Chapter 9

Report
Chapter 10
Transaction and
Translation
Exposure
Learning Objectives
• Distinguish between the three major foreign
exchange exposures experienced by firms
• Analyze the pros and cons of hedging foreign
exchange transaction exposure
• Examine the alternatives available to a firm for
managing a large and significant transaction
exposure
• Evaluate the institutional practices and concerns of
foreign exchange risk management
10-2
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Learning Objectives
• Demonstrate how translation practices result in a foreign
exchange exposure for the multinational enterprise
• Explain the meaning behind the designation of a foreign
subsidiary’s “functional currency”
• Illustrate both the theoretical and practical differences
between the two primary methods of translating foreign
currency denominated financial statements into the
currency reporting of the parent company
• Compare translation exposure with operating expense
• Analyze the costs and benefits of managing translation
exposure
10-3
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Foreign Exchange Exposure
• Foreign exchange exposure is a measure of the
potential for a firm’s profitability, net cash flow,
and market value to change because of a change
in exchange rates
– These three components (profits, cash flow and market
value) are the key financial elements of how we view
the relative success or failure of a firm
– While finance theories tell us that cash flows matter
and accounting does not, we know that currencyrelated gains and losses can have destructive impacts
on reported earnings – which are fundamental to the
markets opinion of that company
10-4
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Foreign Exchange Exposure
• Types of foreign exchange exposure
– Transaction Exposure – measures changes in
the value of outstanding financial obligations
incurred prior to a change in exchange rates but
not due to be settled until after the exchange
rate changes
– Translation Exposure – also called accounting
exposure, is the potential for accounting
derived changes in owner’s equity to occur
because of the need to “translate” financial
statements of foreign subsidiaries into a single
reporting currency for consolidated financial
statements
10-5
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Foreign Exchange Exposure
– Operating Exposure – also called economic exposure,
measures the change in the present value of the firm
resulting from any change in expected future operating
cash flows caused by an unexpected change in exchange
rates
– Exhibit 10.1 shows schematically the three main types of
foreign exchange exposure: transaction, translation, and
operating
10-6
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Exhibit 10.1 Corporate Foreign
Exchange Exposure
10-7
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Why Hedge?
• Hedging protects the owner of an asset (future
stream of cash flows) from loss
• However, it also eliminates any gain from an
increase in the value of the asset hedged against
• Since the value of a firm is the net present value
of all expected future cash flows, it is important to
realize that variances in these future cash flows
will affect the value of the firm and that at least
some components of risk (currency risk) can be
hedged against
10-8
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Why Hedge - the Pros & Cons
• Opponents of hedging give the following
reasons:
– Shareholders are more capable of diversifying risk than
the management of a firm; if stockholders do not wish to
accept the currency risk of any specific firm, they can
diversify their portfolios to manage that risk
– Currency risk management does not increase the
expected cash flows of a firm; currency risk management
normally consumes resources thus reducing cash flow
– Management often conducts hedging activities that
benefit management at the expense of shareholders
10-9
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Why Hedge - the Pros & Cons
• Opponents of hedging give the following reasons
(continued):
– Managers cannot outguess the market; if and when markets are
in equilibrium with respect to parity conditions, the expected
NPV of hedging is zero
– Management’s motivation to reduce variability is sometimes
driven by accounting reasons; management may believe that it
will be criticized more severely for incurring foreign exchange
losses in its statements than for incurring similar or even higher
cash cost in avoiding the foreign exchange loss
– Efficient market theorists believe that investors can see through
the “accounting veil” and therefore have already factored the
foreign exchange effect into a firm’s market valuation
10-10
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Why Hedge - the Pros & Cons
• Proponents of hedging give the
following reasons:
