1. 1 Chapter no.10 Measuring and Managing Translation Exposure

2. 2 Presented By: Ayesha Ahmad Naila Ahmed Shumaila Naz Nadia Rashid Nadia Yasmin

3. 3 CHAPTER OVERVIEW (con’t) 1TRANSACTION EXPOSURE 2.DESIGNING A HEDGING STRATEGY 3MANAGING TRANSLATION EXPOSURE 4MANAGING TRANSACTION EXPOSURE

4. 4 ALTERNATIVE MEASURES OF FOREIGN EXCHANGE EXPOSURE 1. Accounting/Translation Exposure: when reporting and consolidating financial statements requires conversion from foreign to local currency. 2. Transaction Exposure: occurs from changes in the value of foreign currency contracts as a result of exchange rate changes. 3. Operating Exposure arises because exchange rate changes may alter the value of future revenues and costs. 4. Economic Exposure = Transaction + Operating Exposures

5. 5 Types of Exposure: Accounting, Operating and Transaction

6. 6 Comparison of Exposure Types

7. 77 EXPOSURE: Accounting and Economic Risk I.ALTERNATIVE MEASURES TYPES I.ALTERNATIVE MEASURES TYPES 1.Accounting Exposure: 1.Accounting Exposure: Arises when reporting and consolidating financial statements require conversion from subsidiary to parent currency Arises when reporting and consolidating financial statements require conversion from subsidiary to parent currency 2.Economic Exposure: 2.Economic Exposure: Arises because unexpected exchange rate changes alter the value of future revenues and costs. Arises because unexpected exchange rate changes alter the value of future revenues and costs.

8. 8 Accounting Exposure [Terminology] “Exposure” - need to convert financial statements of foreign operations from local currency to the home currency. “Exposure” - need to convert financial statements of foreign operations from local currency to the home currency. “Translation” - restatement of accounts due to exchange rate changes. “Translation” - restatement of accounts due to exchange rate changes.

9. 99 Accounting Exposure Accounting Exposure = Transaction risk + Translation risk

10. 10 Accounting Exposure [Terminology] “Translation Exposure” - “Translation Exposure” - Difference between exposed assets and exposed liabilities Which assets & liabilities are exposed? Which assets & liabilities are exposed? When should gains and losses be recognized on the income statement? When should gains and losses be recognized on the income statement?

11. 11 ALTERNATIVE CURRENCY TRANSLATION METHODS A. Current/Noncurrent Method B. Monetary/Nonmonetary Method C. Temporal Method D. Current Rate Method

12. 1212 How Accounting Exposure Arises Translation Risk Translation Risk Subsidiary Financials Headquarters’ Consolidated Financials ¥ £ £ £ € $ Japan United States Germany

13. 1313 ALTERNATIVE MEASURES OF FOREIGN EXCHANGE EXPOSURE C. Economic Exposure C. Economic Exposure = Transaction Exposure +Operating Exposure = Transaction Exposure +Operating Exposure Operating Exposure defined: Operating Exposure defined: Arises because exchange rate changes alter the value of future revenues and expenses. Arises because exchange rate changes alter the value of future revenues and expenses.

14. 1414 ALTERNATIVE CURRENCY TRANSLATION METHODS I.FOUR METHODS OF TRANSLATION I.FOUR METHODS OF TRANSLATION A.Current/Noncurrent Method A.Current/Noncurrent Method 1. Current accounts use current exchange rate for conversion. 1. Current accounts use current exchange rate for conversion. 2. Income statement accounts use 2. Income statement accounts use average exchange rate for the period. average exchange rate for the period.

15. 1515 ALTERNATIVE CURRENCY TRANSLATION METHODS B. Monetary/Non monetary Method B. Monetary/Non monetary Method 1.Monetary accounts use current 1.Monetary accounts use current rate rate 2.Pertains to 2.Pertains to - cash - cash - accounts receivable - accounts receivable - accounts payable - accounts payable - current portion long term debt - current portion long term debt

16. 1616 ALTERNATIVE CURRENCY TRANSLATION METHODS 3.Nonmonetary accounts 3.Nonmonetary accounts - use historical rates - use historical rates - Pertains to - Pertains to inventory inventory fixed assets fixed assets long term investments long term investments 4.Income statement accounts 4.Income statement accounts - use average exchange rate for the period. - use average exchange rate for the period.

17. 1717 ALTERNATIVE CURRENCY TRANSLATION METHODS C.Temporal Method C.Temporal Method 1. Similar to monetary/Nonmonetary 1. Similar to monetary/Nonmonetary method. method. 2.Use current method for inventory. 2.Use current method for inventory.

