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

Subsidiary Financials

Japan

Headquarters Consolidated Financials

United States
Subsidiary Financials

Translation Risk

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 the value of future revenues and costs. rate changes alter

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 firms balance sheet.

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Fin 4328 (Moore)

Chapter 10 Notes and Problems

Summer 2006

Sample Problem
Suppose on January 1, American Golfs 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. Hedgings 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

A. RISK SHIFTING
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Fin 4328 (Moore)

Chapter 10 Notes and Problems

Summer 2006

1. 2. 3. 4. 5.

Home currency invoicing Zero sum game Common in global business Firm will invoice exports in strong currency, import in weak 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

$1.50/
Take no actions Take no action

$1.60/

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 firms local currency accounting exposure.

2. Forward contracts
Reducing a firms 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) EASY 10.1 a. b. c. d. 10.2 a. b. c. d.

Chapter 10 Notes and Problems

Summer 2006

(factual) Under FASB 52, foreign exchange gains and losses flow into a special reserve account are usually determined according to the current rate method both a and b flow directly into the income statement Translation exposure reflects the exposure of a company's foreign operations to currency movements foreign sales to currency movements financial statements to currency movements 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 nominal real 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

b. c. d.

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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

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 - 10 -

Fin 4328 (Moore) a. b. c. d.

Chapter 10 Notes and Problems

Summer 2006

selling pesetas forward in the amount of net assets buying pesetas forward in the amount of net assets reducing the liabilities of the subsidiary 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

Ajax Manufacturing's German subsidiary has the following balance sheet: - 11 -

Fin 4328 (Moore) Cash, marketable securities Accounts receivable Inventory (at market. Fixed Assets Total assets

Chapter 10 Notes and Problems DM 250,000 1,000,000 2,700,000 5,100,000 ----------------DM 9,050,000 Current liabilities Long-term debt Equity Total liabilities plus equity

Summer 2006 DM 750,000 3,400,000 4,900,000 --------------DM 9,050,000

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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