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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
methods.
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
change.
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
hedging.
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
P.V. Viswanath 8
Comparison of Exposure Types
P.V. Viswanath 9
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
rates.
I/S items are translated at the average exchange rate during the period
except for revenue and expense items related to nonmonetary
assets/liabilities.
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
changes
DM debt is a monetary liability, evaluated at current rate; affected by rate
changes
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
component.
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
include
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%
resply.
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
loan.
The payoff in one year should be the same with the forward
hedge or the money market hedge provided interest rate parity
holds.
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
matters.
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
receivables
£ 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
transaction.
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-
0.08/2)
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
