Measuring and Managing Translation and Transaction Exposure

1. Measuring and Managing Translation and Transaction Exposure Chapter 9

2. 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.

3. Accounting Exposure • Accounting Exposure = • Transaction risk + Translation risk

4. How Accounting Exposure Arises • Translation Risk United States Japan Headquarters’ Consolidated Financials £ £ Subsidiary Financials Subsidiary Financials ¥ $ £ Germany Subsidiary Financials €

5. 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.

6. 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.

7. 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

8. 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.

9. ALTERNATIVE CURRENCY TRANSLATION METHODS • C. Temporal Method • 1. Similar to monetary/nonmonetary • method. • 2. Use current method for inventory.

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

11. 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.

12. 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.

13. 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.

14. 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.

15. 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.

16. STATEMENT OF FINANCIAL ACCOUNTING STANDARDS NO. 52 • When Functional = Reporting Currencies are the Same (con’t) • 2. During hyperinflations in the subsidiary countries • Brazil, 1992 • Hyperinflation is defined as a cumulative inflation rate of 100% over a three-year period.

17. Consolidation Method • Current Rate

18. 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.

19. Managing Accounting Exposure Chapter 10B

20. PART III.DESIGNING A HEDGING STRATEGY • I. DESIGNING A HEDGING STRATEGY • A. Strategies • a management objective • B. Hedging’s basic objective: • reduce/eliminate volatility of • earnings as a result of exchange rate changes.

21. DESIGNING A HEDGING STRATEGY • C. Hedging exchange rate risk • 1. Is a cost-center • 2. Should be evaluated as a purchase of insurance.

22. 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.

23. 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

24. 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.

25. 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.

26. The Zone Take no actions $1.50/£ $1.60/£ Take no action

27. MANAGING TRANSACTION EXPOSURE • B. CURRENCY RISK SHARING (con’t) • 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.

28. 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.

29. 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.

30. 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.

31. 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 firm’s local currency accounting exposure.

32. MANAGING TRANSLATION EXPOSURE • 2. Forward contracts • reducing a firm’s translation exposure by creating an offsetting asset or liability in the foreign currency.

33. 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.

34. 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. increasingsoft-currency liabilities

35. 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