18. 1818 D.Current Rate Method D.Current Rate Method All statements use current exchange rate for conversions. All statements use current exchange rate for conversions.

19. 1919 STATEMENT OF FINANCIAL ACCOUNTING STANDARDS # 8 I.FASB NO. 8 I.FASB NO. 8 A.Uniform conversion rules established A.Uniform conversion rules established B.Temporal method B.Temporal method C.Translation gains or losses C.Translation gains or losses 1. Reported on income statement 1. Reported on income statement 2. Result: net income greatly affected by exchange rate volatility and subsequent uncertainty. 2. Result: net income greatly affected by exchange rate volatility and subsequent uncertainty.

20. 2020 STATEMENT OF FINANCIAL ACCOUNTING STANDARDS # 52 I.FASB NO. 52 I.FASB NO. 52 A.Dissatisfaction with FASB No. 8: A.Dissatisfaction with FASB No. 8: True profitability often disguised by exchange rate volatility. True profitability often disguised by exchange rate volatility.

21. 21 STATEMENT OF INANCIAL ACCOUNTING STANDARDS NO. 52 A.Dissatisfaction with FASB No. 8 -- true profitability often disguised by exchange rate volatility. B.Balance sheet translation uses current rate method. C.Income statement uses 1. Weighted average rate during period or 2. The rate in effect when revenue and expenses incurred. D. Translation Gains or Losses 1. 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 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. 3. If foreign subsidiary’ operations are direct extension of parent firm

22. 2222 Managing Accounting Exposure

23. 23 METHODS OF MANAGING TRANSLATION EXPOSURE 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 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.

24. 2424 Managing Translation Exposure B.Basic hedging strategy for reducing translation exposure: 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

25. 2525 MANAGING TRANSLATION EXPOSURE How to increase soft-currency liabilities How to increase soft-currency liabilities Reduce the level of cash, Reduce the level of cash, Tighten credit terms to decrease accounts receivable, Tighten credit terms to decrease accounts receivable, Increase LC borrowing, Increase LC borrowing, Delay accounts payable Delay accounts payable

26. 26 Basic Strategy for Hedging Translation Exposure ASSETSLIABILITIES Hard Currencies (Likely to Appreciate) INCREASEDECREASE Soft Currencies (Likely to Depreciate) DECREASE INCREASE

27. 27 Designing a Hedging Strategy

28. 28 Definition of Hedging Strategy An investment strategy by which the investor tries to eliminate all potential future gain or loss on an investment is known as a hedging strategy investmentstrategyinvestorfutureinvestment strategyinvestorfutureinvestment

29. 29 Types of Hedging Strategies 1. Internal Hedging strategies Natural hedge Natural hedge Invoicing in own currency Invoicing in own currency Split currency invoicing Split currency invoicing Netting Netting Leading and lagging Leading and lagging Price adjustments Price adjustments Risk sharing agreements Risk sharing agreements Review of market – product combination Review of market – product combination

30. 30 Types of Hedging Strategies (Cont’d) 2. External Hedging Strategies Currency forward contracts Currency forward contracts Currency future contracts Currency future contracts Currency options Currency options Money Market Hedge Money Market Hedge

31. 31 Designing a Hedging Strategy  Before using a hedging technique, a firm must decide on; Which exposures to manage, Which exposures to manage, How to manage them How to manage them  For this purpose, it requires an operational set of goals for those involved in exchange risk management.  Failure to set out objectives leads to possibly conflicting and costly actions on the part of employees.  So, a manager should make an effective exposure management strategy.

32. 32 Designing a Hedging Strategy (Cont’d) Following elements are suggested for an effective exposure management strategy:   Determine the types of exposure to be monitored   Formulate corporate objectives and give guidance in resolving conflicts in objectives   Ensuring corporate objectives as related to maximizing shareholder value   Specifying the responsibility for each exposure and detail the criteria for judging each manager

33. 33 Designing a Hedging Strategy (Cont’d)  Making explicit any constraints (e.g. limitations) on use of exposure management techniques  Identifying the channels by which exchange rate considerations are incorporated  Develop a system for monitoring and evaluating exchange risk management activities.

34. 34 Objectives of Hedging strategy The usefulness of particular hedging strategy depends upon,  Acceptability refers to approval of top management  Quality refers to ability to provide better decisions.

