Measuring and managing Accounting or Translation Exposure

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• Measuring and managing Accounting or Translation
  Exposure
  
• (Shapiro Chapter 10)

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Exposure to Currency Risk

• A key concept is the firms exposure to foreign
  currency risk
  
• FX exposure and FX risk are two completely
  different concepts
  
• --Exchange risk depends on
• Uncertainty about future spot exchange rate (XR)
• --Exchange risk exposure
• Measures how the firm is affected by unexpected
  XR changes
  
• it is a measure of what the firm has at risk
• --a large exposure means that a given XR change
  has a large impact on the firm

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Three Types of Corporate Exposures

• Accounting (translation) exposure
• Changes in the book value of assets and
  liabilities and income caused by changes in
  exchange rates.
  
• Based on activities that occurred in the past.
• Restatement of numbers based on changes in
  exchange rates
  
• Transaction exposure
• Changes in binding future cash flows that are
  linked to foreign currencies e.g. changes in
  exchange rates that affect receivables
  
• Changes in future cash flows that could be based
  on contracts already in place
  
• e.g. payables and receivables, loans and deposits

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Three Types of Corporate Exposures

• Operating exposure
• Changes in exchange rates that affect future
  operating cash flows - revenues and costs
  
• Could affect firms that do not have foreign
  operations
  
• Operating and transaction exposure together
  constitute economic exposure
  

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Accounting or Translation Exposure

• Translation exposure arises because of the need
  for reporting and consolidation purposes to
  translate financial statements of foreign
  affiliates from foreign currencies to the
  parents reporting or home currency.
• Translation exposure is the difference between
  exposed assets and exposed liabilities.

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Alternative Currency Translation Methods

• Companies with international operations will have
  foreign-currency-denominated assets and
  liabilities, revenues, and expenses. However,
  because home-country investors and the entire
  financial community are interested in home
  currency values, the foreign currency balance
  sheet accounts and income statement must be
  assigned HC values.

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Alternative Currency Translation Methods

• 4 methods are currently in use around the world
• The current-noncurrent method (1)
• --survive mainly in low income countries
• The monetary-nonmonetary method (2)
• --use in some industrialized and smaller
  industrial countries
  
• The temporal method (3)
• --a modified version of the monetary-nonmonetary
  method
  
• --use by some major countries usually in
  combination with current rate method
  
• The current rate method (4)
• --use by the majority of countries

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Exchange Rates Used to Translate B/S Items
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Exchange Rates Used to Translate B/S Items
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• Temporal or Monetary/Nonmonetary
• Monetary items such as cash, payables,
  receivables are translated at the current rate
  
• Nonmonetary items such as inventory, fixed assets
  should be valued using historical rates
  
• Equity is translated using the historical rate
  (or the beginning of the period rate or the rate
  relevant at the time of the issue
  
• Income statement items are translated using the
  average rate for all items except Cost of Goods
  sold and Depreciation
  
• COGS is translated at the average rate and
  depreciation at the historical rate (beginning of
  period rate)
  
• Accounting exposure hence is the net monetary
  asset or liability position since nonmonetary
  assets are translated at historical rates (and
  their value is not affected)
• Changes to the value of the monetary assets due
  to changes in exchange rates (translation gains
  or losses) are included in the parents income
  statement

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• Current/Non current
• All current assets of a foreign subsidiary are
  translated using the current exchange rate
  
• All noncurrent assets and liabilities are
  translated at historical exchange rates (at time
  of purchase)
  
• All income statement items are translated at the
  average rate
  
• All balance sheet items are translated at the
  current rate except equity which is translated at
  the historical rate
  
• Since all assets and liabilities are translated
  at the current rate, the accounting exposure is
  the parents net investment in the foreign
  operations
• Gains or losses arising from translation are
  reported as a component of stockholders equity
  and do not flow through to the income statement
  
• Foreign currency related gains and losses would
  bypass the income statement and will be reported
  in an account called cumulative translation
  adjustment

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U.S. Concept of Financial Currency

• Functional currency
• The currency in which the subsidiary primarily
  conducts its business
  
• The functional currency choice is between
• --the parent currency (the dollar)
• --a foreign currency that the subsidiary
  primarily operates in
  
• Choice of functional currency determines the
  method used for foreign subsidiary translation
  
• --dollar as functional currency ? temporal
  method
  
• --FC as functional currency ? current rate
  method

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• Use local currency if the entity is self
  contained and operating primarily in local
  markets current method is used to report
  changes in financials
• If the subsidiary is an integrated part of the
  parent (sales outlets for the parent), use the
  parents currency a Hong Kong assembly plant
  for radios that sources components in the U.S.
  and also sells to U.S. consumers - here the
  functional currency could be the dollar
  temporal method is used
• If the subsidiary is operating in a super
  inflationary environment use the parents
  currency as the functional currency temporal
  method is used

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Temporal Method

• Embodies a parent-company perspective
• Restates the subsidiaries a/cs as if they had
  originally been recorded in the parent currency
  (PC)
  
• Foreign currency items are re-measured in PC
• --as a result the temporal method is often
  called re-measurement rather than translation
  
• Implication
• --reported income is affected by both realized
  and unrealized XR gains/losses

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Current Rate (CR) Method

• Embodies a subsidiary perspective
• FC operating and financial ratios are largely
  preserved under the CR translation method
  
• Realized XR gains/losses taken into account
• Unrealized XR gains/losses report directly in
  B/S
  
• Implication
• --reported income is not affected by
  unrealized XR gains/losses

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• Temporal method Current method
• Monetary
• assets and lia. Current rate Current rate
• Other assets Historical rate Current rate
• Inventory Historical rate Current rate
• Equity Historical rate Historical rate
• Revenues Average rat e Average rate
• Expenses Average rate Average rate
• COGS Historical rate Average rate
• Depreciation Historical rate Average rate

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• Example (from Shapiro) Sterling Ltd.is the
  British subsidiary of a U.S. company. The firm
  acquired fixed assets during the year. The
  following are the exchange rates relevant for
  translation
• Beginning of year 1.50 1
• End of the year 1.30 1
• Average exchange rate 1.40 1
• Historical rate for inventory 1.45 1
• No dividends are paid during the year

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Managing Translation Exposure

• Basic strategy
• --increase hard currency assets and decrease
  soft currency assets
  
• --decrease hard currency liabilities and
  increase soft currency liabilities
  

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Managing Translation Exposure

• Three methods
• Adjusting fund flows
• --if FC likely to appreciate then increase
  assets and reduce liabilities
  
• ex increase cash, reduce account payable
• --these hedging activities are not valuable if
  the market recognize the likelihood of
  appreciation (already reflected on prices)
  
• Entering into forward contracts
• Exposure netting this involves offsetting
  exposures in one currency with exposures in the
  same or another currency such that gains and
  losses on the two currency positions will offset
  each other