Measuring and Managing
Foreign Exchange Exposure
International Financial Management
Dr. A. DeMaskey
1
Learning Objectives
• What are the three different types of foreign
exchange exposures?
• How is translation and transaction exposure
measured?
• What are the two primary methods of converting
foreign currency denominated financial statements
into the reporting currency of the U.S. parent
company?
• What are the basic hedging strategies and
techniques used by firms to manage their currency
transaction and translation risks?
2
Foreign Exchange Risk
Management
• Exposure refers to the degree to which a
company is affected by exchange rate
changes.
• Exchange rate risk is defined as the
variability of a firm’s value due to uncertain
changes in the rate of exchange.
3
Foreign Exchange Risk
Management
• Managing accounting exposure centers
around the concept of hedging, which
means:
– Entering into an offsetting currency position so
whatever is lost/gained on the original currency
exposure is exactly offset by a corresponding
currency gain/loss on the currency hedge.
– The coordinated buying or selling of a currency
to minimize exchange rate risk.
4
Types of Exposures
• Translation Exposure
• Transaction Exposure
• Operating Exposure
Economic Exposure
• Tax Exposure
5
Translation Exposure
• It arises from the need, for purposes of
reporting and consolidation, to convert the
results of foreign operations from the local
currency to the home currency.
– Paper exchange gains or losses
– Retrospective in nature
– Short-term in nature
6
Transaction Exposure
• It stems from the possibility of incurring
exchange gains or losses on transactions
already entered into and denominated in a
foreign currency.
– Real exchange gains or losses
– Mixes retrospective and prospective
– Short-term in nature
7
Operating Exposure
• It arises because currency fluctuations
combined with price level changes can alter
the amounts and riskiness of a firm’s future
revenues and costs.
– Real exchange gains or losses
– Prospective in nature
– Long-term in nature
8
Economic Exposure
• It is defined as the extent to which the value
of the firm, as measured by the present
value of all expected future cash flows, will
change when exchange rates change.
9
Tax Exposure
• The tax consequence of foreign exposure
varies by countries.
• As a general rule:
– Only realized foreign exchange losses are tax
deductible.
– Only realized foreign exchange gains create
taxable income
10
Measuring Translation
Exposure
• The difference between exposed assets and
exposed liabilities.
– Exposed assets and liabilities are translated at
the current exchange rate.
– Non-exposed assets and liabilities are translated
at the historical exchange rate.
11
Currency Translation Methods
• Translation methods differ by country along two
dimensions.
• Subsidiary Characterization
– Integrated foreign entity
– Self-sustained entity
• Functional Currency
– The currency of the primary economic environment in
which the subsidiary operates and in which it generates
and expends cash.
12
Translation Methods
• 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
13
Current Rate Method
• All financial statement items are translated at the
“current” exchange rate.
–
–
–
–
Assets & liabilities
Income statement items
Dividends
Equity account
• Unrealized translation gains or losses are recorded
in a separate equity account on the parent’s
consolidated balance sheet called the
“Cumulative Translation Adjustment (CTA)”
account.
14
Temporal Method
• Specific assets and liabilities are translated
at exchange rates consistent with the timing
of the item’s creation.
– It 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.
15
Temporal Method
• Line items included in this method are
–
–
–
–
–
Monetary balance sheet items
Non-monetary balance sheet items
Income statement items
Dividends
Equity account
• Unrealized translation gains or losses are recorded
within the income statement, not to equity
reserves, thereby affecting net income.
16
US Translation Procedures
• The US differentiates foreign subsidiaries on the
basis of the functional currency, not subsidiary
characterization.
• This, in turn, determines which translation method
is used:
– Local currency
Current rate method
– U.S. dollar
Temporal method
17
Hyperinflation Countries
• A hyperinflationary country is one which
has cumulative inflation of approximately
100% or more over a three year period.
– Functional currency
U.S. dollar
– Translation method
Temporal method
18
Measuring Translation Exposure:
Illustration
Zapata Auto Parts, the Mexican affiliate of American
Diversified, Inc., had the following balance sheet on January 1:
Assets (Ps million)
Liabilities (Ps million)
Cash, marketable securities 1,000
Current liabilities
47,000
Accounts receivables
50,000
Long-term debt
12,000
Inventory
32,000
Equity
135,000
Fixed assets
111,000
194,000
194,000
______________________________________________________________
The exchange rate on January 1 was Ps 8,000/$ and on December 31 is Ps
12,000/$
19
Transaction Exposure
• It arises from the various types of
transactions that require settlement in a
foreign currency.
– Purchasing or selling on credit goods or
services denominated in foreign currency.
– Borrowing and lending funds with repayment
made in foreign currency.
– Acquiring assets denominated in foreign
currency.
20
Net Transaction Exposure
• Is measured currency by currency.
• Is the difference between contractually
fixed future cash inflows and cash outflows
in each currency.
• It represents real gains and losses.
21
Designing a Hedging Strategy
• Management of Foreign Exchange
Exposure
• Organizational Policies for Managing
Exposure
– Degree of centralization
– Responsibility
• Statement of Objectives
22
Hedging Strategy Objectives
• Minimize translation exposure.
• Minimize quarter-to-quarter earnings fluctuations
arising from exchange rate changes.
• Minimize transaction exposure.
• Minimize economic exposure.
• Minimize foreign exchange risk management
costs.
• Avoid surprises.
23
Managing Translation Exposure
Assets
Liabilities
Hard currencies
Increase
Decrease
Soft currencies
Decrease
Increase
______________________________________________
______________________________________
24
Balance Sheet Hedge
• It 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 the monetary balance.
– The cost of this method depends on relative
borrowing costs in the varying currencies.
25
Funds Adjustment
• Altering either the amounts or the
currencies or both of the planned cash flows
of the parent and/or subsidiary.
