Translation and Transaction Exposure by hli12090

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									Translation and Transaction Exposure

       International Corporate Finance

               P.V. Viswanath

   For use with Alan Shapiro “Multinational
            Financial Management”
                Learning Objectives

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

                      P.V. Viswanath                    2
                        Exchange Risk

 Definition: A gain/loss that results due to an exchange rate
 Only unanticipated exchange rate changes constitute risk.
 Question: Whose gain or loss?
 Ans: The subsidiary’s? The parent’s? No, the shareholder’s.
 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

                            P.V. Viswanath                      3
      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.

                         P.V. Viswanath                      4
                 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.

                          P.V. Viswanath                         5
                 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.

                          P.V. Viswanath                      6
                Operating Exposure

 The extent to which currency fluctuations can alter
  a company’s 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

                       P.V. Viswanath                     7
         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.
                                P.V. Viswanath                              10
                Current/Noncurrent Currency
                    Translation Method
 Maturity is used to divided assets into two categories. Not in general
  use at the moment.
 All the foreign subsidiary’s 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.
                                 P.V. Viswanath                           11
            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
 I/S items are translated at the average exchange rate during the period
  except for revenue and expense items related to nonmonetary
 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).

                              P.V. Viswanath                           12
                         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.
                               P.V. Viswanath                          13
                                    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
      DM debt is a monetary liability, evaluated at current rate; affected by rate
      Hence, enormous translation exposure and volatile earnings statements
                                  P.V. Viswanath
                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.
                           P.V. Viswanath                       15
Impact of Translation Alternatives

            P.V. Viswanath           16
Impact of Translation Alternatives

            P.V. Viswanath           17
      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 parent’s statements.
 This gives firms the opportunity to identify the primary economic
  environment and select the appropriate functional currency for each
  subsidiary. An affiliate’s 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.
                              P.V. Viswanath                            18
P.V. Viswanath   19
   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
  affiliate’s 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 parent’s foreign exchange equity account.

                               P.V. Viswanath                              20
       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 £1=$1.50.
 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.

                      P.V. Viswanath                21
Example of FASB-52 Translation

          P.V. Viswanath         22
Example of FASB-52 Translation

          P.V. Viswanath         23
        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 Sterling’s income statement.
 This is calculated as the difference between translated
  income before currency gains ($23m.) and the retained
  earnings figure ($131m.)

                          P.V. Viswanath                     24
                 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).

                               P.V. Viswanath                              25
        Exception to functional currency losses

 Under FASB 52, the following gains/losses need not be included
  on the foreign unit’s 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
      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.

                                 P.V. Viswanath
                 US Accounting Standards

                             1975-81              1981-today

                             FASB 8                FASB 52

                         Temporal Method      Current Rate Method

Monetary (A/R debt,      Current Exchange      Current Exchange
       etc.)                    Rate                 Rate
Fixed Assets (P&E,      Historical Exchange    Current Exchange
    inventory)                  Rate                 Rate
  Asset translation      Income Statement       Separate Equity
gains/losses reported                           Account in B/S
                             P.V. Viswanath                       27
          Managing Translation Exposure

 Three major techniques:
      Adjusting Funds flows
      Entering into forward contracts
      Exposure Netting

                           P.V. Viswanath   28
                            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
       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

                                     P.V. Viswanath                                 29
                   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.

                          P.V. Viswanath                     30
           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.
 It’s 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.

                                 P.V. Viswanath                                31
                     Hedging Strategies

 The objective underlying hedging should be made explicit.
 Trying to manage accounting exposure is inconsistent with
  empirical evidence; since it doesn’t 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.

                            P.V. Viswanath                         32
               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.
                         P.V. Viswanath                         33
                 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%
 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
 The payoff in one year should be the same with the forward
  hedge or the money market hedge provided interest rate parity
                          P.V. Viswanath                       34
                        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.

                          P.V. Viswanath                      35
                            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
 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.

                                  P.V. Viswanath                               36
                      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.

                            P.V. Viswanath                         37
             In-house factoring

                            Factoring Unit

                                              euro payment
 Sells export

                £ payment

U.K Seller                   goods            German Buyer

                               euro invoice

                    P.V. Viswanath                           38
                      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
 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-
      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)
                                  P.V. Viswanath                             39
Protection with Currency Risk Sharing

             P.V. Viswanath         40
            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 < $0.95, then RF = $0.95
       If $0.95 < e1 < $$1.05, then RF = e1
       If e1 > $1.05, then RF = $1.05
 If e1 < $0.95, GE will be shielded from losses on its receivable.
 If e1 > $1.05, the bank will make a profit.
 By forgoing the profit, the cost, for GE, of the downside protection will
  be lower.
                                   P.V. Viswanath                     41
Protection with Currency Collars

           P.V. Viswanath          42
                       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.
                          P.V. Viswanath                          43
              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.

                          P.V. Viswanath                      44
              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.
                          P.V. Viswanath                     45
               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.

                          P.V. Viswanath                      46

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