
• All the foreign subsidiarys current
  assets/liabilities are translated to the HC at
  the current exchange rate only these are
  presumed to change in value when the local
  currency appreciates/depreciates.
• The underlying assumption is that rates are
  essentially fixed but subject to occasional
  adjustments that correct themselves in time.
  This was generally true in the Bretton Woods era.
• Each non-current asset/liability is translated at
  its historical exchange rate the rate at the
  time the asset was acquired or the liability
  incurred.
• The income statement is translated at the average
  exchange rate of the period, except for revenues
  and expense items associated with noncurrent
  assets or liabilities.
• These latter, such as depreciation expense, are
  translated at the same rate as the corresponding
  balance sheet items.

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Monetary/Nonmonetary Method

• Monetary assets/liabilities are those items that
  represent a claim to receive or an obligation to
  pay a fixed amount of foreign currency, e.g.
  cash, A/P, A/R, long-term debt they are
  translated at the current rate.
• Nonmonetary refers to physical assets or
  liabilities (e.g. inventory, fixed assets,
  long-term investments) they are translated at at
  historical rates.
• I/S items are translated at the average exchange
  rate during the period except for revenue and
  expense items related to nonmonetary
  assets/liabilities.
• These are translated at the same rate as the
  corresponding B/S items.
• The underlying assumption is that the local
  currency value of monetary assets increases
  immediately after a devaluation so that there is
  full compensation for the exchange rate change
  (Law of One Price).

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Temporal Method

• The choice of exchange rate for translation is
  based on the underlying approach to evaluating
  cost (historical/market). If an item is carried
  on the balance sheet of the affiliate at its
  current value, it is translated using the current
  exchange rate. Items carried at historical cost
  are translated at the historical rate.
• Modified version of the monetary/nonmonetary
  method. Under the monetary/nonmonetary method,
  inventory is always translated at the historical
  rate. Under the temporal method, inventory is
  normally translated at the historical rate, but
  it can be translated at the current rate if the
  inventory is shown on the balance sheet at market
  value.
• I/S items are normally translated at an average
  rate for the reporting period. However, cost of
  goods sold and depreciation charges related to
  balance sheet items carried at past prices are
  translated at historical rates.

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FASB 8

• In 1975, FASB 8 required the temporal method
• Monetary assets/liabilities at current
  exchange-rate
• Fixed assets at historical exchange rate
• Translation gains losses reported in income
  statement, creating volatile reported earnings
• Example U.S. parent firm issues DM bonds
  builds German factory DM revenues cover DM
  coupon payments little operating exposure
• Under FASB 8
• Factory is fixed asset, evaluated at historical
  rate, unaffected by rate changes
• DM debt is a monetary liability, evaluated at
  current rate affected by rate changes
• Hence, enormous translation exposure and volatile
  earnings statements

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Current/Current Method

• At the end of 1981, FASB 52 required the
  current/current method to allow more flexibility.
• All B/S items are translated at the current rate
  I/S translated at current rate or appropriately
  weighted average exchange rate for period. (See
  Sterling case.)
• A variation is to translate all items except net
  fixed assets at the current rate net fixed
  assets are translated at the historical rate.
• If a firms foreign-currency denominated assets
  exceed its foreign-currency denominated
  liabilities, a devaluation results in a loss and
  a revaluation in a gain.
• Translation losses moved to special sub-account
  in the net worth section of balance sheet,
  reducing income volatility.

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Impact of Translation Alternatives
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Impact of Translation Alternatives
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FASB 52 and the functional currency

• Under FASB 52, affiliates financial statements
  must be first converted to the functional
  currency using the temporal method and then
  translated into the home currency before being
  included in the parents statements.
• This gives firms the opportunity to identify the
  primary economic environment and select the
  appropriate functional currency for each
  subsidiary. An affiliates functional currency is
  the currency of the primary economic environment
  in which the affiliate generates and expends
  cash.
• Location does not automatically indicate the
  right functional currency. For example, the
  functional currency is the dollar for a HK
  assembly plant for radios that sources components
  in the US and sells the assembled radios in the
  US.
• However, in the case of a hyperinflationary
  environment, the dollar must be used as the
  functional currency.
• In practice, all US firms either use the local
  foreign currency (80) or the dollar (20)as the
  functional currency.

