Measuring and Managing Translation and Transaction Exposure

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Measuring and Managing Translation and
Transaction Exposure

• Chapter 9

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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
• (difficult to hedge an event that occurred
  in the past)
• 2. Economic Exposure
• arises because unexpected 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 defined
• arises because exchange rate
• changes alter the value of future
  revenues and expenses.

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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
• - current portion 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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• 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.
• 3. Located in the equity section.

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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 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 Reporting Currencies are the
  Same (cont)
• 2. During hyperinflations in the subsidiary
  countries
• Brazil, 1992
• Hyperinflation is defined as a cumulative
  inflation rate of 100 over a three-year period.

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Consolidation Method

• Current Rate

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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
• Focuses on future impact of exchange rate
  changes.

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Managing Accounting Exposure

• Chapter 10B

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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. Is a cost-center
• 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 IV.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