Fin 4328 (Moore)
Chapter 10 Notes and Problems
Summer 2006
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
A. TYPES
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.
Accounting Exposure
B. Accounting Exposure =
Transaction risk + Translation risk
How Accounting Exposure Arises
Translation Risk
United States
Japan
Subsidiary Financials
¥
£
Headquarters’ £
Consolidated
Financials
Subsidiary Financials
$
£
Subsidiary Financials
€
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Germany
Fin 4328 (Moore)
Chapter 10 Notes and Problems
Summer 2006
ALTERNATIVE MEASURES OF FOREIGN EXCHANGE EXPOSURE
C. Economic Exposure
= Transaction Exposure +Operating Exposure
Operating Exposure arises because exchange rate changes alter
the value of future revenues and costs.
PART II. ALTERNATIVE CURRENCY TRANSLATION METHODS (ACCY)
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.
B. Monetary/Nonmonetary Method
1. Monetary accounts use current rate
2. Pertains to
- Cash
- Accounts receivable
- Accounts payable
- Long term debt
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.
C. Temporal Method
1. Similar to monetary/non-monetary method.
2. Use current method for inventory.
D. Current Rate Method
all statements use current exchange rate for conversions.
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Fin 4328 (Moore)
Chapter 10 Notes and Problems
Summer 2006
I. FASB NO. 52
A.
Dissatisfaction with FASB No. 8: “true” profitability often
disguised by exchange rate volatility.
B.
Translation Gains or Losses:
1. 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.
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Fin 4328 (Moore)
Chapter 10 Notes and Problems
Summer 2006
Sample Problem
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
on
Dec 31
= $.1270
= $.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
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Fin 4328 (Moore)
Chapter 10 Notes and Problems
Summer 2006
PART TWO
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
c. Implementation
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
D. Cross-hedging
E. Exposure netting
F. Forward market hedge
G. Foreign currency options
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Fin 4328 (Moore)
Chapter 10 Notes and Problems
Summer 2006
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
5. Drawback: not possible with informed customers/suppliers.
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.
The Zone
Take no actions
$1.50/£
$1.60/£
Take no
action
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.
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Fin 4328 (Moore)
Chapter 10 Notes and Problems
Summer 2006
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.
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.
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.
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Fin 4328 (Moore)
Chapter 10 Notes and Problems
Summer 2006
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.
2. Forward contracts
Reducing a firm’s translation exposure by creating an offsetting
asset or liability in the foreign currency.
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.
B. Basic hedging strategy for reducing translation exposure:
1.
2.
3.
4.
Increasing hard-currency (likely to appreciate) assets.
Decreasing soft-currency (likely to depreciate) assets.
Decreasing hard-currency liabilities.
Increasing soft-currency liabilities.
How to increase soft-currency liabilities





Reduce the level of cash,
Tighten credit terms to decrease accounts receivable,
Increase LC borrowing,
Delay accounts payable, and
Sell the weak currency forward.
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Fin 4328 (Moore)
Chapter 10 Notes and Problems
Summer 2006
EASY (factual)
10.1 Under FASB 52, foreign exchange gains and losses
a. flow into a special reserve account
b. are usually determined according to the current rate method
c. both a and b
d. flow directly into the income statement
10.2 Translation exposure reflects the exposure of a company's
a. foreign operations to currency movements
b. foreign sales to currency movements
c. financial statements to currency movements
d. cash flows to currency movements
10.8 The functional currency of a Colombian manufacturing subsidiary selling
exclusively to the U.S.
a. depends on where it sources its raw materials
b. depends on where it sells the completed product
c. will be the Colombian peso
d. will be the U.S. dollar
10.9 The functional currency of a Mexican subsidiary that both manufactures and
sells most of its output in Mexico will
a. always be the U.S. dollar
b. always be the Mexican peso
c. be the U.S. dollar unless Mexico has a high rate of inflation
d. be the Mexican peso unless Mexico has a high rate of inflation
10.21 Hedging cannot provide protection against ________ exchange rate
changes.
a. expected
b.
nominal
c.
real
d.
pegged
10.22 The basic hedging strategy involves
a. reducing hard currency assets and soft currency liabilities
b. increasing hard currency liabilities and soft currency assets
c.