– Reduction in risk in future cash flows improves
the planning capability of the firm
– Reduction of risk in future cash flows reduces
the likelihood that the firm’s cash flows will fall
below a necessary minimum
– Management has a comparative advantage over
the individual investor in knowing the actual
currency risk of the firm
– Markets are usually in disequilibirum because of
structural and institutional imperfections
10-11
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Exhibit 10.2 Hedging’s Impact on the
Expected Cash Flows of the Firm
10-12
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Measurement of Transaction
Exposure
• Transaction exposure measures gains or losses
that arise from the settlement of existing financial
obligations, namely
– Purchasing or selling on credit goods or services when
prices are stated in foreign currencies
– Borrowing or lending funds when repayment is to be
made in a foreign currency
– Being a party to an unperformed forward contract and
– Otherwise acquiring assets or incurring liabilities
denominated in foreign currencies
10-13
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Purchasing or Selling on Open
Account
• Suppose Trident Corporation sells merchandise on
open account to a Belgian buyer for €1,800,000
payable in 60 days
• Further assume that the spot rate is $1.2000/€
and Trident expects to exchange the euros for
€1,800,000 x $1.2000/€ = $2,160,000 when
payment is received
– Transaction exposure arises because of the risk that
Trident will something other than $2,160,000 expected
– If the euro weakens to $1.1000/€, then Trident will
receive $1,980,000
– If the euro strengthens to $1.3000/€, then Trident will
receive $2,340,000
10-14
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Purchasing or Selling on Open
Account
• Trident might have avoided transaction exposure
by invoicing the Belgian buyer in US dollars, but
this might have lead to Trident not being able to
book the sale
• Even if the Belgian buyer agrees to pay in dollars,
however, Trident has not eliminated transaction
exposure, instead it has transferred it to the
Belgian buyer whose dollar account payable has
an unknown euro value in 60 days
10-15
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Exhibit 10.3 The Life Span of a
Transaction Exposure
10-16
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Borrowing and Lending
• A second example of transaction exposure arises
when funds are loaned or borrowed
• Example: PepsiCo’s largest bottler outside the US
is located in Mexico, Grupo Embotellador de
Mexico (Gemex)
– On 12/94, Gemex had US dollar denominated debt of
$264 million
– The Mexican peso (Ps) was pegged at Ps$3.45/US$
– On 12/22/94, the government allowed the peso to float
due to internal pressures and it sank to Ps$5.50/US$
10-17
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Borrowing and Lending
• Gemex’s peso obligation now looked like
this
– Dollar debt mid-December, 1994:
• US$264,000,000  Ps$3.45/US$ = Ps$910,800,000
– Dollar debt in mid-January, 1995:
• US$264,000,000  Ps$5.50/US$ = Ps$1,452,000,000
– Dollar debt increase measured in Ps
• Ps$541,200,000
• Gemex’s Peso obligation increased by 59%
due to transaction exposure
10-18
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Other Causes of Transaction
Exposure
• When a firm buys a forward exchange
contract, it deliberately creates transaction
exposure; this risk is incurred to hedge an
existing exposure
– Example: US firm wants to offset transaction
exposure of ¥100 million to pay for an import
from Japan in 90 days
– Firm can purchase ¥100 million in forward
market to cover payment in 90 days
10-19
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Contractual Hedges
• Transaction exposure can be managed by contractual,
operating, or financial hedges
• The main contractual hedges employ forward, money,
futures and options markets
• Operating and financial hedges use risk-sharing
agreements, leads and lags in payment terms, swaps,
and other strategies
• A natural hedge refers to an offsetting operating cash
flow, a payable arising from the conduct of business
• A financial hedge refers to either an offsetting debt
obligation or some type of financial derivative such as a
swap
10-20
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Trident’s Transaction Exposure
• Maria Gonzalez, CFO of Trident, has just
concluded a sale to Regency, a British firm,
for £1,000,000
• The sale is made in March for settlement
due in three months time, June
– Assumptions
• Spot rate is $1.7640/£
• 3 month forward rate is $1.7540/£ (a 2.2676%
discount)
• Trident’s cost of capital is 12.0%
• UK 3 month borrowing rate is 10.0% p.a.
• UK 3 month investing rate is 8.0% p.a.
10-21
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Trident’s Transaction Exposure
– Assumptions
• US 3 month borrowing rate is 8.0% p.a.
• US 3 month investing rate is 6.0% p.a.
