Transaction and Translation Exposure

Transaction and Translation Exposure
Chapter 10 Transaction and Translation Exposure

Learning Objectives Distinguish between the three major foreign exchange exposures experienced by firms Analyze the pros and cons of hedging foreign exchange transaction exposure Examine the alternatives available to a firm for managing a large and significant transaction exposure Evaluate the institutional practices and concerns of foreign exchange risk management

Learning Objectives Demonstrate how translation practices result in a foreign exchange exposure for the multinational enterprise Explain the meaning behind the designation of a foreign subsidiary’s “functional currency” Illustrate both the theoretical and practical differences between the two primary methods of translating foreign currency denominated financial statements into the currency reporting of the parent company Compare translation exposure with operating expense Analyze the costs and benefits of managing translation exposure

Foreign Exchange Exposure
Foreign exchange exposure is a measure of the potential for a firm’s profitability, net cash flow, and market value to change because of a change in exchange rates These three components (profits, cash flow and market value) are the key financial elements of how we view the relative success or failure of a firm While finance theories tell us that cash flows matter and accounting does not, we know that currency-related gains and losses can have destructive impacts on reported earnings – which are fundamental to the markets opinion of that company

Types of foreign exchange exposure Transaction Exposure – measures changes in the value of outstanding financial obligations incurred prior to a change in exchange rates but not due to be settled until after the exchange rate changes Translation Exposure – also called accounting exposure, is the potential for accounting derived changes in owner’s equity to occur because of the need to “translate” financial statements of foreign subsidiaries into a single reporting currency for consolidated financial statements

Operating Exposure – also called economic exposure, measures the change in the present value of the firm resulting from any change in expected future operating cash flows caused by an unexpected change in exchange rates Exhibit 10.1 shows schematically the three main types of foreign exchange exposure: transaction, translation, and operating

Exhibit 10.1 Corporate Foreign Exchange Exposure

Why Hedge? Hedging protects the owner of an asset (future stream of cash flows) from loss However, it also eliminates any gain from an increase in the value of the asset hedged against Since the value of a firm is the net present value of all expected future cash flows, it is important to realize that variances in these future cash flows will affect the value of the firm and that at least some components of risk (currency risk) can be hedged against

Why Hedge - the Pros & Cons
Opponents of hedging give the following reasons: Shareholders are more capable of diversifying risk than the management of a firm; if stockholders do not wish to accept the currency risk of any specific firm, they can diversify their portfolios to manage that risk Currency risk management does not increase the expected cash flows of a firm; currency risk management normally consumes resources thus reducing cash flow Management often conducts hedging activities that benefit management at the expense of shareholders

Opponents of hedging give the following reasons (continued): Managers cannot outguess the market; if and when markets are in equilibrium with respect to parity conditions, the expected NPV of hedging is zero Management’s motivation to reduce variability is sometimes driven by accounting reasons; management may believe that it will be criticized more severely for incurring foreign exchange losses in its statements than for incurring similar or even higher cash cost in avoiding the foreign exchange loss Efficient market theorists believe that investors can see through the “accounting veil” and therefore have already factored the foreign exchange effect into a firm’s market valuation

Proponents of hedging give the following reasons: Reduction in risk in future cash flows improves the planning capability of the firm Reduction of risk in future cash flows reduces the likelihood that the firm’s cash flows will fall below a necessary minimum Management has a comparative advantage over the individual investor in knowing the actual currency risk of the firm Markets are usually in disequilibirum because of structural and institutional imperfections

Exhibit 10.2 Hedging’s Impact on the Expected Cash Flows of the Firm

Measurement of Transaction Exposure
Transaction exposure measures gains or losses that arise from the settlement of existing financial obligations, namely Purchasing or selling on credit goods or services when prices are stated in foreign currencies Borrowing or lending funds when repayment is to be made in a foreign currency Being a party to an unperformed forward contract and Otherwise acquiring assets or incurring liabilities denominated in foreign currencies

