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 - 1 -
Transcript
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 MEASURESA.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.
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 rate changes alter the value of future revenues and costs.
PART II. ALTERNATIVE CURRENCY TRANSLATION METHODS (ACCY)
I. FOUR METHODS OF TRANSLATIONA. 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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How Accounting Exposure Arises
Translation Risk
Subsidiary Financials
Subsidiary Financials
Subsidiary FinancialsHeadquarters’Consolidated
Financials¥
£
£ £
€
$
Japan United States
Germany
Fin 4328 (Moore) Chapter 10 Notes and Problems 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
investments4. 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. 52A. 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.
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Fin 4328 (Moore) Chapter 10 Notes and Problems Summer 2006
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 REALITYI. Accounting v. Economic Exposure:
measurement of exchange rate risk indicates major difference exists.
A. Accounting exposure reflects past decisions of the firm.
B. Economic exposure1. Focuses on future impact of exchange rate changes.2. Not all future cash flows appear on the firm’s
balance sheet.
Sample Problem
Suppose on January 1, American Golf’s 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 = $.1270on Dec 31 = $.1180
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Fin 4328 (Moore) Chapter 10 Notes and Problems 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 TWOManaging Translation and Transaction Exposure
I. DESIGNING A HEDGING STRATEGYA.Strategies: a management objective
B.Hedging’s basic objective:reduce/eliminate volatility of earnings as a result of
exchange rate changes.
C.Hedging exchange rate risk1. Incurs a cost2. Should be evaluated as a purchase of insurance.
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Fin 4328 (Moore) Chapter 10 Notes and Problems Summer 2006
D.Centralization is key1. Important aspects:
a. Degree of centralizationb. Responsibility for its developmentc. Implementation
2. Maximum benefits accrue from centralizing policy-making, formulation, and implementation.
II. METHODS OF HEDGINGA.Risk shiftingB.Currency risk sharingC. Currency collarsD. Cross-hedgingE. Exposure nettingF. Forward market hedgeG.Foreign currency options
A. RISK SHIFTING1. Home currency invoicing2. Zero sum game3. Common in global business4. Firm will invoice exports in strong currency, import in
weak 5. Drawback: not possible with informed
customers/suppliers.
B. CURRENCY RISK SHARING1. Developing a customized hedge contract.
2. The contract typically takes the form of a Price AdjustmentClause, whereby a base price is adjusted to reflect certain exchange rate changes.
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Fin 4328 (Moore) Chapter 10 Notes and Problems Summer 2006
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 COLLARS1. 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-HEDGING1. Often forward contracts not available in a certain
currency.2. Solution: a cross-hedge
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The Zone
$1.50/£ $1.60/£
Take no actions
Take no action
Fin 4328 (Moore) Chapter 10 Notes and Problems Summer 2006
- a forward contract in a related currency.3. Correlation between 2 currencies is critical to success of this hedge.
E. EXPOSURE NETTING1. Protection can be gained by selecting currencies that
minimize exposure2. 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 EXPOSUREA.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 firm’s local currency accounting exposure.
2.Forward contracts
Reducing a firm’s translation exposure by creating an offsetting asset or liability in the foreign currency.
3.Exposure netting
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Fin 4328 (Moore) Chapter 10 Notes and Problems 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 strategy for reducing translation exposure:
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 accounts
receivable, Increase LC borrowing, Delay accounts payable, and Sell the weak currency forward.
EASY (factual)10.1 Under FASB 52, foreign exchange gains and losses
a. flow into a special reserve accountb. are usually determined according to the current rate methodc. both a and bd. flow directly into the income statement
10.2 Translation exposure reflects the exposure of a company'sa. foreign operations to currency movementsb. foreign sales to currency movementsc. financial statements to currency movementsd. 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) Chapter 10 Notes and Problems Summer 2006
c. will be the Colombian pesod. 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 inflationd. be the Mexican peso unless Mexico has a high rate of inflation
10.21 Hedging cannot provide protection against ________ exchange rate changes.a. expectedb. nominalc. reald. pegged
10.22 The basic hedging strategy involvesa. reducing hard currency assets and soft currency liabilitiesb. increasing hard currency liabilities and soft currency assetsc. reducing soft currency assets and hard currency liabilitiesd. 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 witha. more risk, not lessb. less riskc. a profit as well as reduced riskd. 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. buyb. sellc. borrowd. 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 contractb. currency collarc. money-market hedged. currency option
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Fin 4328 (Moore) Chapter 10 Notes and Problems 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 todayb. lend £1 million pounds todayc. borrow £869,565 pounds todayd. 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. $173,160b. $44,743c. Pepsi gains $173,160 from the forward contractd. 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 bya. selling pesetas forward in the amount of net assetsb. buying pesetas forward in the amount of net assetsc. reducing the liabilities of the subsidiaryd. 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. dollarsb. buy French francs forward in the amount of the contractc. buy a put option on francs in the amount of the franc exposured. sell a call option on francs in the amount of franc exposure
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Fin 4328 (Moore) Chapter 10 Notes and Problems Summer 2006
Ajax Manufacturing's German subsidiary has the following balance sheet:
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 $294,000b. a gain of $192,000c. a loss of $174,000
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Fin 4328 (Moore) Chapter 10 Notes and Problems Summer 2006
d. a loss of $12,000ANSWER: 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 $174,000d. 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 $294,000b. a gain of $192,000c. a loss of $174,000d. a loss of $12,000
