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Measuring and Measuring and Managing Translation Managing Translation and Transaction and Transaction ExposureExposure

Chapter 9Chapter 9

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PART I. ALTERNATIVE PART I. ALTERNATIVE MEASURES OF FOREIGN MEASURES OF FOREIGN EXCHANGE EXPOSUREEXCHANGE EXPOSURE

I.I. ALTERNATIVE MEASURESALTERNATIVE MEASURES

A.A. TYPESTYPES1.1. Accounting Exposure:Accounting Exposure:

arises when reporting and consolidating arises when reporting and consolidating financial statements requirefinancial statements requireconversion from subsidiary to parent conversion from subsidiary to parent

currencycurrency(difficult to hedge an event that occurred (difficult to hedge an event that occurred

in the past)in the past)

2.2. Economic Exposure:Economic Exposure:arises because arises because unexpectedunexpected exchange exchange

rate changes alter the value of rate changes alter the value of futurefuture revenues and costs. revenues and costs.

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ALTERNATIVE MEASURES OF ALTERNATIVE MEASURES OF FOREIGN EXCHANGE EXPOSUREFOREIGN EXCHANGE EXPOSURE

B.B. Economic Exposure Economic Exposure

= Transaction Exposure +Operating = Transaction Exposure +Operating ExposureExposure

Operating Exposure defined:Operating Exposure defined:

arises because exchange ratearises because exchange rate

changes alter the value of changes alter the value of future revenues and expenses.future revenues and expenses.

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PART II.PART II.ALTERNATIVE CURRENCY ALTERNATIVE CURRENCY TRANSLATION METHODSTRANSLATION METHODS

I.I. FOUR METHODS OF TRANSLATIONFOUR METHODS OF TRANSLATION

A.A. Current/Noncurrent MethodCurrent/Noncurrent Method1. Current accounts use current 1. Current accounts use current exchange rate for exchange rate for

conversion.conversion.

2. 2. Income statement accounts useIncome statement accounts use

average exchange rate for the average exchange rate for the period.period.

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ALTERNATIVE CURRENCY ALTERNATIVE CURRENCY TRANSLATION METHODSTRANSLATION METHODS

B.B. Monetary/Nonmonetary MethodMonetary/Nonmonetary Method

1.1. Monetary accounts use Monetary accounts use currentcurrent

raterate

2.2. Pertains toPertains to- cash- cash- accounts receivable- accounts receivable- accounts payable- accounts payable- current portion long term - current portion long term debtdebt

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ALTERNATIVE CURRENCY ALTERNATIVE CURRENCY TRANSLATION METHODSTRANSLATION METHODS

3.3. Nonmonetary accountsNonmonetary accounts

- use historical rates- use historical rates

- Pertains to - Pertains to

inventoryinventory

fixed assetsfixed assets

long term investmentslong term investments

4.4. Income statement accounts Income statement accounts

- use average exchange rate - use average exchange rate for for the period. the period.

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ALTERNATIVE CURRENCY ALTERNATIVE CURRENCY TRANSLATION METHODSTRANSLATION METHODS

C.C. Temporal MethodTemporal Method

1.1. Similar to Similar to monetary/nonmonetary monetary/nonmonetary method.method.

2.2. Use current method for Use current method for inventory.inventory.

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D. Current Rate MethodD. Current Rate Method

all statements use current exchange all statements use current exchange rate for conversionsrate for conversions

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PART III. PART III. TRANSACTION EXPOSURETRANSACTION EXPOSURE

I. Transaction ExposureI. Transaction Exposure

A. Often included as accounting A. Often included as accounting exposureexposure

B. As a cash-flow exposure, it is B. As a cash-flow exposure, it is rightly rightly

part of economic exposurepart of economic exposure

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PART IV.PART IV.DESIGNING A HEDGING DESIGNING A HEDGING STRATEGYSTRATEGY

I. DESIGNING A HEDGING STRATEGYI. DESIGNING A HEDGING STRATEGY

A.A. StrategiesStrategies

a management objectivea management objective

B.B. Hedging’s basic objective:Hedging’s basic objective:reduce/eliminate volatility ofreduce/eliminate volatility ofearnings as a result of earnings as a result of exchange rate changes. exchange rate changes.

C. It is a cost like insurance.C. It is a cost like insurance.

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PART V.PART V.MANAGING TRANSLATION MANAGING TRANSLATION EXPOSUREEXPOSURE

I.I. MANAGING TRANSLATION EXPOSUREMANAGING TRANSLATION EXPOSURE

A.A. Choices faced by the MNC:Choices faced by the MNC:

1.1. Adjusting fund flows altering Adjusting fund flows altering either either the amounts or the the amounts or the currencies of the currencies of the planned cash planned cash flows of the parent or flows of the parent or its its subsidiaries to reduce the firm’s subsidiaries to reduce the firm’s local currency accounting exposure.local currency accounting exposure.

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MANAGING TRANSLATION MANAGING TRANSLATION EXPOSUREEXPOSURE

2.2. Forward contractsForward contractsreducing a firm’s reducing a firm’s

translation translation exposure by creating an offsetting exposure by creating an offsetting

asset or liability in the asset or liability in the foreign foreign currency.currency.