35. 35 Objectives of Hedging strategy (Cont’d) The objectives of hedging strategy includes the following; Minimize translation exposure Minimize translation exposure Minimize quarter-to-quarter earnings fluctuations owing to exchange rate changes Minimize quarter-to-quarter earnings fluctuations owing to exchange rate changes Minimize transaction exposure Minimize transaction exposure Minimize economic exposure Minimize economic exposure Minimize foreign exchange risk management costs Minimize foreign exchange risk management costs Avoid surprises Avoid surprises

36. 36 Cost and Benefits of Standard Hedging Techniques A fundamental and key question that one has to answer is which of the risk one want to hedge against and which one want to either pass through to one’s investors or exploit. To make this judgment, one has to consider the potential costs and benefits of hedging techniques. A fundamental and key question that one has to answer is which of the risk one want to hedge against and which one want to either pass through to one’s investors or exploit. To make this judgment, one has to consider the potential costs and benefits of hedging techniques.

37. 37 Costs of Hedging Techniques Costs of Hedging risks are of two types: 1. Explicit costs 2. Implicit costs

38. 38 Benefits of Hedging Techniques It includes; Tax Benefits Tax Benefits Better Investment Decisions Better Investment Decisions 1. Managerial risk aversion 2. Capital market frictions Distress Costs Distress Costs Capital Structure Capital Structure Informational Benefits Informational Benefits

39. 39 Exposure Netting A technique which companies can use to reduce their exchange risk at no cost A technique which companies can use to reduce their exchange risk at no cost Involves offsetting exposures in one currency with exposures in the same or another currency, where exchange rates are expected to move in a way such that losses (gains) on the first exposed position will be offset by gains (losses) on the second currency exposure Involves offsetting exposures in one currency with exposures in the same or another currency, where exchange rates are expected to move in a way such that losses (gains) on the first exposed position will be offset by gains (losses) on the second currency exposure

40. 40 Centralization Vs Decentralization 1.Important aspects: a.Degree of centralization b.Responsibility for developing c.Implementing the hedging strategy 2.Maximum benefits accrue from centralizing policy-making, centralizing policy-making, formulation, and implementation. formulation, and implementation.

41. 41 TRANSACTION EXPOSURE: TRANSACTION EXPOSURE: Transaction exposure stems from the possibility of incurring future exchange gains or losses on transactions already entered into and denominated in a foreign currency. Transaction exposure stems from the possibility of incurring future exchange gains or losses on transactions already entered into and denominated in a foreign currency.

42. 42 Example: IBM sells a main frame computer to Royal Dutch Shell it typically will not be paid until a later date. If that sale is priced in pounds, IBM has a pound transaction exposure. IBM sells a main frame computer to Royal Dutch Shell it typically will not be paid until a later date. If that sale is priced in pounds, IBM has a pound transaction exposure.

43. 43 TRANSACTION EXPOSURE  Some items included in translation exposure, such as inventories and fixed assets are excluded from transaction exposure Other items included in the transaction exposure such as contracts for future sales and purchases, are not included in translation exposure. Other items included in the transaction exposure such as contracts for future sales and purchases, are not included in translation exposure. Thus it is possible that transaction exposure in a currency to be positive and translation exposure to be negative and vice versa. Thus it is possible that transaction exposure in a currency to be positive and translation exposure to be negative and vice versa.

44. 44 COMPUTING THE TRANSACTION EXPOSURE: Suppose Boeing Airlines sells five 747s to Garuda, the Indonesian airlines, in rupiahs.the rupaih price is Rp 140 billion. To help reduce the impact of Indonesia BOP, Boeing agrees to buy parts from various Indonesians companies worth Rp 55 billions Suppose Boeing Airlines sells five 747s to Garuda, the Indonesian airlines, in rupiahs.the rupaih price is Rp 140 billion. To help reduce the impact of Indonesia BOP, Boeing agrees to buy parts from various Indonesians companies worth Rp 55 billions

45. 45 COMPUTING THE TRANSACTION EXPOSURE A) If spot rate is $ 0.004/Rp, what is Boeing net rupaih transaction exposure? A) If spot rate is $ 0.004/Rp, what is Boeing net rupaih transaction exposure? = Rp 40 billions – RP 55 billions = Rp 40 billions – RP 55 billions = Rp 85 billion = Rp 85 billion Converting into $ at spot rate of $0.004/Rp Converting into $ at spot rate of $0.004/Rp Thus, transaction exposure is equal to $340 millions. Thus, transaction exposure is equal to $340 millions.