• June put option in OTC market for £1,000,000;
strike price $1.75; 1.5% premium
• Trident’s foreign exchange advisory service
forecasts future spot rate in 3 months to be
$1.7600/£
• Trident operates on thin margins and Maria
wants to secure the most amount of US
dollars; her budget rate (lowest acceptable
amount) is $1.7000/£
10-22
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Exhibit 10.4 Trident’s Transaction
Exposure
10-23
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Trident’s Transaction Exposure
• Maria faces four possibilities:
–
–
–
–
10-24
Remain unhedged
Hedge in the forward market
Hedge in the money market
Hedge in the options market
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Trident’s Transaction Exposure
• Unhedged position
– Maria may decide to accept the transaction risk
– If she believes that the future spot rate will be
$1.76/£, then Trident will receive £1,000,000 x
$1.76/£ = $1,760,000 in 3 months time
– However, if the future spot rate is $1.65/£,
Trident will receive only $1,650,000 well below
the budget rate
10-25
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Trident’s Transaction Exposure
• Forward Market hedge
– A forward hedge involves a forward or futures contract
and a source of funds to fulfill the contract
– The forward contract is entered at the time the A/R is
created, in this case in March
– When this sale is booked, it is recorded at the spot rate.
– In this case the A/R is recorded at a spot rate of
$1.7640/£, thus $1,764,000 is recorded as a sale for
Trident
– If Trident does not have an offsetting A/P in the same
amount, then the firm is considered uncovered
10-26
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Trident’s Transaction Exposure
• Forward Market hedge
– Should Maria want to cover this exposure with a
forward contract, then she will sell £1,000,000 forward
today at the 3 month rate of $1.7540/£
– She is now “covered” and Trident no longer has any
transaction exposure
– In 3 months, Trident will received £1,000,000 and
exchange those pounds at $1.7540/£ receiving
$1,754,000
– This sum is $6,000 less than the uncertain $1,760,000
expected from the unhedged position
– This would be recorded in Trident’s books as a foreign
exchange loss of $10,000 ($1,764,000 as booked,
$1,754,000 as settled)
10-27
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Trident’s Transaction Exposure
• Money Market hedge
– A money market hedge also includes a contract
and a source of funds, similar to a forward
contract
– In this case, the contract is a loan agreement
• The firm borrows in one currency and exchanges the
proceeds for another currency
• Hedges can be left “open” (i.e. no investment) or
“closed” (i.e. investment)
10-28
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Trident’s Transaction Exposure
• Money Market hedge
– To hedge in the money market, Maria will
borrow pounds in London, convert the pounds
to dollars and repay the pound loan with the
proceeds from the sale
• To calculate how much to borrow, Maria needs to
discount the PV of the £1,000,000 to today
• £1,000,000/1.025 = £975,610
• Maria should borrow £975,610 today and in 3 months
time repay this amount plus £24,390 in interest
(£1,000,000) from the proceeds of the sale
10-29
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Trident’s Transaction Exposure
• Money Market hedge
– Trident would exchange the £975,610 at the
spot rate of $1.7640/£ and receive $1,720,976
at once
– This hedge creates a pound denominated
liability that is offset with a pound denominated
asset thus creating a balance sheet hedge
Assets
Liabilities and Net Worth
Account receivable £1,000,000
Bank loan (principal)
Interest payable
£1,000,000
10-30
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£ 975,610
24,390
£1,000,000
Trident’s Transaction Exposure
• In order to compare the forward hedge
with the money market hedge, Maria must
analyze the use of the loan proceeds
– Remember that the loan proceeds may be used
today, but the funds for the forward contract
may not
– Because the funds are relatively certain,
comparison is possible in order to make a
decision
– Three logical choices exist for an assumed
investment rate for the next 3 months
10-31
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Trident’s Transaction Exposure
• First, if Trident is cash rich the loan proceeds might be
invested at the US rate of 6.0% p.a.
• Second, Maria could use the loan proceeds to substitute an
equal dollar loan that Trident would have otherwise taken for
working capital needs at a rate of 8.0% p.a.
• Third, Maria might invest the loan proceeds in the firm itself
in which case the cost of capital is 12.0% p.a.
