Measuring and Managing Translation and Transaction Exposure

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Measuring and Managing Translation and
Transaction Exposure

• Chapter 10

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Measuring Translation and Transaction Exposure
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PART I. ALTERNATIVE MEASURES OF FOREIGN EXCHANGE
EXPOSURE Accounting and Economic Risk

• I. ALTERNATIVE MEASURES
• A. TYPES
• 1. Accounting Exposure
• arises when reporting and
  consolidating financial statements require
  conversion from subsidiary to parent currency.
• 2. Economic Exposure
• arises because exchange rate changes alter
  the value of future revenues and
  costs.

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Accounting Exposure

• Accounting Exposure
• Transaction risk Translation risk

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How Accounting Exposure Arises

• Translation Risk

United States
Japan
Headquarters Consolidated Financials


Subsidiary Financials
Subsidiary Financials



Germany
Subsidiary Financials

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ALTERNATIVE MEASURES OF FOREIGN EXCHANGE EXPOSURE

• C. Economic Exposure
• Transaction Exposure Operating Exposure
• Operating Exposure arises because exchange
  rate changes alter the value of future revenues
  and costs.

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PART II. ALTERNATIVE CURRENCY TRANSLATION METHODS

• I. FOUR METHODS OF TRANSLATION
• A. Current/Noncurrent Method
• 1. Current accounts use current
  exchange rate for conversion.
• 2. Income statement accounts use
• average exchange rate for the period.

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ALTERNATIVE CURRENCY TRANSLATION METHODS

• B. Monetary/Nonmonetary Method
• 1. Monetary accounts use current rate
• 2. Pertains to
• - Cash
• - Accounts receivable
• - Accounts payable
• - Long term debt

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ALTERNATIVE CURRENCY TRANSLATION METHODS

• 3. Nonmonetary accounts
• - Use historical rates
• - Pertains to
• Inventory
• Fixed assets
• Long term investments
• 4. Income statement accounts
• - Use average exchange rate for the
  period.

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ALTERNATIVE CURRENCY TRANSLATION METHODS

• C. Temporal Method
• 1. Similar to monetary/nonmonetary
• method.
• 2. Use current method for inventory.

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ALTERNATIVE CURRENCY TRANSLATION METHODS

• D. Current Rate Method
• all statements use current exchange rate for
  conversions.

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PART III. STATEMENT OF FINANCIAL ACCOUNTING
STANDARDS NO. 8

• I. FASB NO. 8
• A. Uniform conversion rules established
• B. Temporal method
• C. Translation gains or losses
• 1. Reported on income statement
• 2. Result net income greatly affected by
  exchange rate volatility and subsequent
  uncertainty.

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PART IV. STATEMENT OF FINANCIAL ACCOUNTING
STANDARDS NO. 52

• I. FASB NO. 52
• A. Dissatisfaction with FASB No. 8
• true profitability often disguised by
• exchange rate volatility.

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STATEMENT OF FINANCIAL ACCOUNTING STANDARDS NO. 52

• D. Translation Gains or Losses
• 1. Recorded in separate equity account on
  balance sheet.
• 2. Known as cumulative translation
  adjustment account.

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STATEMENT OF FINANCIAL ACCOUNTING STANDARDS NO. 52

• E. New Distinction under FASB No. 52
• functional v. reporting currency
• 1. Functional currency
• for foreign subsidiary
• - The currency used in the primary
  economic environment in which it
  operates.
• 2. Reporting currency
• - The currency the parent firm uses to
  
• prepare its financial statements.

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STATEMENT OF FINANCIAL ACCOUNTING STANDARDS NO. 52

• F. When Functional and Reporting Currencies are
  the Same
• 1. If foreign subsidiary operations are
  direct extension of parent firm
• e.g. Hong Kong assembly plant
• which sells all its products in the U.S.
• market.

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STATEMENT OF FINANCIAL ACCOUNTING STANDARDS NO. 52

• When Functional and Reporting Currencies are the
  Same (cont)
• 2. During hyperinflations in the subsidiary
  countries
• Hyperinflation is defined as a cumulative
  inflation rate of 100 over a three-year period.

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PART VI. ACCOUNTING PRACTICE AND ECONOMIC REALITY

• I. Accounting v. Economic Exposure
• measurement of exchange rate risk indicates
  major difference exists.
• A. Accounting exposure
• reflects past decisions of the firm.
• B. Economic exposure
• 1. Focuses on future impact of exchange rate
  changes.
• 2. Not all future cash flows appear on the
  firms balance sheet.