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Functional Currency/ Reporting Currency

• The reporting currency is the currency in which
  the parent firm prepares its own financial
  statements.
• At each balance sheet date, any
  assets/liabilities denominated in a currency
  other than the functional currency of the
  affiliate must be adjusted to reflect the current
  exchange rate on that date.
• If the dollar is the functional currency, then
  local currency accounts are translated into
  dollars using the temporal method.
• Transaction gains/losses from such adjustments
  must appear on the affiliates income statement,
  with some exceptions. Obviously, if the
  functional currency is judiciously chosen, these
  will be minimal.
• After all financial statements have been
  converted into the functional currency, these are
  then translated into dollars translation
  gains/losses flow directly into the parents
  foreign exchange equity account.

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Example of FASB-52 Translation

• Sterling Ltd. is the British subsidiary of a US
  company started business and acquired fixed
  assets when the exchange rate was 11.50.
• The average exchange rate for the period was
  1.40
• The rate at the end of the period was 1.30.
• The historical rate for investory was 1.45.
• During the year, Sterling has income after tax of
  20m. which goes into retained earnings. No
  dividends are paid.

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Example of FASB-52 Translation
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Example of FASB-52 Translation
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Example of FASB-52 Translation

• We see that if the pound is the functional
  currency, Sterling will have a translation loss
  of 22m., which bypasses the I/S and appears on
  the B/S as a separate item.
• The translation loss is calculated as the number
  that reconciles the equity account with the
  remaining translated accounts to balance assets
  with liabilities and equity.
• If the dollar is the functional currency, there
  is a gain of 108m., which appears on Sterlings
  income statement.
• This is calculated as the difference between
  translated income before currency gains (23m.)
  and the retained earnings figure (131m.)

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Implications of FASB 52

• Fluctuations in local reported earnings are
  reduced significantly under FASB-52 when the
  local currency is the functional currency,
  compared to when the US dollar is used as the
  functional currency.
• When the is the functional currency,
  translation losses/gains show up in the Income
  Statement.
• Key financial ratios and relationships remain the
  same after translation into dollars under
  FASB-52, when the local currency is used as the
  functional currency, as they are in the local
  currency financial statements.
• This is because the current/current method is
  used to convert into dollars hence the same
  exchange rate is used for all items in the B/S
  (exchange rate on reporting date) and the same
  exchange rate for all items in the I/S (average
  rate for period in Sterling case).

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Exception to functional currency losses

• Under FASB 52, the following gains/losses need
  not be included on the foreign units income
  statement
• Gains/losses due to foreign currency transaction
  that is designated as an economic hedge of a net
  investment in a foreign entity included in
  shareholders equity component.
• Gains/losses due to inter-company foreign
  currency transactions that are of a long-term
  investment nature included in shareholders
  equity component.
• Gains/losses due to foreign currency transactions
  that hedge identifiable foreign currency
  commitments are to be deferred and included in
  the measurement of the basis of the related
  foreign transactions.

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US Accounting Standards
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Managing Translation Exposure

• Three major techniques
• Adjusting Funds flows
• Entering into forward contracts
• Exposure Netting

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Funds Adjustment

• Funds Adjustment involves altering the amounts or
  the currencies or both of the planned cashflows
  of the parent or its subsidiaries to reduce the
  firms local currency accounting exposure.
• If an LC devaluation is anticipated, direct
  funds-adjustment methods include
• pricing exports in hard currencies
• Pricing imports in the local currency
• investing in hard currency securities
• Replacing hard currency loans with local currency
  loans
• Indirect methods include
• Adjusting transfer prices on the sale of goods
  between affiliaties
• Speeding up the payment of dividends, fees, and
  royalties
• Adjusting the leads and lags of intersubsidiary
  accounts, viz. speeding up the payment of
  intersubsidiary A/P and delaying the collection
  of intersubsidiary A/R

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Forward Contracts

• The translation exposure is reduced by creating
  an offsetting asset or liability in the foreign
  currency.
• For example, if IBM UK has translation exposure
  in an asset of 40m, it can sell 40m forward.
• Any loss (gain) on its translation exposure will
  be offset by a corresponding gain (loss) on the
  forward contract.
• However, the gain/loss on the forward contract is
  a cashflow, while this is not true of the
  accounting exposure.
• Presumably, these hedges would not be designated
  as economic hedges under FASB 52.