Purchasing or Selling on Open Account
Suppose Trident Corporation sells merchandise on open account to a Belgian buyer for €1,800,000 payable in 60 days Further assume that the spot rate is $1.2000/€ and Trident expects to exchange the euros for €1,800,000 x $1.2000/€ = $2,160,000 when payment is received Transaction exposure arises because of the risk that Trident will something other than $2,160,000 expected If the euro weakens to $1.1000/€, then Trident will receive $1,980,000 If the euro strengthens to $1.3000/€, then Trident will receive $2,340,000

Purchasing or Selling on Open Account
Trident might have avoided transaction exposure by invoicing the Belgian buyer in US dollars, but this might have lead to Trident not being able to book the sale Even if the Belgian buyer agrees to pay in dollars, however, Trident has not eliminated transaction exposure, instead it has transferred it to the Belgian buyer whose dollar account payable has an unknown euro value in 60 days

Exhibit 10.3 The Life Span of a Transaction Exposure

Borrowing and Lending A second example of transaction exposure arises when funds are loaned or borrowed Example: PepsiCo’s largest bottler outside the US is located in Mexico, Grupo Embotellador de Mexico (Gemex) On 12/94, Gemex had US dollar denominated debt of $264 million The Mexican peso (Ps) was pegged at Ps$3.45/US$ On 12/22/94, the government allowed the peso to float due to internal pressures and it sank to Ps$5.50/US$

Borrowing and Lending Gemex’s peso obligation now looked like this
Dollar debt mid-December, 1994: US$264,000,000  Ps$3.45/US$ = Ps$910,800,000 Dollar debt in mid-January, 1995: US$264,000,000  Ps$5.50/US$ = Ps$1,452,000,000 Dollar debt increase measured in Ps Ps$541,200,000 Gemex’s Peso obligation increased by 59% due to transaction exposure

Other Causes of Transaction Exposure
When a firm buys a forward exchange contract, it deliberately creates transaction exposure; this risk is incurred to hedge an existing exposure Example: US firm wants to offset transaction exposure of ¥100 million to pay for an import from Japan in 90 days Firm can purchase ¥100 million in forward market to cover payment in 90 days

Contractual Hedges Transaction exposure can be managed by contractual, operating, or financial hedges The main contractual hedges employ forward, money, futures and options markets Operating and financial hedges use risk-sharing agreements, leads and lags in payment terms, swaps, and other strategies A natural hedge refers to an offsetting operating cash flow, a payable arising from the conduct of business A financial hedge refers to either an offsetting debt obligation or some type of financial derivative such as a swap

Trident’s Transaction Exposure
Maria Gonzalez, CFO of Trident, has just concluded a sale to Regency, a British firm, for £1,000,000 The sale is made in March for settlement due in three months time, June Assumptions Spot rate is $1.7640/£ 3 month forward rate is $1.7540/£ (a % discount) Trident’s cost of capital is 12.0% UK 3 month borrowing rate is 10.0% p.a. UK 3 month investing rate is 8.0% p.a.

Assumptions US 3 month borrowing rate is 8.0% p.a. US 3 month investing rate is 6.0% p.a. June put option in OTC market for £1,000,000; strike price $1.75; 1.5% premium Trident’s foreign exchange advisory service forecasts future spot rate in 3 months to be $1.7600/£ Trident operates on thin margins and Maria wants to secure the most amount of US dollars; her budget rate (lowest acceptable amount) is $1.7000/£

Exhibit 10.4 Trident’s Transaction Exposure

Maria faces four possibilities: Remain unhedged Hedge in the forward market Hedge in the money market Hedge in the options market

Unhedged position Maria may decide to accept the transaction risk If she believes that the future spot rate will be $1.76/£, then Trident will receive £1,000,000 x $1.76/£ = $1,760,000 in 3 months time However, if the future spot rate is $1.65/£, Trident will receive only $1,650,000 well below the budget rate

Forward Market hedge A forward hedge involves a forward or futures contract and a source of funds to fulfill the contract The forward contract is entered at the time the A/R is created, in this case in March When this sale is booked, it is recorded at the spot rate. In this case the A/R is recorded at a spot rate of $1.7640/£, thus $1,764,000 is recorded as a sale for Trident If Trident does not have an offsetting A/P in the same amount, then the firm is considered uncovered

