Measuring and Managing Translation and Transaction Exposure [Shapiro: Chapter 10]

1
Measuring and Managing Translation and
Transaction ExposureShapiro Chapter 10
2
Problems Chapter 10

• 10.2

3
Wide German Protests Planned Today in Dispute on
Sick Pay(New York Times, 10-24-96)

• IG Metall, Germanys largest union, said today
  that big rallies were planned nationwide on
  Thursday to protest possible cuts in sick pay,
  after the collapse of talks with employers aimed
  at resolving the matter.

4
Wide German Protests Planned Today in Dispute on
Sick Pay(New York Times, 10-24-96)

• Given German tradition, it is difficult to see
  companies in one industry having many different
  policies. Wages and labor policy in Germany have
  traditionally been settled through industry-wide
  contracts, not company by company.

5
Wide German Protests Planned Today in Dispute on
Sick Pay(New York Times, 10-24-96)

• German industry wants to reduce sick-pay coverage
  to 80 percent of base wages, in line with a new
  legal minimum passed last month. Until now, sick
  pay has been 100 percent of wages plus average
  overtime.

6
Wide German Protests Planned Today in Dispute on
Sick Pay(New York Times, 10-24-96)

• Days after Parliament passed the legislation on
  Sept. 13, Daimler-Benz announced that it would
  cut sick pay for its 220,000 German employees. A
  number of large companies followed with similar
  announcements.

7
Swedens cradle-to-grave welfare starts to get
illIntl. Herald Tribune, 9-25-02

• one in 20 Swedish workers were on sick leave
  for more than a week last year, double the
  European Union average, and that paid sick leave
  averaged nearly 25 days, up from 14 days in 1998.

8
Swedens cradle-to-grave welfare starts to get
illIntl. Herald Tribune, 9-25-02

• An average of 430,000 Swedish employees, 10
  percent of the countrys work force is on sick
  leave at any given time.

9
Swedens cradle-to-grave welfare starts to get
illIntl. Herald Tribune, 9-25-02

• The government pays a benefit equal to 80
  percent of a persons salary during sick leave,
  no matter how long, and an additional 10 percent
  in what is called contract insurance for the
  first three months.

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Average number of days a Swedish worker is on
sick leave
11
Foreign Exchange Exposure

• Accounting Exposure
• Transaction Exposure
• Operating Exposure

12
Accounting ExposureTerminology

• Exposure - need to convert financial statements
  of foreign operations from local currency to the
  home currency.
• Translation - restatement of accounts due to
  exchange rate changes.

13
Accounting ExposureTerminology

• Translation Exposure -
• Difference between exposed assets and exposed
  liabilities
• Which assets liabilities are exposed?
• When should gains and losses be recognized on the
  income statement?

14
Transaction Exposure

• results from transactions that give rise to
  known, contractually binding future foreign
  currency-denominated cash inflows or outflows.

15
Operating Exposure

• measures the extent to which currency
  fluctuations can alter a companys future
  operating cash flows.

16
Translation Methods

• Current / Noncurrent
• Monetary / Nonmonetary
• Temporal (FASB 8)
• Current Rate (FASB 52)

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Current Rate Method

• All balance sheet and income statement items are
  translated at the current rate

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Current Rate Method

• If assets gt liabilities
• devaluation translation loss
• revaluation translation gain
• If assets lt liabilities
• devaluation translation gain
• revaluation translation loss

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FASB No. 52 (1981)

• Replaced FASB No. 8 (1976)
• Required current rate method for assets and
  liabilities
• Income Statement
• exchange rate when items recognized
• weighted average rate for the period

20
FASB No. 52

• Gains and Losses
• generally bypass income statement
• accumulate on balance sheet in a separate equity
  account
• account title cumulative translation
  adjustment

21
FASB No. 52

• Functional vs. reporting currency
• Functional - primary economic environment
• Reporting - parent firms financial statements

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Shapiro Problem 10.2

• Rolls-Royce
• A/R 1.5 Billion
• A/P 740 million
• Borrowings of 600 million
• Current spot rate 1.5128/

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Shapiro Problem 10.2

• What is Rolls-Royce dollar translation exposure
  in dollar terms? In Pound terms?
• 1.5 Bil. - 740 -600 160
• 160 / 1.5128 105.76

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Shapiro Problem 10.2

• appreciates to 1.7642 /
• 160 / 1.7642 90.69
• 90.69 - 105.76 -15.07

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Hedging

• ... establishing an offsetting currency
  position ...
• ... whatever is lost or gained on the original
  currency exposure ...
• is exactly offset by a corresponding foreign
  exchange gain or loss ...
• on the currency hedge.

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Hedging

• Regardless of what happens to the future
  exchange rate ...
• hedging locks in a dollar (home currency) value
  for the currency exposure.

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Managing Transaction Exposure

• Which exposures to manage?
• Those that are
• large in size
• involve volatile currencies
• extend over long periods of time

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Managing Transaction Exposure

• Which exposures to manage?
• How to manage the position?
• How much of the position to hedge?
• Which exposure-reducing techniques to employ?

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Transaction Exposure

• Committed to a foreign currency- denominated
  transaction
• Future foreign currency cash inflow or
  outflow
  
• Risk exchange rate may vary
• Hedge offsetting cash flows

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Managing Transaction Exposure

• Forward market hedge
• Money market hedge
• Risk shifting
• Pricing decisions
• Exposure netting
• Currency risk sharing
• Currency collars

31
General Electric Example

• Jan. 1 contract for 10 million
• Dec 31 payment to be received
• Current spot price 1.00
• One-year forward 0.957
• What are the risks to GE? How would you manage
  those risks?