Received today
10-32
Invested in
Rate
Future value in 3 months
$1,720,976
Treasury bill
6% p.a. or 1.5%/quarter
$1,746,791
$1,720,976
Debt cost
8% p.a. or 2.0%/quarter
$1,755,396
$1,720,976
Cost of capital
12% p.a. or 3.0%/quarter
$1,772,605
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Trident’s Transaction Exposure
• Because the proceeds in 3 months from the
forward hedge will be $1,754,000, the money
market hedge is superior to the forward hedge if
Maria used the proceeds to replace a dollar loan
(8%) or conduct general business operations
(12%)
• The forward hedge would be preferable if Maria
were to just invest the loan proceeds (6%)
• We will assume she uses the cost of capital as the
reinvestment rate
10-33
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Trident’s Transaction Exposure
• A breakeven investment rate can be
calculated in order to forgo numerous
calculations and still aid Maria in her
decision
(Loanproceeds)(1 rate) (forwardproceeds)
$1,720,976(1 r)  $1,754,000
r  0.0192
To convert this 3 month rate to an annual rate,
360
0.0192 x
x 100  7.68%
90
10-34
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Trident’s Transaction Exposure
• In other words, if Maria can invest the loan
proceeds at a rate equal to or greater than
7.68% p.a. then the money market hedge
will be superior to the forward hedge
• The following chart shows the value of
Trident’s A/R over a range of possible spot
rates both uncovered and covered using
the previously mentioned alternatives
10-35
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Trident’s Transaction Exposure
• Option market hedge
– Maria could also cover the £1,000,000 exposure
by purchasing a put option. This allows her to
speculate on the upside potential for
appreciation of the pound while limiting her
downside risk
• Given the quote earlier, Maria could purchase 3 month
put option at an ATM strike price of $1.75/£ and a
premium of 1.5%
• The cost of this option would be
(Size of option)x (premium)x (spot rate) cost of option
£1,000,000x 0.015x $1.7640 $26,460
10-36
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Trident’s Transaction Exposure
• Because we are using future value to compare the various
hedging alternatives, it is necessary to project the cost of
the option in 3 months forward
• Using a cost of capital of 12% p.a. or 3.0% per quarter, the
premium cost of the option as of June would be
$26,460  1.03 = $27,254
• Since the upside potential is unlimited, Trident would not
exercise its option at any rate above $1.75/£ and would
purchase pounds on the spot market
• If for example, the spot rate of $1.76/£ materializes, Trident
would exchange pounds on the spot market to receive
£1,000,000  $1.76/£ = $1,760,000 less the premium of the
option ($27,254) netting $1,732,746
10-37
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Trident’s Transaction Exposure
• Unlike the unhedged alternative, Maria has limited
downside with the option
• Should the pound depreciate below $1.75/£, Maria
would exercise her option and exchange her
£1,000,000 at $1.75/£ receiving $1,750,000
– Less the premium of the option, Maria nets $1,722,746
– Although this downside is less than that of the forward or
money market hedge, the upside potential is not limited
10-38
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Trident’s Transaction Exposure
• As with the forward and money market
hedges, Maria can also calculate her
breakeven price on the option
– The upper bound of the range is determined
by comparison of the forward rate
• The pound must appreciate above $1.754/£
forward rate plus the cost of the option, $0.0273/£,
to $1.7813/£
– The lower bound of the range is determined
in a similar manner
• If the pound depreciates below $1.75/£, the net
proceeds would be $1.75/£ less the cost of
$0.0273/£ or $1.722/£
10-39
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Exhibit 10.5 Valuation of Cash Flows Under
Hedging Alternatives for Trident with Option
10-40
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Trident’s Transaction Exposure
10-41
Put Option Strike Price
ATM Option $1.75/£
Option cost (future cost)
$27,254
Proceeds if exercised
$1,750,000
Minimum net proceeds
$1,722,746
Maximum net proceeds
unlimited
Breakeven spot rate (upside)
$1.7813/£
Breakeven spot rate (downside)
$1.7221/£
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Strategy Choice and Outcome
• Trident, like all firms, must decide on a
strategy to undertake before the exchange
rate changes but how will Maria choose
among the strategies?
• Two criteria can be utilized to help Maria
choose her strategy
– Risk tolerance - of the firm,as expressed in its
stated policies and
– Viewpoint – Maria’s own view on the expected
direction and distance of the exchange rate
10-42
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Strategy Choice and Outcome
• After all the strategies have been explained,
Trident now needs to compare the alternatives
and their outcomes in order to choose a strategy
• There were four alternatives available to manage
this account receivable and Maria has a budget
rate at which she cannot fall below on this
transaction
10-43
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Strategy Choice and Outcome
Hedging Strategy
Outcome/Payout
Remain uncovered
Unknown
Forward Contract hedge @ $1.754/£
$1,754,000
Money market hedge @ 8% p.a.
$1,755,396
Money market hedge @ 12% p.a.
