Measuring/Managing Translation and Transaction Exposure Chapter 10 Lecture Notes

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 =
risk
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Transaction risk
Translation
Fin 4328 (Moore)
Summer 2006
How Accounting Exposure Arises

Translation Risk
Japan
Subsidiary Financials
United States
Headquarters
Consolidated
Financials
Germany
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.
(ACCY)
ALTERNATIVE
CURRENCY
TRANSLATION
METHODS
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
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Summer 2006
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.
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.
account.
Known
as
cumulative
translation
adjustment
C. New Distinction in FASB No. 52: functional v. reporting

currency
1. Functional currency for foreign subsidiary:
- The currency used in the primary
environment in which it operates.
economic
2. Reporting currency :
- The currency the parent firm uses to prepare its
financial statements.
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Fin 4328 (Moore)
D.When Functional and Reporting
Summer 2006
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.
firm.
Accounting exposure reflects past decisions of the
B. Economic exposure
1. Focuses on future impact of exchange rate changes.
2.
Not all future cash flows appear on the firms
balance sheet.
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 = $.1270
on
Dec 31 = $.1180
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Summer 2006
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
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.
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Summer 2006
D.Centralization is key
1. Important aspects:
a. Degree of centralization
b. Responsibility for its development
c. Implementation
2. Maximum benefits accrue from centralizing policymaking, 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
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.
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Summer 2006
The Zone
Take no actions
$1.60/
$1.50/
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.
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
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Summer 2006
- 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.
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
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Summer 2006
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
exposure:
strategy
for
reducing
translation
1. Increasing hard-currency (likely to appreciate) assets.

2. Decreasing soft-currency (likely to depreciate) assets.
3. Decreasing hard-currency liabilities.
4. Increasing soft-currency liabilities.
How to increase soft-currency liabilities
Reduce the level of cash,

Tighten credit terms to decrease
receivable,
Increase LC borrowing,
Delay accounts payable, and
Sell the weak currency forward.
accounts
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
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Fin 4328 (Moore)

c. will be the Colombian peso
d. will be the U.S. dollar
Summer 2006
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
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
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Fin 4328 (Moore)

Summer 2006
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
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)
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
9,050,0
00
Current
liabilities
Long-term debt
Equity
Total liabilities
plus equity
DM 750,000
3,400,000
4,900,000
--------------DM
9,050,0
00
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
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Fin 4328 (Moore)

d. a loss of $12,000
ANSWER: b: p. 253, current/non current method
Summer 2006
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
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
ANSWER: a: p. 254, current rate method
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Chapter 10 Notes and Problems