Forward Market hedge Should Maria want to cover this exposure with a forward contract, then she will sell £1,000,000 forward today at the 3 month rate of $1.7540/£ She is now “covered” and Trident no longer has any transaction exposure In 3 months, Trident will received £1,000,000 and exchange those pounds at $1.7540/£ receiving $1,754,000 This sum is $6,000 less than the uncertain $1,760,000 expected from the unhedged position This would be recorded in Trident’s books as a foreign exchange loss of $10,000 ($1,764,000 as booked, $1,754,000 as settled)

Money Market hedge A money market hedge also includes a contract and a source of funds, similar to a forward contract In this case, the contract is a loan agreement The firm borrows in one currency and exchanges the proceeds for another currency Hedges can be left “open” (i.e. no investment) or “closed” (i.e. investment)

Money Market hedge To hedge in the money market, Maria will borrow pounds in London, convert the pounds to dollars and repay the pound loan with the proceeds from the sale To calculate how much to borrow, Maria needs to discount the PV of the £1,000,000 to today £1,000,000/1.025 = £975,610 Maria should borrow £975,610 today and in 3 months time repay this amount plus £24,390 in interest (£1,000,000) from the proceeds of the sale

Money Market hedge Trident would exchange the £975,610 at the spot rate of $1.7640/£ and receive $1,720,976 at once This hedge creates a pound denominated liability that is offset with a pound denominated asset thus creating a balance sheet hedge Assets Liabilities and Net Worth Account receivable £1,000,000 £1,000,000 Bank loan (principal) £ 975,610 Interest payable ,390 £1,000,000

In order to compare the forward hedge with the money market hedge, Maria must analyze the use of the loan proceeds Remember that the loan proceeds may be used today, but the funds for the forward contract may not Because the funds are relatively certain, comparison is possible in order to make a decision Three logical choices exist for an assumed investment rate for the next 3 months

First, if Trident is cash rich the loan proceeds might be invested at the US rate of 6.0% p.a. Second, Maria could use the loan proceeds to substitute an equal dollar loan that Trident would have otherwise taken for working capital needs at a rate of 8.0% p.a. Third, Maria might invest the loan proceeds in the firm itself in which case the cost of capital is 12.0% p.a. Received today Invested in Rate Future value in 3 months $1,720,976 Treasury bill 6% p.a. or 1.5%/quarter $1,746,791 $1,720,976 Debt cost 8% p.a. or 2.0%/quarter $1,755,396 $1,720,976 Cost of capital 12% p.a. or 3.0%/quarter $1,772,605

Because the proceeds in 3 months from the forward hedge will be $1,754,000, the money market hedge is superior to the forward hedge if Maria used the proceeds to replace a dollar loan (8%) or conduct general business operations (12%) The forward hedge would be preferable if Maria were to just invest the loan proceeds (6%) We will assume she uses the cost of capital as the reinvestment rate

A breakeven investment rate can be calculated in order to forgo numerous calculations and still aid Maria in her decision To convert this 3 month rate to an annual rate,

In other words, if Maria can invest the loan proceeds at a rate equal to or greater than 7.68% p.a. then the money market hedge will be superior to the forward hedge The following chart shows the value of Trident’s A/R over a range of possible spot rates both uncovered and covered using the previously mentioned alternatives

Option market hedge Maria could also cover the £1,000,000 exposure by purchasing a put option. This allows her to speculate on the upside potential for appreciation of the pound while limiting her downside risk Given the quote earlier, Maria could purchase 3 month put option at an ATM strike price of $1.75/£ and a premium of 1.5% The cost of this option would be

Because we are using future value to compare the various hedging alternatives, it is necessary to project the cost of the option in 3 months forward Using a cost of capital of 12% p.a. or 3.0% per quarter, the premium cost of the option as of June would be $26,460  1.03 = $27,254 Since the upside potential is unlimited, Trident would not exercise its option at any rate above $1.75/£ and would purchase pounds on the spot market If for example, the spot rate of $1.76/£ materializes, Trident would exchange pounds on the spot market to receive £1,000,000  $1.76/£ = $1,760,000 less the premium of the option ($27,254) netting $1,732,746