$1,772,605
Put option hedge @ strike $1.75/£
10-44
Minimum if exercised
$1,722,746
Maximum if not exercised
Unlimited
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Managing an Account Payable
• Just as Maria’s alternatives for managing
the receivable, the choices are the same
for managing a payable
– Assume that the £1,000,000 was an account
payable in 90 days
• Remain unhedged – Trident could wait the
90 days and at that time exchange dollars
for pounds to pay the obligation
– If the spot rate is $1.76/£ then Trident would
pay $1,760,000 but this amount is not certain
10-45
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Managing an Account Payable
• Use a forward market hedge – Trident could
purchase a forward contract locking in the
$1.754/£ rate ensuring that their obligation will
not be more than $1,754,000
• Use a money market hedge – this hedge is
distinctly different for a payable than a receivable
– Here Trident would exchange US dollars spot and invest
them for 90 days in pounds
– The pound obligation for Trident is now offset by a pound
asset for Trident with matching maturity
10-46
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Managing an Account Payable
• Using a money market hedge –
– To ensure that exactly £1,000,000 will be
received in 90 days time, Maria discounts the
principal by 8% p.a.
£1,000,000
 £980,392.1
6
 
90 
1   .08 x 360

 
This £980,392.16 would require $1,729,411.77
at the current spot rate
£980,392.1
6 x $1.7640/£ $1,729,411
.77
10-47
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Managing an Account Payable
• Using a money market hedge –
– Finally, carry the cost forward 90 days in order
to compare the payout from the money market
hedge
 
90 
$1,729,411.77 x 1   0.12 x
  $1,781,294.12
360
 
This is higher than the forward hedge of
$1,754,000 thus unattractive
10-48
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Managing an Account Payable
• Using an option hedge – instead of
purchasing a put as with a receivable,
Maria would want to purchase a call option
on the payable
– The terms of an ATM call option with strike
price of $1,75/£ would be a 1.5% premium
£1,000,000x 0.015x $1.75/£ $26,460
Carried forward 90 days the premium amount is
comes to $27,254
10-49
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Managing an Account Payable
• Using an option hedge –
– If the spot rate is less than $1.75/£ then the
option would be allowed to expire and the
£1,000,000 would be purchased on the spot
market
– If the spot rate rises above $1.75/£ then the
option would be exercised and Trident would
exchange the £1,000,000 at $1.75/£ less the
option premium for the payable
Exercise call option (£1,000,000  $1.75/£
Call option premium (carried forward 90 days)
Total maximum expense of call option hedge
10-50
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$1,750,000
$27,254
$1,777,254
Exhibit 10.6 Valuation of Hedging
Alternatives for an Account Payable
10-51
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Risk Management in Practice
• Which Goals?
– The treasury function of most firms is usual considered a
cost center; it is not expected to add to the bottom line
– However, in practice some firms’ treasuries have become
aggressive in currency management and act as profit
centers
• Which Exposures?
– Transaction exposures exist before they are actually
booked yet some firms do not hedge this backlog
exposure
– However, some firms are selectively hedging these
backlog exposures and anticipated exposures
10-52
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Risk Management in Practice
• Which Contractual Hedges?
– Transaction exposure management programs
are generally divided along an “option-line;”
those which use options and those that do not
– Also, these programs vary in the amount of risk
covered; these proportional hedges are policies
that state which proportion and type of
exposure is to be hedged by the treasury
10-53
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Translation Exposure
• Translation exposure, also called accounting
exposure, arises because the financial statements of
foreign subsidiaries must be restated in the parent’s
reporting currency for the firm to prepare its consolidated
financial statements
• Translation exposure is the potential for an increase or
decrease in the parent’s net worth and reported income
caused by a change in exchange rates since the last
transaction
• Translation methods differ by country along two
dimensions
– One is a difference in the way a foreign subsidiary is
characterized depending on its independence
– The other is the definition of which currency is most
important for the subsidiary
10-54
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Subsidiary Characterization
• Most countries specify the translation method to
be used by a foreign subsidiary based upon its
operations
• A foreign subsidiary can be classified as
– Integrated Foreign Entity – one which operates as an
extension of the parent company, with cash flows and line
items that are highly integrated with the parent
– Self-sustaining Foreign Entity – one which operates in
the local economy independent of its parent
• The foreign subsidiary should be valued in terms
of the currency that is the basis of its economic
viability
10-55
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Functional Currency