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Managing Transaction Exposure

• Transaction exposure stems from the possibility
  of incurring future exchange gains or losses on
  transactions already entered into and denominated
  in a foreign currency.
• Its measured currency by currency and equals the
  difference between contractually fixed future
  cash inflows and outflows in each currency
• Some of these unsettled transactions, such as
  foreign currency denominated debt and accounts
  receivable are already on the balance sheet
  others such as contracts for future sales are
  not.
• Some actions taken to hedge against translation
  exposure could increase transaction exposure.
  For example, if a currency is expected to weaken,
  then translation exposure for the current period
  could be reduced by deferring the sale to a
  future period this would reduce A/R in the
  current period, but if there is a contract for
  the sale to take place in the future, it would
  increase transaction exposure.

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Hedging Strategies

• The objective underlying hedging should be made
  explicit.
• Trying to manage accounting exposure is
  inconsistent with empirical evidence since it
  doesnt affect cashflows, it amounts to assuming
  that investors cannot see beyond financial
  statements.
• If this assumption is false, hedging for this
  purpose would have positive costs and no
  benefits.
• Selective hedging may end up increasing cashflow
  variances, rather than reduce them, if the firm
  has no predictive abilities.
• All costs of hedging should be taken into
  account. For example, the cost of increasing LC
  borrowings is the cost of the LC loan less the
  profit generated from those funds, such as
  prepaying a hard currency loan. Interest rates
  on loans in local currencies may be higher
  because of anticipated devaluations.

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Forward Market Hedge

• A company that is long (short) a foreign currency
  will sell (buy) the foreign currency forward.
• Suppose GE expects to received 10m. from the
  sale of turbines in 1 year.
• Suppose the current spot price is 1.00/ and the
  forward price is 0.957/.
• A forward sale of 10m. For delivery in one year
  will yield GE 9.57m on Dec. 31.
• Without hedging, GE will have a 10m asset, whose
  value will fluctuate with the euro. With the
  hedge, the value is fixed at 9.57m
• Hedging with forward contracts eliminates the
  forward risk at the expense of forgoing the
  upside potential.

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Money Market Hedge

• A money market hedge involves simultaneous
  borrowing and lending in two different currencies
  to lock in the dollar value of a future foreign
  currency flow.
• Suppose Euro and US dollar interest rates are
  15 and 10 resply.
• GE can borrow (10/1.15)m 8.7m in the spot
  market and invest it for one year.
• On 12/31, GE will get (1.1)(8.7) 9.57m
• GE will use the 10m from its euro receivable to
  repay the euro loan.
• The payoff in one year should be the same with
  the forward hedge or the money market hedge
  provided interest rate parity holds.

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Risk Shifting

• GE can avoid the transaction exposure to euros if
  Lufthansa, its customer would allow it to bill in
  dollars.
• However, since Lufthansa is aware of the forward
  rate and the alternative available to GE, it
  would be willing to accept such billing only if
  it receives a discount of 0.43m, for a total
  bill of 9.57m as before.
• If Lufthansa uses the spot rate of 1/ and
  accepted a quote of 10m, it would be forgoing
  0.43m.

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Exposure Netting

• This refers to offsetting exposures in one
  currency with exposures in the same or other
  currency, where exchange rates are expected to
  move in such a way that loss on the first exposed
  position are offset by gains on the second
  exposure. This assumes that the net gain or loss
  on the entire currency exposure portfolio is what
  matters.
• This can be achieved in one of three ways
• A firm can offset a long position in a currency
  with a short position in that same currency.
• If the exchange rate movements of two currencies
  are positively correlated, then the firm can
  offset a long position in one currency with a
  short position in the other.
• If the currency movements are negatively
  correlated, then short (or long) positions can be
  used to offset each other.

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Exposure Netting

• Such offset of exposures does not require actual
  netting (bilateral or multilateral). Rather, if
  there is the potential for actual netting, then
  there is no real exchange exposure, whether or
  not the netting is actually done.
• However, it may be useful to do the actual
  netting one to reduce costs, and two, to have
  better control of how much hedging is actually
  necessary.
• Reinvoicing centers and in-house factoring can
  also procure the same result.