Unlike the unhedged alternative, Maria has limited downside with the option Should the pound depreciate below $1.75/£, Maria would exercise her option and exchange her £1,000,000 at $1.75/£ receiving $1,750,000 Less the premium of the option, Maria nets $1,722,746 Although this downside is less than that of the forward or money market hedge, the upside potential is not limited

As with the forward and money market hedges, Maria can also calculate her breakeven price on the option The upper bound of the range is determined by comparison of the forward rate The pound must appreciate above $1.754/£ forward rate plus the cost of the option, $0.0273/£, to $1.7813/£ The lower bound of the range is determined in a similar manner If the pound depreciates below $1.75/£, the net proceeds would be $1.75/£ less the cost of $0.0273/£ or $1.722/£

Exhibit 10.5 Valuation of Cash Flows Under Hedging Alternatives for Trident with Option

Put Option Strike Price ATM Option $1.75/£ Option cost (future cost) $27,254 Proceeds if exercised $1,750,000 Minimum net proceeds $1,722,746 Maximum net proceeds unlimited Breakeven spot rate (upside) $1.7813/£ Breakeven spot rate (downside) $1.7221/£

Strategy Choice and Outcome
Trident, like all firms, must decide on a strategy to undertake before the exchange rate changes but how will Maria choose among the strategies? Two criteria can be utilized to help Maria choose her strategy Risk tolerance - of the firm,as expressed in its stated policies and Viewpoint – Maria’s own view on the expected direction and distance of the exchange rate

After all the strategies have been explained, Trident now needs to compare the alternatives and their outcomes in order to choose a strategy There were four alternatives available to manage this account receivable and Maria has a budget rate at which she cannot fall below on this transaction

Hedging Strategy Outcome/Payout Remain uncovered Unknown Forward Contract $1.754/£ $1,754,000 Money market 8% p.a. $1,755,396 Money market 12% p.a. $1,772,605 Put option strike $1.75/£ Minimum if exercised $1,722,746 Maximum if not exercised Unlimited

Managing an Account Payable
Just as Maria’s alternatives for managing the receivable, the choices are the same for managing a payable Assume that the £1,000,000 was an account payable in 90 days Remain unhedged – Trident could wait the 90 days and at that time exchange dollars for pounds to pay the obligation If the spot rate is $1.76/£ then Trident would pay $1,760,000 but this amount is not certain

Use a forward market hedge – Trident could purchase a forward contract locking in the $1.754/£ rate ensuring that their obligation will not be more than $1,754,000 Use a money market hedge – this hedge is distinctly different for a payable than a receivable Here Trident would exchange US dollars spot and invest them for 90 days in pounds The pound obligation for Trident is now offset by a pound asset for Trident with matching maturity

Using a money market hedge – To ensure that exactly £1,000,000 will be received in 90 days time, Maria discounts the principal by 8% p.a. This £980, would require $1,729, at the current spot rate

Using a money market hedge – Finally, carry the cost forward 90 days in order to compare the payout from the money market hedge This is higher than the forward hedge of $1,754,000 thus unattractive

Using an option hedge – instead of purchasing a put as with a receivable, Maria would want to purchase a call option on the payable The terms of an ATM call option with strike price of $1,75/£ would be a 1.5% premium Carried forward 90 days the premium amount is comes to $27,254

Using an option hedge – If the spot rate is less than $1.75/£ then the option would be allowed to expire and the £1,000,000 would be purchased on the spot market If the spot rate rises above $1.75/£ then the option would be exercised and Trident would exchange the £1,000,000 at $1.75/£ less the option premium for the payable Exercise call option (£1,000,000  $1.75/£ $1,750,000 Call option premium (carried forward 90 days) $27,254 Total maximum expense of call option hedge $1,777,254

Exhibit 10.6 Valuation of Hedging Alternatives for an Account Payable

Risk Management in Practice
Which Goals? The treasury function of most firms is usual considered a cost center; it is not expected to add to the bottom line However, in practice some firms’ treasuries have become aggressive in currency management and act as profit centers Which Exposures? Transaction exposures exist before they are actually booked yet some firms do not hedge this backlog exposure However, some firms are selectively hedging these backlog exposures and anticipated exposures

Risk Management in Practice
Which Contractual Hedges? Transaction exposure management programs are generally divided along an “option-line;” those which use options and those that do not Also, these programs vary in the amount of risk covered; these proportional hedges are policies that state which proportion and type of exposure is to be hedged by the treasury

