Measuring/Managing Translation and Transaction Exposure
Chapter 10 Lecture Notes
Measuring Translation and Transaction Exposure
PART I. ALTERNATIVE MEASURES OF FOREIGN EXCHANGE EXPOSURE: Accounting and Economic Risk
I. ALTERNATIVE MEASURES
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.
B. Accounting Exposure = Transaction risk + Translation risk
ALTERNATIVE MEASURES OF FOREIGN EXCHANGE EXPOSURE
Recorded in separate equity account on balance sheet.
2. Known as cumulative translation adjustment account.
C. New Distinction in 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.
D. 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.
2. During hyperinflations in the subsidiary countries
Hyperinflation is defined as a cumulative inflation rate of 100% over a three-year period.
PART III. 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 firm’s balance sheet.
Suppose on January 1, American Golf’s Mexican subsidiary showed:
Current assets of 1 million Pesos;
Current liabilities of 300,000 Pesos;
Total assets = 2.5 million Pesos;
Total liabilities = 900,000 Pesos
Exchange rate on Jan 1 = $.1270
on Dec 31 = $.1180
Under FASB-52, what is the exposure if the Peso is the functional currency?
- All assets and liabilities translated at current rate.
At beginning of the year:
2,500,000-900,000 = 1,600,000 Pesos Equity
1,600,000 x $.1270 = $203,200
At the end of the year:
1,600,000 x $.1180 = $188,800
This involves a translation loss for American Golf of:
$203,200 – 188,800 = $14,400 Pesos
Managing Translation and Transaction Exposure
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.
C. Hedging exchange rate risk
1. Incurs a cost
2. Should be evaluated as a purchase of insurance.
D. Centralization is key
1. Important aspects:
a. Degree of centralization
b. Responsibility for its development
2. Maximum benefits accrue from centralizing policy-making, formulation, and implementation.
II. METHODS OF HEDGING
A. Risk shifting
B. Currency risk sharing
C. Currency collars
E. Exposure netting
F. Forward market hedge
G. Foreign currency options
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...