46. 46 COMPUTING THE TRANSACTION EXPOSURE B) If Rupiah depreciate to $0.0035/Rp, what is Boeing transaction loss? B) If Rupiah depreciate to $0.0035/Rp, what is Boeing transaction loss? Rp 85 billion (0.004-0.00350) Rp 85 billion (0.004-0.00350) = $4.25 million = $4.25 million

47. 47 PROTECTIVE MEASURES FOR TRANSACTION EXPOSURE PROTECTIVE MEASURES FOR TRANSACTION EXPOSURE Forward contracts Forward contracts Price adjustments clauses Price adjustments clauses Currency options Currency options Borrowing or lending in foreign currency. Borrowing or lending in foreign currency.

48. 48 Example: General Electric: General Electric: No of techniques are used to manage the currency exchange including: No of techniques are used to manage the currency exchange including: Selective borrowing in local currencies Selective borrowing in local currencies Selective hedging of significant cross currency transaction. Selective hedging of significant cross currency transaction.

49. 49 CURRENCY FORWARDS AND OPTIONS Manage exposure to change in currency exchange rates associated with commercial purchase and sale transaction. Manage exposure to change in currency exchange rates associated with commercial purchase and sale transaction. Net investment exposure are managed by using currency forward and currency swap. Net investment exposure are managed by using currency forward and currency swap.

50. 50 CURRENCY FORWARDS AND OPTIONS The company try to invoice all the transactions in $ and to avoid transaction exposure entirely. The company try to invoice all the transactions in $ and to avoid transaction exposure entirely. However eliminating all the transaction exposure will not eliminate the total foreign exchange risk. However eliminating all the transaction exposure will not eliminate the total foreign exchange risk. It still has to face exchange risk in its operating cash flows It still has to face exchange risk in its operating cash flows

51. 51 EXAMPLE: On Jan.01, GE take a contact to supply turbine blades to Lufthansa, German airline. On Jan.01, GE take a contact to supply turbine blades to Lufthansa, German airline. On Dec. 31, GE ill receive payment of € 10 million for these blades. On Dec. 31, GE ill receive payment of € 10 million for these blades. The most direct way for GE is to hedge this receivables is to sell a € 10 million forward contract for delivery in one year The most direct way for GE is to hedge this receivables is to sell a € 10 million forward contract for delivery in one year It can also use the money market hedge, which involves borrowing of this € 10 million for one year, converting into dollar and investing the proceeds in a security that will matures in Dec 31. It can also use the money market hedge, which involves borrowing of this € 10 million for one year, converting into dollar and investing the proceeds in a security that will matures in Dec 31. If interest rate parity holds the two methods will yields the same results. If interest rate parity holds the two methods will yields the same results.

52. 52 METHODS FOR MANAGING THE TRANSACTION EXPOSURE: Forward market hedge Forward market hedge Money market hedge Money market hedge Risk shifting Risk shifting Risk sharing Risk sharing Exposure netting Exposure netting Currency options Currency options

53. 53 FORWARD MARKET HEDGE In the forward market hedge a company that is a long foreign currency will sell the foreign currency forward, whereas a company that is short foreign currency will buy the currency forward. In this way, the company can fix the dollar value of the future currency cash flows. In the forward market hedge a company that is a long foreign currency will sell the foreign currency forward, whereas a company that is short foreign currency will buy the currency forward. In this way, the company can fix the dollar value of the future currency cash flows.

54. 54 Example: By selling forward the proceeds from its sale of turbine blades GE can effectively transform €10 million receivables from euros to dollars thereby eliminating the all currency risk on the sale. By selling forward the proceeds from its sale of turbine blades GE can effectively transform €10 million receivables from euros to dollars thereby eliminating the all currency risk on the sale. As current spot price for euro is $1.00/€ and As current spot price for euro is $1.00/€ and One year forward rate is $0.957/€ One year forward rate is $0.957/€ Thus forward sale will yield $ 9.57 million on dec.31 Thus forward sale will yield $ 9.57 million on dec.31

55. 55 Contd….. Without hedging GE value fluctuate with the exchange rates. Without hedging GE value fluctuate with the exchange rates. The forward contract creates an equal euro liability, offset by an asset worth $ 9.57 million. The euro asset and liability cancel each other out and GE is left with a $ 9.57 million asset The forward contract creates an equal euro liability, offset by an asset worth $ 9.57 million. The euro asset and liability cancel each other out and GE is left with a $ 9.57 million asset