Translation Exposure Translation exposure, also called accounting exposure, arises because the financial statements of foreign subsidiaries must be restated in the parent’s reporting currency for the firm to prepare its consolidated financial statements Translation exposure is the potential for an increase or decrease in the parent’s net worth and reported income caused by a change in exchange rates since the last transaction Translation methods differ by country along two dimensions One is a difference in the way a foreign subsidiary is characterized depending on its independence The other is the definition of which currency is most important for the subsidiary

Subsidiary Characterization
Most countries specify the translation method to be used by a foreign subsidiary based upon its operations A foreign subsidiary can be classified as Integrated Foreign Entity – one which operates as an extension of the parent company, with cash flows and line items that are highly integrated with the parent Self-sustaining Foreign Entity – one which operates in the local economy independent of its parent The foreign subsidiary should be valued in terms of the currency that is the basis of its economic viability

Functional Currency A foreign affiliate’s functional currency is the currency of the primary economic environment in which the subsidiary operates The geographic location of a subsidiary and its functional currency can be different Example: US subsidiary located in Singapore may find that its functional currency could be US dollars (integrated subsidiary) Singapore dollars (self-sustaining subsidiary) British pounds (self-sustaining subsidiary)

Translation Methods There are two basic methods for the translation of foreign subsidiary financial statements The current rate method The temporal method Regardless of which is used, either method must designate The exchange rate at which individual balance sheet and income statement items are remeasured Where any imbalances are to be recorded This can affect either the balance sheet or the income statement

Current Rate Method Under this method all financial statement items are translated at the “current” exchange rate Assets & liabilities – are translated at the rate of exchange in effect on the balance sheet date Income statement items – all items are translated at either the actual exchange rate on the dates the various revenues, expenses, gains and losses were incurred or at a weighted average exchange rate for the period Distributions – dividends paid are translated at the rate in effect on the date of payment Equity items – common stock and paid-in capital are translated at historical rates; year end retained earnings consist of year-beginning plus or minus any income or loss on the year

Current Rate Method Any gain or loss from re-measurement is closed to an equity reserve account entitled the cumulative translation adjustment, rather than through the company’s consolidated income statement These cumulative gains and losses from remeasurement are only recognized in current income under the current rate method when the foreign subsidiary giving rise to that gain or loss is liquidated

Temporal Method Under this method, specific assets and liabilities are translated at exchange rates consistent with the timing of the item’s creation The temporal method assumes that a number of line items such as inventories and net plant and equipment are restated to reflect market value If these items were not restated and carried at historical costs, then the temporal method becomes the monetary/non-monetary method

Temporal Method Line items included in this method are
Monetary assets (primarily cash, accounts receivable, and long-term receivables) and all monetary liabilities are translated at current exchange rates Non-monetary assets (primarily inventory and plant and equipment) are translated at historical exchange rates Income statement items – are translated at the average exchange rate for the period except for depreciation and cost of goods sold which are associated with non-monetary items, these items are translated at their historical rate

Temporal Method Line items included in this method are
Distributions – dividends paid are translated at the exchange rate in effect the date of payment Equity items – common stock and paid-in capital are translated at historical rates; year end retained earnings consist of year-beginning plus or minus any income or loss on the year plus or minus any imbalance from translation Under the temporal method, any gains or losses from remeasurement are carried directly to current consolidated income and not to equity reserves

US Translation Procedures
The US differentiates foreign subsidiaries on the basis of functional currency, not subsidiary characterization Under US GAAP, following are the procedures for foreign subsidiary translation

Translation Example – Trident Europe
As we continue with our Trident example we now shift from Trident’s operating exposure to its translation exposure Recall that the euro depreciated by 16.67% or moved from $1.200/€ in December 2002 to $1.000/€ in January 2003 The functional currency of the subsidiary is the euro and the currency of the parent is US dollars PP&E, common stock, and long-term debt were acquired by Trident Europe at a past rate of $1.2760/€ Inventory on hand was purchased or manufactured during the immediately prior quarter when the average exchange rate was $1.2180/€ The example will also look at the consequences had the euro appreciated to $1.3200/€