• Funds Adjustment Methods
– Direct
– Indirect
26
Forward Market Hedge
• Uncovered or open hedge.
• Not a hedge but an attempt to gain by
forward speculation a sum equal to the book
loss in translation.
• Success depends on precise prediction of
future exchange rates.
• Such a hedge will increase the tax burden.
27
Managing Transaction Exposure
• A transaction exposure arises whenever a
company is committed to a foreign currency
denominated transaction.
• Protective measures to guard against
transaction exposure involve entering into
foreign currency transactions whose cash
flows exactly offset in whole or in part the
cash flows of the transaction exposure.
28
Managing Transaction Exposure
• Contractual Hedges
• Operating Strategies
– Forward Market Hedge
– Risk Shifting
– Money Market Hedge
– Price adjustment
clauses
– Options Market Hedge
– Futures Market Hedge
– Exposure Netting
– Risk Sharing
• Financial Hedges
– Swaps
29
Managing Transaction Exposure:
Illustration
• American Airlines is trying to decide how to go
about hedging €70 million in ticket sales
receivable in 180 days. The following exchange/
interest rates are available:
 Spot rate
 180-day forward rate
 Euro 180-day interest rate (p.a.)
 U.S.$ 180-day interest rate (p.a.)
$0.6433-42/€
$0.6578-99/€
4.01%-3.97%
8.01%-7.98%
30
Alternative Use of Hedging
Techniques
Remain unhedged.
Hedge in the forward market.
Hedge in the money market.
31
Unhedged Position
• American Airlines will wait 180 days and
receive an unknown amount of U.S. dollars,
depending on the spot rate prevailing in 180
days, for €70 million of the ticket sales.
32
Future Spot Rate Scenarios
Spot
rate in 180 days
Receivables in dollar terms
____________________________________________
€ 1 = $0.64
€ 1 = $0.67
€____________________________________________
1 = $0.70
SR0 = $0.6433
FR180 = $0.6578
33
Forward Market Hedge
• Involves a forward contract and a source of funds
to fulfill that contract.
• The forward contract is entered at the time the
transaction exposure is created.
• Offsetting receivables/payables denominated in a
foreign currency with a forward contract to
sell/buy that currency.
– Covered hedge
– Uncovered or open hedge
– Cost of forward cover
34
Forward Market Hedge
• To hedge in the forward market, American
Airlines will enter into a 180-day forward
contract to sell €70 million for dollars today
(t=0).
35
Evaluation of Forward Market
Hedge
Future
Value of
Gain/Loss on
Spot
Rate
Receivable (e1)
Forward (f180)
Net Cash Flow
____________________________________________________________
€ 1 = $0.64
€ 1 = $0.6578
€ 1 = $0.67
$46,046,000
$0
$46,046,000
$49,000,000
€ 1 = $0.70
_________________________________________________________
36
Money Market Hedge
• Involves a contract and a source of funds to fulfill
that contract. In this case, the contract is a loan
agreement.
• Reversing foreign currency receivables/payables
by creating matching payables/receivables through
borrowing in the money markets.
–
–
–
–
Covered hedge
Uncovered or open hedge
Cost of money market hedge
Covered interest arbitrage
37
Money Market Hedge
•
To hedge in the money market, American Airlines has to
borrow today (t=0) sufficient euros for 180 days which,
when exchanged today for dollars and invested for 180
days in the U.S., will be paid off with exactly the euro
receivable of €70 million.
Amount of euros borrowed in Germany for 180 days:
Amount of dollars to be invested today in the U.S.:
Amount of dollars received from U.S. investment in 180
days:
38
Comparison of Alternative
Hedging Strategies
Future
Forward
Spot Rate Unhedged Market
Money
Market
€ 1 = $0.64
$44,800,000
€ 1 = $0.6578
€ 1 = $0.67
$46,900,000
€ 1 = $0.70
____________________________________
39
Covered Interest Arbitrage
• IRP does not hold:
– Interest rate differential is not equal to forward
discount/premium on foreign currency.
• Effective forward rate:
40
Futures Market Hedge
• Similar to hedging with forwards
• Limitations:
– Limited number of currencies
– Limited number of maturity dates
– Standardized contract size
• Cross hedge
41
Options Market Hedge
• Offsetting a foreign currency denominated
receivable/payable with a put option or a call
option in that currency.
• Valuable hedging tool when:
– Waiting on the outcome of a bid denominated in
foreign currency
– Using of foreign currency price list
– Shifts in competitor’s currency
42
General Hedging Rule
• Future foreign currency cash outflow
– Certain: Go long futures or forwards
– Uncertain: Buy a call option
• Future foreign currency cash inflow
– Certain: Go short futures or forwards
– Uncertain: Buy a put option
43
Currency Risk Shifting
• Risk shifting: Invoice in U.S. dollar
• Strategy for risk shifting
– Denominating exports in a strong currency.
– Denominating imports in a weak currency.
• Outcome depends on:
– Bargaining power or parties involved.
– Competitiveness of firm’s particular business
44
Exposure Netting
• Offsetting exposures in one currency with
exposures in the same or another currency.
• A firm’s currency exposures can be viewed as a
portfolio.
• Exposure netting depends on the correlation
between currencies.
• Exposure netting strategies:
– Negatively correlated currencies
– Positively correlated currencies
45
Currency Risk Sharing
• Agreement to share currency risk
• Risk sharing arrangements
– Price adjustment clause
– Neutral zone
– Outside neutral zone
46
Currency Collars
• Providing protection if the currency moves
outside an agreed-on range.
– Range forward
– Cylinder
•
•
•
•
Combined put purchase and call sale
Limits upside potential
Provides downside risk protection
Lowers hedging cost
47
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.
48