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Managing Transaction Exposure

• Forward market hedge
• if long, sell currency forward
• if short, buy currency forward
• Fix the dollar value of future foreign currency
  cash flow

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GE Forward Market Hedge
Spot Rate (12/31) Original Receivable Gain (Loss) On Contract Total Cash Flow ()
1.000 10,000,000 (430,000) 9,570,000



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GE Forward Market Hedge
Spot Rate (12/31) Original Receivable Gain (Loss) On Contract Total Cash Flow ()
1.000 10,000,000 (430,000) 9,570,000
0.957 9,570,000 0 9,570,000


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GE Forward Market Hedge
Spot Rate (12/31) Original Receivable Gain (Loss) On Contract Total Cash Flow ()
1.000 10,000,000 (430,000) 9,570,000
0.957 9,570,000 0 9,570,000
0.900 9,000,000 570,000 9,570,000

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GE Forward Market Hedge
Spot Rate (12/31) Original Receivable Gain (Loss) On Contract Total Cash Flow ()
1.000 10,000,000 (430,000) 9,570,000
0.957 9,570,000 0 9,570,000
0.900 9,000,000 570,000 9,570,000
1.100 11,000,000 (1,430,000) 9,570,000
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Managing Transaction Exposure

• Forward market hedge
• Money market hedge

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Money Market Hedge

• Simultaneous borrowing and lending in ...
• two different currencies to ...
• lock in the dollar value of a future foreign
  currency cash flow.

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Money Market Hedge

• interest rate 15
• US interest rate 10
• GE borrows 8.70 (10/1.15) million for one year
• Convert into 8.7 million
• Invest 8.7 million for one year

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Money Market Hedge

• On 12/31, GE receives 8.7 x 1.10 9.57 million
• GE collects its receivable 10 million
• GE repays the 10 million it owes ( 8.7 x 1.15)

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GE Money Market Hedge
Spot Rate (12/31) Original Receivable Gain (Loss) On Hedge Total Cash Flow ()
1.000 10,000,000 (430,000) 9,570,000
0.957 9,570,000 0 9,570,000
0.900 9,000,000 570,000 9,570,000
1.100 11,000,000 (1,430,000) 9,570,000
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Managing Transaction Exposure

• Forward market hedge
• Money market hedge
• Risk shifting

43
Risk Shifting

• Price transaction in dollars
• Doesnt eliminate currency risk
• Shifts it from GE to Lufthansa
• Zero-sum game

44
Managing Transaction Exposure

• Forward market hedge
• Money market hedge
• Risk shifting
• Pricing decisions

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Pricing Decisions

• 10,000,000 X 1.00 10,000,000
• What is the real worth of the contract with
  Lufthansa? Why?
• 10,000,000 X 0.957 9,570,000
• 10,000,000 / 0.957 10,449,321

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Pricing Decisions

• The general rule on credit sales overseas is to
  convert between the foreign currency price and
  the dollar price by using the forward rate, not
  the spot rate.

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Managing Transaction Exposure

• Forward market hedge
• Money market hedge
• Risk shifting
• Pricing decisions
• Exposure netting

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Exposure Netting

• ...the net gain or loss on the entire currency
  exposure portfolio is what matters, rather than
  the gain or loss on any individual monetary unit.

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Exposure Netting

• Portfolio approach to hedging
• Portfolio risk less than the sum of individual
  risk positions

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Exposure NettingPossible outcomes

• Offset long and short positions in the same
  currency
• Offset long and short positions in positively
  correlated currencies
• Offset long (or short) positions in negatively
  correlated currencies

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Managing Transaction Exposure

• Forward market hedge
• Money market hedge
• Risk shifting
• Pricing decisions
• Exposure netting
• Currency risk sharing

52
Currency Risk Sharing

• Imbedded hedge contract
• Price adjustment clause
• Base price adjusted for certain exchange rate
  changes
• Risk is shared beyond neutral zone

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Currency Risk Sharing

• Base rate 1 1.00
• Neutral zone 1.02 - 0.98
• What happens at 1 0.90?
• Rate used 0.96 1
• 0.96 (1.00 - .08 / 2)
• 10,000,000 X 0.96 9,600,000
• 9,600,000 0.90 10,666,667

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Managing Transaction Exposure

• Forward market hedge
• Money market hedge
• Risk shifting
• Pricing decisions
• Exposure netting
• Currency risk sharing
• Currency collars

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Currency CollarsRange Forward

• GE accepts some but not all risk
• GE buys protection outside a range
• Range 0.95 - 1.05
• If e1 lt 0.95, then RF 0.95
• If 0.95 e1 1.05, then RF e1
• If e1 gt 1.05, then RF 1.05

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Managing Transaction Exposure

• Forward market hedge
• Money market hedge
• Risk shifting
• Pricing decisions
• Exposure netting
• Currency risk sharing
• Currency collars
• Foreign currency options

57
Foreign Currency Options

• Uncertain foreign currency flows
• Example competitive bid contract
• GE buys a put option (0.957) for 100,000
• GE loses bid maximum loss 100,000
• e1 gt 0.957 let option expire, sell at spot

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Managing Translation Exposure

• Adjusting Fund Flows

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Basic Strategy for Hedging Translation Exposure
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Basic Strategy for Hedging Translation Exposure
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Basic Strategy for Hedging Translation Exposure
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Basic Strategy for Hedging Translation Exposure
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Basic Strategy for Hedging Translation Exposure
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Basic Strategy for Hedging Translation Exposure
Assets Liabilities
Hard Currencies (Likely to Appreciate) Increase Decrease
Soft Currencies (Likely to Depreciate) Decrease Increase