Exhibit 10.7 Trident Corporation:US Multinational

Managerial Implications
In the previous slides, the translation loss or gain is larger under the current rate method because inventory and PP&E as well as monetary assets are deemed exposed The managerial implications are If management expects a currency to depreciate, it could minimize translation exposure by reducing net exposed assets If management expects appreciation, it should increase net exposed assets to benefit from the gain

Managing Translation Exposure
Balance Sheet Hedge – this requires an equal amount of exposed foreign currency assets and liabilities on a firm’s consolidated balance sheet A change in exchange rates will change the value of exposed assets but offset that with an opposite change in liabilities This is termed monetary balance The cost of this method depends on relative borrowing costs in the varying currencies

Managing Translation Exposure
When is a balance sheet hedge justified? The foreign subsidiary is about to be liquidated so that the value of its CTA would be realized The firm has debt covenants or bank agreements that state the firm’s debt/equity ratios will be maintained within specific limits Management is evaluated on the basis of certain income statement and balance sheet measures that are affected by translation losses or gains The foreign subsidiary is operating in a hyperinflationary environment

Choosing Which Exposure to Minimize
As a general matter, firms seeking to reduce both types of exposures typically reduce transaction exposure first They then recalculate translation exposure and then decide if any residual translation exposure can be reduced without creating more transaction exposure

Summary of Learning Objectives
MNEs encounter three types of currency exposure: (1) transaction; (2) operating; and (3) translation exposure Transaction exposure measures gains or losses that arise from the settlement of financial obligations whose terms are stated in a foreign currency Operating exposure measures the change in the present value of the firm resulting from any change in future operating cash flows caused by an unexpected change in exchange rates Translation exposure is the potential for accounting-oriented changes in owner’s equity when a firm translates foreign subsidiaries’ financial statements to consolidated financial statements

Considerable theoretical debate exists as to whether firms should hedge currency risk. Theoretically, hedging reduces the variability of the cash flows to the firm. It does not increase the cash flows to the firm. In fact, the costs of hedging may potentially lower them Transaction exposure can be managed by contractual techniques and certain operating strategies. Contractual hedging techniques include forward, futures, money market, and option hedges The choice of which contractual hedge to use depends on the individual firm’s currency risk tolerance and its expectation of the probable movement of exchange rates over the transaction exposure period

In general, if an exchange rate is expected to move in a firm’s favor, the preferred contractual hedges are probably those which allow it to participate in some up-side potential, but protect it against significant adverse exchange rate movements In general, if the exchange rate is expected to move against the firm, the preferred contractual hedge is one which locks in an exchange rate, such as the forward contract hedge or money market hedge Risk management in practice requires a firm’s treasury department to identify its goals. Is treasury a cost center or profit center?

Treasury must also choose which contractual hedges it wishes to use and what proportion of the currency risk should be hedged. Additionally, treasury must determine whether the firm should buy and/or sell currency options, a strategy that has historically been risky for some firms and banks Translation exposure results from translating foreign– currency-denominated statements of foreign subsidiaries into the parent’s reporting currency so the parent can prepare consolidated financial statements. Translation exposure is the potential for loss or gain from this translation process

A foreign subsidiary’s functional currency is the currency of the primary economic environment in which the subsidiary operates and in which it generates cash flows. In other words, it is the dominant currency used by that foreign subsidiary in its day-today operations The two basic procedures for translation used in most countries today are the current rate method and the temporal method Technical aspects of translation include questions about when to recognize gains or losses in the income statement, the distinction between functional and reporting currency, and the treatment of subsidiaries in hyperinflation countries

Translation gains and losses can be quite different from operating gains and losses, not only in magnitude but also in sign. Management may need to determine which is of greater significance prior to deciding which exposure is to be managed first The main technique for managing translation exposure is a balance sheet hedge. This calls for having an equal amount of exposed foreign currency assets and liabilitie Even if management chooses to follow an active policy of hedging translation exposure, it is nearly impossible to offset both transaction and translation exposure simultaneously. If forced to choose, most managers will protect against transaction losses because these are realized cash losses, rather than protect against translation losses

Transaction and Translation Exposure

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