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Sample Problem

• Suppose on January 1, American Golfs French
  subsidiary showed
• Current assets of FF1 million
• Current liabilities of FF300,000
• Total assets FF2.5 million
• Total liabilities FF900,000
• Exchange rate on Jan 1 .1270
• on Dec 31 .1180

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Sample Problem

• Under FASB-52, what is the exposure if the franc
  is the functional currency?
• - All assets and liabilities translated at
  current
• rate.
• At beginning of the year
• FF2,500,000-FF900,000 FF1,600,000
• 1,600,000 x .1270 203,200
• At the end of the year
• 1,600,000 x .1180 188,800

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Sample Problem

• This involves a translation loss for American
  Golf of
• 203,200 188,800 14,400

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PART TWO
Managing Translation and Transaction Exposure
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PART III. DESIGNING A HEDGING STRATEGY

• I. DESIGNING A HEDGING STRATEGY
• A. Strategies
• a management objective
• B. Hedgings basic objective
• reduce/eliminate volatility of
• earnings as a result of exchange rate
  changes.

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DESIGNING A HEDGING STRATEGY

• C. Hedging exchange rate risk
• 1. Incurs a cost
• 2. Should be evaluated as a purchase of
  insurance.

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DESIGNING A HEDGING STRATEGY

• D. Centralization is key
• 1. Important aspects
• a. Degree of centralization
• b. Responsibility for its
  development
• c. Implementation
• 2. Maximum benefits accrue from
• centralizing policy-making, formulation, and
  implementation.

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PART II. MANAGING TRANSACTION EXPOSURE

• I. METHODS OF HEDGING
• A. Risk shifting
• B. Currency risk sharing
• C. Currency collars
• D. Cross-hedging
• E. Exposure netting
• F. Forward market hedge
• G. Foreign currency options

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MANAGING TRANSACTION EXPOSURE

• A. RISK SHIFTING
• 1. Home currency invoicing
• 2. Zero sum game
• 3. Common in global business
• 4. Firm will invoice exports in strong
  currency, import in weak currency
• 5. Drawback
• it is not possible with informed customers
  or suppliers.

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MANAGING TRANSACTION EXPOSURE

• B. CURRENCY RISK SHARING
• 1. Developing a customized hedge contract.
• 2. The contract typically takes the form of a
  Price Adjustment Clause, whereby a base
  price is adjusted to reflect certain
  exchange rate changes.

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The Zone

• Take no actions

1.50/
1.60/
Take no action
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MANAGING TRANSACTION EXPOSURE

• B. CURRENCY RISK SHARING (cont)
• 3. Parties would share the currency risk
  beyond a neutral zone of exchange
• rate changes.
• 4. The neutral zone represents the
  currency range in which risk is not
  shared.

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MANAGING TRANSACTION EXPOSURE

• C. CURRENCY COLLARS
• 1. Contract
• - bought to protect against currency
• moves outside the neutral zone.
• 2. Firm would convert its foreign currency
  denominated receivable at the zone
  forward rate.

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MANAGING TRANSACTION EXPOSURE

• D. CROSS-HEDGING
• 1. Often forward contracts not available
• in a certain currency.
• 2. Solution a cross-hedge
• - a forward contract in a related
  currency.
• 3. Correlation between 2 currencies is
• critical to success of this hedge.

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MANAGING TRANSACTION EXPOSURE

• E. EXPOSURE NETTING
• 1. Protection can be gained by selecting
• currencies that minimize exposure
• 2. Netting
• MNC chooses currencies that are not
• perfectly positively correlated.
• 3. Exposure in one currency can be
• offset by the exposure in another.

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PART III. MANAGING TRANSLATION EXPOSURE

• I. MANAGING TRANSLATION EXPOSURE
• A. Choices faced by the MNC
• 1. Adjusting fund flows
• Altering either the amounts or the
  currencies of the planned cash flows of the
  parent or its subsidiaries to reduce the
  firms local currency accounting exposure.

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MANAGING TRANSLATION EXPOSURE

• 2. Forward contracts
• Reducing a firms translation exposure by
  creating an offsetting asset or liability in
  the foreign currency.

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MANAGING TRANSLATION EXPOSURE

• 3. Exposure netting
• a. Offsetting exposures in one currency
  with exposures in the same or another
  currency
• b. Gains and losses on the two
  currency positions will offset each
  other.

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Managing Translation Exposure

• B. Basic hedging strategy for reducing
  translation exposure
• 1. Increasing hard-currency (likely to
  
• appreciate) assets.
• 2. Decreasing soft-currency (likely to
  depreciate) assets.
• 3. Decreasing hard-currency liabilities.
• 4. Increasing soft-currency liabilities.

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MANAGING TRANSLATION EXPOSURE

• How to increase soft-currency liabilities
• Reduce the level of cash,
• Tighten credit terms to decrease accounts
  receivable,
• Increase LC borrowing,
• Delay accounts payable, and
• Sell the weak currency forward.