• A foreign affiliate’s functional currency is
the currency of the primary economic
environment in which the subsidiary
operates
• The geographic location of a subsidiary and
its functional currency can be different
– Example: US subsidiary located in Singapore
may find that its functional currency could be
• US dollars (integrated subsidiary)
• Singapore dollars (self-sustaining subsidiary)
• British pounds (self-sustaining subsidiary)
10-56
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Translation Methods
• There are two basic methods for the translation of
foreign subsidiary financial statements
– The current rate method
– The temporal method
• Regardless of which is used, either method must
designate
– The exchange rate at which individual balance sheet and
income statement items are remeasured
– Where any imbalances are to be recorded
• This can affect either the balance sheet or the income
statement
10-57
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Current Rate Method
• Under this method all financial statement items are translated
at the “current” exchange rate
• Assets & liabilities – are translated at the rate of exchange in
effect on the balance sheet date
• Income statement items – all items are translated at either
the actual exchange rate on the dates the various revenues,
expenses, gains and losses were incurred or at a weighted
average exchange rate for the period
• Distributions – dividends paid are translated at the rate in
effect on the date of payment
• Equity items – common stock and paid-in capital are
translated at historical rates; year end retained earnings
consist of year-beginning plus or minus any income or loss on
the year
10-58
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Current Rate Method
• Any gain or loss from re-measurement is closed to
an equity reserve account entitled the cumulative
translation adjustment, rather than through the
company’s consolidated income statement
• These cumulative gains and losses from
remeasurement are only recognized in current
income under the current rate method when the
foreign subsidiary giving rise to that gain or loss is
liquidated
10-59
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Temporal Method
• Under this method, specific assets and liabilities
are translated at exchange rates consistent with
the timing of the item’s creation
• The temporal method assumes that a number of
line items such as inventories and net plant and
equipment are restated to reflect market value
• If these items were not restated and carried at
historical costs, then the temporal method
becomes the monetary/non-monetary method
10-60
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Temporal Method
• Line items included in this method are
– Monetary assets (primarily cash, accounts
receivable, and long-term receivables) and all
monetary liabilities are translated at current
exchange rates
– Non-monetary assets (primarily inventory and
plant and equipment) are translated at
historical exchange rates
– Income statement items – are translated at the
average exchange rate for the period except for
depreciation and cost of goods sold which are
associated with non-monetary items, these
items are translated at their historical rate
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Temporal Method
• Line items included in this method are
– Distributions – dividends paid are translated at the
exchange rate in effect the date of payment
– Equity items – common stock and paid-in capital are
translated at historical rates; year end retained earnings
consist of year-beginning plus or minus any income or
loss on the year plus or minus any imbalance from
translation
• Under the temporal method, any gains or losses
from remeasurement are carried directly to
current consolidated income and not to equity
reserves
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US Translation Procedures
• The US differentiates foreign subsidiaries on the
basis of functional currency, not subsidiary
characterization
• Under US GAAP, following are the procedures for
foreign subsidiary translation
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Translation Example – Trident
Europe
• As we continue with our Trident example we now shift from
Trident’s operating exposure to its translation exposure
• Recall that the euro depreciated by 16.67% or moved from
$1.200/€ in December 2002 to $1.000/€ in January 2003
• The functional currency of the subsidiary is the euro and the
currency of the parent is US dollars
• PP&E, common stock, and long-term debt were acquired by
Trident Europe at a past rate of $1.2760/€
• Inventory on hand was purchased or manufactured during the
immediately prior quarter when the average exchange rate
was $1.2180/€
• The example will also look at the consequences had the euro
appreciated to $1.3200/€
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Exhibit 10.7 Trident Corporation:US
Multinational
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Exhibit 10.9 Trident Europe: Translation
Loss Just After Depreciation of the Euro
Copyright
© 2009
Pearson
Prentice
Hall.
All reserved.
rights reserved.
10-66
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Pearson
Education,
Inc. All
rights
Exhibit 10.10 Trident Europe: Translation
Loss Just After Depreciation of the Euro
(cont.)
Copyright
© 2009
Pearson
Prentice
Hall.
All reserved.
rights reserved.
