MEASURING ACCOUNTING EXPOSURE I. ALTERNATIVE MEASURES OF FOREIGN EXCHANGE EXPOSUREII. ALTERNATIVE CURRENCY TRANSLATION METHODSIII. STATEMENT OF FINANCIAL ACCOUNTING STANDARDS NO.52

Fred Thompson

CHAPTER OVERVIEW (cont)IV.TRANSACTION EXPOSUREV.DESIGNING A HEDGING STRATEGYVI.MANAGING TRANSLATION EXPOSUREVII.MANAGING TRANSACTION EXPOSURE

Fred Thompson

ALTERNATIVE MEASURES OF FOREIGN EXCHANGE EXPOSUREAccounting/Translation Exposure: when reporting and consolidating financial statements requires conversion from foreign to local currency. Transaction Exposure: occurs from changes in the value of foreign currency contracts as a result of exchange rate changes.Operating Exposure arises because exchange rate changes may alter the value of future revenues and costs.Economic Exposure = Transaction + Operating Exposures

Fred Thompson

ALTERNATIVE CURRENCY TRANSLATION METHODSCurrent/Noncurrent MethodMonetary/Nonmonetary MethodTemporal MethodCurrent Rate Method

Fred Thompson

STATEMENT OF INANCIAL ACCOUNTING STANDARDS NO. 52A.Dissatisfaction with FASB No. 8 -- true profitability often disguised by exchange rate volatility.B.Balance sheet translation uses current rate method.C.Income statement uses1. Weighted average rate during period or2. The rate in effect when revenue and expenses incurred.D. Translation Gains or Losses1. Recorded in separate equity account on balance sheet.2. Known as cumulative translation adjustment account.E.New Distinction under FASB No. 52: functional v. reporting currency1. 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.3. If foreign subsidiary operations are direct extension of parent firm

Fred Thompson

TRANSACTION EXPOSURE I. WHEN DOES IT OCCUR?A. From the time of agreement to time of payment.B. Arises from possibility of exchange rate gains and losses from the transaction.II. MEASUREMENTA. Currency by currencyB. Equals the difference between1. The contractually-fixed invoice amount in a specific currency2. The final payment amount denominated in current exchange rate for the specific currency.

Fred Thompson

DESIGNING A HEDGING STRATEGY A. Strategies -- a function of managements objectivesB. Hedgings basic objective: reduce/eliminate volatility of earnings as a result of exchange rate changes.C. Hedging exchange rate risk1. Costs money2. Should be evaluated as any other purchase of insurance.3. Taking advantage of tax asymmetries lowers hedging costs.D.Centralization v. Decentralization1. Important aspects:a. Degree of centralizationb. Responsibility for developingc. Implementing the hedging strategy.2. Maximum benefits accrue from centralizing policy-making, formulation, and implementation.

Fred Thompson

METHODS OF MANAGING TRANSLATION EXPOSURE1. 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 nettinga. 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.

Fred Thompson

Basic Hedging Strategy for Reducing Translation ExposureIncreasing hard-currency(likely to appreciate) assetsDecreasing soft-currency(likely to depreciate) assetsDecreasing hard-currency liabilitiesIncreasing soft-currency liabilitiesi.e. reduce the level of cash, tighten credit terms to decrease accounts receivable, increase LC borrowing, delay accounts payable, and sell the weak currency forward.

Fred Thompson

METHODS OF HEDGINGA. Forward market hedgeB. Money market hedgeC. Risk shiftingD. Pricing decisionE. Exposure nettingF. Currency risk sharingG. Currency collarsH. Cross-hedgingI. Foreign currency options

Fred Thompson

CENTRAL IDEAHedging a particular currency exposure means establishing an offsetting currency positionWhatever is lost or gained on the original currency exposure is exactly offset by a corresponding foreign exchange gain or loss on the currency hedge

Fred Thompson

MANAGING TRANSACTION EXPOSUREA transaction exposure arises whenever a company is committed to a foreign currency-denominated transaction.Protective measures include using: forward contracts, price adjustment clauses, currency options, and HC invoicing.

Fred Thompson

FORWARD MARKET HEDGEConsists of offsettinga. Receivables or payables in a foreign currencyb. Forward contract:s- to sell or buy that currency- at set delivery dates- coincident foreign currency receipts or payments c. The opportunity cost of which depends upon future spot rate at settlementf1 - e1 e0 where f1 = forward rate, e0 = spot rate, e1 = future spot rate

Fred Thompson

MONEY MARKET HEDGE

Simultaneous borrowing and lending activities in two different currencies to lock in the dollar value of a future foreign currency cash flow

Fred Thompson

RISK SHIFTING1. Home currency invoicing2. Zero sum game3. Common in global business4. Firm will invoice exports in strong currency, import in weak currency5. Drawback: not possible with informed customers or suppliers.

Fred Thompson

PRICING DECISIONSGeneral rule: on credit sales connect foreign price to home price using forward rate, but not spot rate.If the dollar price is high/low enough the exporter/importer should follow through with the sale.

Fred Thompson

EXPOSURE NETTING Protection can be gained by selecting currencies that minimize exposureNetting: MNC chooses currencies that are not perfectly positively correlated.Exposure in one currency can be offset by the exposure in another.

Fred Thompson

CURRENCY RISK SHARINGDeveloping a customized hedge contract The contract typically takes the form of a Price Adjustment Clause, whereby a base price is adjusted to reflect certain exchange rate changes.Parties would share the currency risk beyond a neutral zone of exchange rate changes.The neutral zone represents the currency range in which risk is not shared.

Fred Thompson

CURRENCY COLLARSContract bought to protect against currency moves outside the neutral zone.Firm would convert its foreign currency denominated receivable at the zone forward rate.

Fred Thompson

CROSS-HEDGINGOften forward contracts not available in a certain currency.Solution: a cross-hedge -- a forward contract in a related currency.Correlation between 2 currencies is critical to success of this hedge.

Fred Thompson

Foreign Currency OptionsWhen transaction is uncertain, currency options are a good hedging tool in situations in which the quantity of foreign exchange to be received or paid out is uncertain.A call option is valuable when a firm has offered to buy a foreign asset at a fixed foreign currency price but is uncertain whether its bid will be accepted.A put option allows the company to insure its profit margin against adverse movements in the foreign currency while guaranteeing fixed prices to foreign customer.

Fred Thompson