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In-house factoring
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Currency Risk Sharing

• Lufthansa and GE can agree to share the currency
  risks associated with their turbine contract.
  This can be done by developing a customized hedge
  contract embedded in the underlying trade
  transaction.
• Possible agreement
• A neutral zone (0.98-1.02/) within which there
  will be no price adjustment. In this zone,
  Lufthansa will pay GE, the dollar equivalent of
  10m at the base rate of 1/.
• If the euro depreciates from 1 to, say, 0.90,
  the actual rate wil have moved 0.08 beyond the
  lower boundary of the neutral zone (0.98/).
  This amount is shared equally. The actual rate
  used, here is 0.96 (1.00-0.08/2)
• If the euro appreciates to, say, 1.1, the actual
  rate will have moved 0.08 beyond the upper
  boundary (1.02/)/ The actual rate used will be
  1.04/. GE collects 10.4m and Lufthansa pays
  9.45 (10.4/1.1)

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Protection with Currency Risk Sharing
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Currency Collars/ Range Forwards

• A currency collar is a contract that provides
  protection against currency moves outside an
  agreed-upon price range.
• Suppose GE is willing to accept variations in the
  value of its euro receivable associated with
  fluctuations in the euro in the range of 0.95 to
  1.05, but not more.
• With a currency collar purchased from a bank, GE
  can obtain the following forward euro rate
• If e1 lt 0.95, then RF 0.95
• If 0.95 lt e1 lt 1.05, then RF e1
• If e1 gt 1.05, then RF 1.05
• If e1 lt 0.95, GE will be shielded from losses on
  its receivable.
• If e1 gt 1.05, the bank will make a profit.
• By forgoing the profit, the cost, for GE, of the
  downside protection will be lower.

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Protection with Currency Collars
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Cross Hedging

• Hedging with futures is similar to hedging with
  forwards.
• However, it is very difficult to find a futures
  contract that matches the needs of the hedger in
  currency, maturity and amount simultaneously.
• As long as the futures price on the futures
  contract that is available is positively
  correlated with the exposure being hedged, the
  company can obtain some protection. Such use of
  futures contracts is called cross-hedging.
• Suppose a US firm has a Danish Krone receivable,
  but it wants to use euro futures to hedge. Then,
  the slope coefficient from the regression of
  changes in the DK/ rate against changes in the
  / rate is the number of euros it should sell
  forward per DK.

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Foreign Currency Options

• Using forwards/futures or currency collars makes
  sense if the extent of the exposure is known.
  However, at times, a firm might want to hedge
  against a future exposure that might or might not
  materialize.
• In this case, using forwards might not be a good
  idea. If the exposure does materialize, well and
  good. However, if the exposure does not
  materialize, then the firm would end up with an
  unwanted exposure, once again.
• One way around this would be to buy an option.
  This is more like insurance.

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Foreign Currency Options

• Suppose GE bids on a contract worth 10m. to be
  paid in 3 months. However, GE will only know in
  2 months if the bid has been accepted.
• If GE sells a forward contract maturing in 3
  months at a price of 0.98/, it will receive
  9.8b. if the bid is accepted, no matter what the
  euro rate in 3 months.
• If the bid is not accepted, then GE will be
  contractually obligated to sell euros at 0.98/
  in 3 months time, no matter what the euro rate.
• If GE buys an option allowing it to sell 10m.
  for dollars in 3 months at a rate of 0.98/, it
  can use the option if its bid is accepted. If
  not, it can let the option lapse unless the
  euro depreciates by then to less than 0.98/.
  The cost to GE will be the cost of the option.

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Options versus Forwards

• Options are more useful than forwards when the
  amount of the exposure is uncertain.
• However, if there is some part of the exposure
  that is known for sure, such as that the exposure
  will be at least 5b., the firm can hedge the
  5b. in the forward market and the rest of the
  potential exposure in the options market.
• This assumes that the objective of the manager is
  to reduce risk, and that both forwards and
  options are priced fairly. Obviously, if these
  conditions do not hold, then the optimal policy
  might be different.