Types of Foreign Exchange Exposures

Types of Exposures Exposure to exchange rate can be divided into the following three types of exposures: Transaction Exposure Operating Exposure Translation Exposure

Transaction Exposure Transaction or contractual exposure refers to a known, specific, cash flow that is denominated in a foreign currency and is therefore subject to risk because of a change in nominal exchange rates. Typically, these exposures arise when a company buys or sells a good or service priced in a foreign currency, or when a company borrows or lends in a foreign currency. Each cash flow can be usually hedged by a forward/futures contract, a money-market hedge (i.e., the forward contract may be replicated by lending or borrowing in the foreign currency), or with options.

Operating Exposure Operating exposure is the effect of a change in exchange rates on the expected value of a firm's future operating cash flows (or the “firm value”). Think of operating exposure as the economic exposure of a firm, the response of operating cash flow to an exchange rate shock. The question we are concerned with is: how will the firm's cash flows be affected by a real exchange rate shock. It is neither easy to estimate nor hedge the operating exposure. We have to estimate the operating exposure by accounting the impact on both revenue and costs.

Operating Exposure: Hintz-Kessels-Kohl Why is HKK current situation unenviable ? From Exhibit 1, the US inflation has been higher than inflation in Austria. For instance, in 1980 (last year), the inflation in Austria was 8.60%, and that in the US was 14.10%. Given the higher inflation, one might expect the Austrian Schilling to strengthen in nominal terms (to maintain the real value of the schilling). However, instead of strengthening, the schilling has weakened. Computing the real exchange rate, one can see that the US$ has appreciated by 23% in real terms over the last 18 months. We noted in the case that HKK can only make money if the dollar strengthens in nominal terms. In other words, HKK cannot compete even when the US$ has appreciated by so much in real terms, and it needs additional appreciation of the US$! Clearly, HKK is in bad shape.

Translation Exposure Translation exposure is exposure of the accounting statements to changes in f/x rates. Suppose a multinational has a subsidiary with assets and liabilities denominated in foreign currency. Even if the subsidiary conducts all of its business in the foreign country (and, therefore, has no transaction or operating exposure), the financial statements have to be translated into the home currency before they can be consolidated into the parent's financial statements. Thus, the parent is subject to translation risk.

Current/Non-Current Method Before 1976, the translation methodology used in the US was the current/non-current method. All current assets were translated at the current exchange rate at the date of the financial statement. All non-current assets and liabilities were translated at historical rates (the rate at at which they were acquired or incurred). Income statements were translated at an average exchange rate for the reporting period or the actual rate, if known, on the dates transactions were incurred.

Monetary/Temporal Method Between 1976 and 1982, the current/non-current method was replaced by the monetary/nonmonetary method or temporal method. Financial assets and liabilities were translated at the current exchange rate (on date of balance sheet), and fixed or real assets were translated at historical exchange rates. Income statement was translated at average with the exception of non-monetary items. In short, all monetary items were translated at current exchange rate, and all non-monetary at historical rates All translation losses or gains had to be reported in the income statement each quarter.

All Current Method FASB 52 took effect in 1982. All assets and liabilities are translated at the current exchange rate on the balance sheet date. But equity accounts are translated at historical rates. Income statements are translated either at the prevailing rate on the date that a sale or purchase is incurred, or a weighted average of rates over the period. Importantly, translation gains or losses do not flow into the income statement. Instead, they are lumped together on a separate equity account called “cumulative translation adjustment” (CTA).

All Current Method Importantly, translation gains or losses do not flow into the income statement. Instead, they are lumped together on a separate equity account called “cumulative translation adjustment” (CTA). Only when an asset is sold or liquidated does the realized gain move from the CTA to the income statement. Each subsidiary must designate a functional currency which is the primary currency in which transactions occur (this may be the US$) The most common means of hedging translation exposure is to have equal amounts of assets and liabilities in each currency that offset each other.

An Example A US multinational has a subsidiary in Europe with total assets of 3.75 million Euro, with equity of 1 million Euro. All of its assets and liabilities are in Euro. The net exposure by FASB 52 is 1 million euro. Suppose the Euro depreciates from 1.20 to 1.0. The translation loss is equivalent to (1 x 1.2 – 1 x 1) million US$ = $200,000. Another example is provided in the next slide.

Hedging Translation Risk To hedge this risk, the subsidiary would have to create some US$ assets, say, by keeping some of its cash in US$, or by “swapping” some of its Euro assets to US$ assets with another firm (who presumably needs Euro assets to offset its own translation risk).

Overall Is it possible to hedge all risks simultaneously? It is possible that hedging one risk might end up increasing another type of risk.

An Example: Tiffany Suppose you think of the exposure of TIF as a transaction exposure: the problem is how to hedge the Yen revenue against a depreciation of the Yen. Assume that you cannot hedge all of the risk with forwards. It is unlikely that anyone will enter into very long- term forward contracts. Stacking your entire position into short term forward contracts may be very dangerous.

An Example: Tiffany Nevertheless, you can hedge yourself against the exchange rate risk by passing it on to your customer – simply adjust the price of your goods with the rate. If the Yen depreciates (appreciates) by 10%, increase (decrease) the Yen price of your goods by 10%. Your net profit in US$ will remain constant. But if you do this, you have traded the transaction exposure with operating exposure! Will your customers be able to buy the good at a higher rate when the Yen depreciates?