reducing soft currency assets and hard currency liabilities
d.
converting soft currencies to hard currencies and lending hard
currencies
10.23 Firms that attempt to reduce risk and beat the market simultaneously may
end up with
a.
more risk, not less
b.
less risk
c.
a profit as well as reduced risk
d.
a loss as well as reduced risk
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Fin 4328 (Moore)
Chapter 10 Notes and Problems
Summer 2006
10.25 In a forward market hedge, a company that is long a foreign currency will
____ the foreign currency forward.
a.
buy
b.
sell
c.
borrow
d.
lend
10.27 A __________ involves offsetting exposures in one currency with exposures
in the same or another currency, where exchange rates are expected to
move in such a way that losses on the first exposed position should be offset
by gains on the second currency exposure and vice versa.
a. forward contract
b. currency collar
c. money-market hedge
d. currency option
10.29 Compaq Computer has a £1 million receivable that it expects to collect in
one year. Suppose the interest rate on pounds is 15%. How could Compaq
protect this receivable using a money market hedge?
a. borrow £1 million pounds today
b. lend £1 million pounds today
c. borrow £869,565 pounds today
d. lend £986,754 pounds today
10.31 American Airlines hedges a £2.5 million receivable by selling pounds
forward. If the spot rate is £1 = $1.73 and the 90-day forward rate is
$1.7158, what is American's cost of hedging?
a. $142,000
b. $35,500
c. $8,875
d. it is unknown at the time American enters into its hedge
10.33 Suppose PepsiCo hedges a ¥1 billion dividend it expects to receive from its
Japanese subsidiary in 90 days with a forward contract. The current spot
rate is ¥150/$1 and the 90-day forward rate is ¥149/$1. If the spot rate in
90 days is ¥154/$, how much has this forward market hedge cost PepsiCo?
a. $173,160
b. $44,743
c. Pepsi gains $173,160 from the forward contract
d. Pepsi gains $217,903 from the forward contract
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Fin 4328 (Moore)
Chapter 10 Notes and Problems
Summer 2006
10.34 If you fear the dollar will rise against the Spanish peseta, with a resulting
adverse change in the dollar value of the equity of your Spanish subsidiary,
you can hedge by
a. selling pesetas forward in the amount of net assets
b. buying pesetas forward in the amount of net assets
c. reducing the liabilities of the subsidiary
d. selling pesetas forward in the amount of total assets
10.35 On March 1, Bechtel submits a franc-denominated bid on a project in France.
Bechtel will not learn until June 1 whether it has won the contract. What is
the most appropriate way for Bechtel to manage the exchange risk on this
contract?
a. sell the franc amount of the bid forward for U.S. dollars
b. buy French francs forward in the amount of the contract
c. buy a put option on francs in the amount of the franc exposure
d. sell a call option on francs in the amount of franc exposure
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Fin 4328 (Moore)
Chapter 10 Notes and Problems
Summer 2006
Ajax Manufacturing's German subsidiary has the following balance sheet:
Cash, marketable
securities
Accounts receivable
Inventory (at
market.
Fixed Assets
DM 250,000
1,000,000
2,700,000
5,100,000
---------------DM 9,050,000
Current liabilities
Long-term debt
Equity
DM 750,000
3,400,000
4,900,000
Total liabilities
plus equity
--------------DM 9,050,000
Total assets
Suppose the DM appreciates from $0.70 to $0.76 during the period.
10.14 Under the current/noncurrent method, what is Ajax's translation gain
(loss).?
a. a gain of $294,000
b. a gain of $192,000
c. a loss of $174,000
d. a loss of $12,000
ANSWER: b: p. 253, current/non current method
10.15 Under the temporal method, what is Ajax's translation gain (loss).?
a. a gain of $294,000
b. a gain of $192,000
c. a loss of $174,000
d. a loss of $12,000
ANSWER: d: p. 254, temporal method
10.16 Under the current rate method, what is Ajax's translation gain (loss).?
a. a gain of $294,000
b. a gain of $192,000
c. a loss of $174,000
d. a loss of $12,000
ANSWER: a: p. 254, current rate method
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