10-67
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Pearson
Education,
Inc. All
rights
Managerial Implications
• In the previous slides, the translation loss or gain
is larger under the current rate method because
inventory and PP&E as well as monetary assets
are deemed exposed
• The managerial implications are
– If management expects a currency to depreciate, it could
minimize translation exposure by reducing net exposed
assets
– If management expects appreciation, it should increase
net exposed assets to benefit from the gain
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Managing Translation Exposure
• Balance Sheet Hedge – this requires an equal
amount of exposed foreign currency assets and
liabilities on a firm’s consolidated balance sheet
– A change in exchange rates will change the value of
exposed assets but offset that with an opposite change in
liabilities
– This is termed monetary balance
– The cost of this method depends on relative borrowing
costs in the varying currencies
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Managing Translation Exposure
• When is a balance sheet hedge justified?
– The foreign subsidiary is about to be liquidated
so that the value of its CTA would be realized
– The firm has debt covenants or bank
agreements that state the firm’s debt/equity
ratios will be maintained within specific limits
– Management is evaluated on the basis of
certain income statement and balance sheet
measures that are affected by translation losses
or gains
– The foreign subsidiary is operating in a
hyperinflationary environment
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Choosing Which Exposure to
Minimize
• As a general matter, firms seeking to reduce both
types of exposures typically reduce transaction
exposure first
• They then recalculate translation exposure and
then decide if any residual translation exposure
can be reduced without creating more transaction
exposure
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Summary of Learning Objectives
• MNEs encounter three types of currency exposure: (1)
transaction; (2) operating; and (3) translation exposure
• Transaction exposure measures gains or losses that arise
from the settlement of financial obligations whose terms are
stated in a foreign currency
• Operating exposure measures the change in the present
value of the firm resulting from any change in future
operating cash flows caused by an unexpected change in
exchange rates
• Translation exposure is the potential for accounting-oriented
changes in owner’s equity when a firm translates foreign
subsidiaries’ financial statements to consolidated financial
statements
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Summary of Learning Objectives
• Considerable theoretical debate exists as to whether firms
should hedge currency risk. Theoretically, hedging reduces
the variability of the cash flows to the firm. It does not
increase the cash flows to the firm. In fact, the costs of
hedging may potentially lower them
• Transaction exposure can be managed by contractual
techniques and certain operating strategies. Contractual
hedging techniques include forward, futures, money market,
and option hedges
• The choice of which contractual hedge to use depends on the
individual firm’s currency risk tolerance and its expectation
of the probable movement of exchange rates over the
transaction exposure period
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Summary of Learning Objectives
• In general, if an exchange rate is expected to move in a
firm’s favor, the preferred contractual hedges are probably
those which allow it to participate in some up-side potential,
but protect it against significant adverse exchange rate
movements
• In general, if the exchange rate is expected to move against
the firm, the preferred contractual hedge is one which locks
in an exchange rate, such as the forward contract hedge or
money market hedge
• Risk management in practice requires a firm’s treasury
department to identify its goals. Is treasury a cost center or
profit center?
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Summary of Learning Objectives
• Treasury must also choose which contractual hedges it
wishes to use and what proportion of the currency risk
should be hedged. Additionally, treasury must determine
whether the firm should buy and/or sell currency options, a
strategy that has historically been risky for some firms and
banks
• Translation exposure results from translating foreign–
currency-denominated statements of foreign subsidiaries
into the parent’s reporting currency so the parent can
prepare consolidated financial statements. Translation
exposure is the potential for loss or gain from this translation
process
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Summary of Learning Objectives
• A foreign subsidiary’s functional currency is the currency of
the primary economic environment in which the subsidiary
operates and in which it generates cash flows. In other
words, it is the dominant currency used by that foreign
subsidiary in its day-today operations
• The two basic procedures for translation used in most
countries today are the current rate method and the
temporal method
• Technical aspects of translation include questions about
when to recognize gains or losses in the income statement,
the distinction between functional and reporting currency,
and the treatment of subsidiaries in hyperinflation countries
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Summary of Learning Objectives
• Translation gains and losses can be quite different from
operating gains and losses, not only in magnitude but also in
sign. Management may need to determine which is of greater
significance prior to deciding which exposure is to be
managed first
• The main technique for managing translation exposure is a
balance sheet hedge. This calls for having an equal amount of
exposed foreign currency assets and liabilitie
• Even if management chooses to follow an active policy of
hedging translation exposure, it is nearly impossible to offset
both transaction and translation exposure simultaneously. If
forced to choose, most managers will protect against
transaction losses because these are realized cash losses,
rather than protect against translation losses
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