56. 56 TRUE COST OF HEDGING: It cannot be calculated in advance because it depends on the future spot rate which is unknown at the time of entering into forward contract. It cannot be calculated in advance because it depends on the future spot rate which is unknown at the time of entering into forward contract. Plus represents the gain Plus represents the gain And negative sign represent the loss And negative sign represent the loss

57. 57 METHOD TO MEASURE THE COST OF FORWARD CONTRACT Cost of forward contract is measured by as its forward discount or premium. Cost of forward contract is measured by as its forward discount or premium. Fi-eo Fi-eo eo eo fi= forward rate fi= forward rate eo= current spot rate in $ eo= current spot rate in $ f1-e1 f1-e1 eo eo

58. 58 MONEY MARKET HEDGE It involves the simultaneous borrowing and lending activities in two different currencies to lock in a dollar value of foreign currency cash flow. It involves the simultaneous borrowing and lending activities in two different currencies to lock in a dollar value of foreign currency cash flow.

59. 59 Example; Suppose euro and us $ interest rates are 15% and 10%. Suppose euro and us $ interest rates are 15% and 10%. Using the money market hedge GE borrow € (10/1.15) million= € 8.70millions for one year Using the money market hedge GE borrow € (10/1.15) million= € 8.70millions for one year Convert into $ in spot market and invest $8.7 millions for one year. Convert into $ in spot market and invest $8.7 millions for one year. GE will receive 1.10×$8.7 millions = $9.57 million GE will receive 1.10×$8.7 millions = $9.57 million GE will then use the proceeds of euro receivables collected on that day to repay the 1.15×€ 8.7 millions = €10 million. GE will then use the proceeds of euro receivables collected on that day to repay the 1.15×€ 8.7 millions = €10 million.

60. 60 Transaction cost: The following transaction cost must be factored in when comparing a forward contract hedge with a money market hedge. The following transaction cost must be factored in when comparing a forward contract hedge with a money market hedge. The bid ask spread on the forward contract and The bid ask spread on the forward contract and Difference between the borrowing and lending rates Difference between the borrowing and lending rates

61. 61 PART IlI. MANAGING TRANSACTION EXPOSURE I.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

62. 62 MANAGING TRANSACTION EXPOSURE 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 currency 4. firm will invoice exports in strong currency, import in weak currency 5. Drawback: it is not possible with informed customers or suppliers.

63. 63 MANAGING TRANSACTION EXPOSURE D. PRICING DECISIONS 1. general roles: on credit sales connect foreign price to home price using forward rate, but not spot rate. 2. if the dollar price is high/low enough the exporter/importer should follow through with the sale. 2. if the dollar price is high/low enough the exporter/importer should follow through with the sale.

64. 64 MANAGING TRANSACTION EXPOSURE E.EXPOSURE NETTING 1. Protection can be gained by selecting currencies that minimize exposure currencies that minimize exposure 2. Netting: MNC chooses currencies that are not MNC chooses currencies that are not perfectly positively correlated. perfectly positively correlated. 3. Exposure in one currency can be offset by the exposure in another. offset by the exposure in another.

65. 65 MANAGING TRANSACTION EXPOSURE 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.

66. 66 The Zone $1.50/£ $1.60/£ Take no actions Take no action

67. 67 MANAGING TRANSACTION EXPOSURE B. CURRENCY RISK SHARING (con’t) 3. Parties would share the currency risk beyond a neutral zone of exchange 3. Parties would share the currency risk beyond a neutral zone of exchange rate changes. rate changes. 4. The neutral zone represents the currency range in which risk is not shared.

68. 68 MANAGING TRANSACTION EXPOSURE C. CURRENCY COLLARS 1. Contract bought to protect against currency moves outside the neutral zone. 2. Firm would convert its foreign currency denominated receivable currency denominated receivable at the zone forward rate. at the zone forward rate.

69. 69 MANAGING TRANSACTION EXPOSURE D.CROSS-HEDGING 1. Often forward contracts not available in a certain currency. in a certain currency. 2. Solution: a cross-hedge - a forward contract in a related currency. - a forward contract in a related currency. 3. Correlation between 2 currencies is critical to success of this hedge. critical to success of this hedge.

70. 70 MANAGING TRANSACTION EXPOSURE I. Foreign Currency Options When 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.

71. 71 MANAGING TRANSACTION EXPOSURE I. Foreign currency options 1. 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.

72. 72 MANAGING TRANSACTION EXPOSURE 2. The firm can lock in a maximum dollar price for its tender offer, while limiting its downside risk to the call premium in the event its bid is rejected.

73. 73 MANAGING TRANSACTION EXPOSURE 3. A put option 3. 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.