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MANAGING TRANSLATION MANAGING TRANSLATION EXPOSUREEXPOSURE

3.3. Exposure nettingExposure netting

a. a. offsetting exposures in offsetting exposures in one one currency with currency with exposures in the exposures in the same same or another currency or another currency

b. b. gains and losses on the gains and losses on the two two currency positions currency positions will offset will offset each other.each other.

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MANAGING TRANSLATION MANAGING TRANSLATION EXPOSUREEXPOSURE

B.B. Basic hedging strategy for reducing Basic hedging strategy for reducing translation exposure:translation exposure:

1.1. increasing hard-currency(likely increasing hard-currency(likely to to appreciate) assetsappreciate) assets

2.2. decreasing soft-currency(likely decreasing soft-currency(likely to to depreciate) assetsdepreciate) assets

3.3. decreasing hard-currency decreasing hard-currency liabilitiesliabilities

4.4. increasing soft-currency increasing soft-currency liabilitiesliabilities

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MANAGING TRANSLATION MANAGING TRANSLATION EXPOSUREEXPOSURE

4. (cont’d) How to increase soft-currency 4. (cont’d) How to increase soft-currency liabilities: liabilities:

reduce the level of cash, reduce the level of cash,

tighten credit terms to decrease tighten credit terms to decrease accounts receivable, accounts receivable,

increase LC borrowing, increase LC borrowing,

delay accounts payable delay accounts payable

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PART VI. PART VI. MANAGING TRANSACTION MANAGING TRANSACTION EXPOSUREEXPOSURE

I.I. METHODS OF HEDGINGMETHODS OF HEDGINGA.A. Risk shiftingRisk shiftingB.B. Currency risk sharingCurrency risk sharingC. Currency collarsC. Currency collarsD. Cross-hedgingD. Cross-hedgingE. E. Exposure nettingExposure nettingF.F. Forward market hedgeForward market hedgeG.G. Foreign currency optionsForeign currency options

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MANAGING TRANSACTION MANAGING TRANSACTION EXPOSUREEXPOSURE

A. RISK SHIFTINGA. RISK SHIFTING

1. home currency invoicing1. home currency invoicing

2. zero sum game2. zero sum game

3. common in global business3. common in global business

4. firm will invoice exports in strong 4. firm will invoice exports in strong currency, import in weak currency, import in weak

currencycurrency

5. Drawback:5. Drawback:

it is not possible with informed it is not possible with informed customers or suppliers. customers or suppliers.

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MANAGING TRANSACTION MANAGING TRANSACTION EXPOSUREEXPOSURE

B. CURRENCY RISK SHARINGB. CURRENCY RISK SHARING

1. Developing a customized hedge 1. Developing a customized hedge contract contract

2. The contract typically takes the 2. The contract typically takes the form form of a of a Price Price Adjustment Clause,Adjustment Clause, whereby a base price is adjusted to whereby a base price is adjusted to

reflect certain exchange rate reflect certain exchange rate changes.changes.

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MANAGING TRANSACTION MANAGING TRANSACTION EXPOSUREEXPOSURE

B. CURRENCY RISK SHARING (con’t)B. CURRENCY RISK SHARING (con’t)

3. Parties would share the 3. Parties would share the currency risk currency risk beyondbeyond a a neutral zone of exchangeneutral zone of exchange

rate changes.rate changes.

4. The neutral zone represents 4. The neutral zone represents the the currency range in which risk currency range in which risk is is not not shared. shared.

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MANAGING TRANSACTION MANAGING TRANSACTION EXPOSUREEXPOSURE

C. CURRENCY COLLARSC. CURRENCY COLLARS

1. Contract bought to protect 1. Contract bought to protect against against currency moves outside currency moves outside the neutral the neutral zone.zone.

2. Firm would convert its foreign2. Firm would convert its foreign

currency denominated currency denominated receivablereceivable

at the zone forward rate.at the zone forward rate.

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MANAGING TRANSACTION MANAGING TRANSACTION EXPOSUREEXPOSURE

D.D. CROSS-HEDGINGCROSS-HEDGING

1. Often forward contracts not 1. Often forward contracts not availableavailable

in a certain currency.in a certain currency.

2. Solution: a cross-hedge2. Solution: a cross-hedge

- a forward contract in a related - a forward contract in a related currency. currency.

3. Correlation between 2 currencies is3. Correlation between 2 currencies is

critical to success of this hedge.critical to success of this hedge.

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MANAGING TRANSACTION MANAGING TRANSACTION EXPOSUREEXPOSURE

E.E. EXPOSURE NETTINGEXPOSURE NETTING

1. 1. Protection can be gained by Protection can be gained by selecting currencies that selecting currencies that

minimize minimize exposureexposure

2. 2. Netting:Netting:

MNC chooses currencies that are MNC chooses currencies that are not perfectly positively not perfectly positively

correlated.correlated.

3. 3. Exposure in one currency can beExposure in one currency can be

offset by the exposure in another.offset by the exposure in another.