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Exposure refers to the degree to which a company is affected by exchange rate changes. Exchange rate risk is defined as the variability of a firms value due to uncertain changes in the rate of exchange.
Types of Exposures
Translation Exposure
Economic Exposure
Transaction Exposure
Operating Exposure
Tax Exposure
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Transaction Exposure
Stems from the possibility of incurring exchange gains or losses on transactions already entered into and denominated in a foreign currency. They are changes in the value of outstanding contracts
Real exchange gains or losses Mixes retrospective and prospective Short-term in nature
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Translation Exposure
Arises from the need, for purposes of reporting and consolidation, to convert the results of foreign operations from the local currency to the home currency. Represents change in value of owner equity
Paper exchange gains or losses Retrospective in nature Short-term in nature
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Operating Exposure
Arises because currency fluctuations combined with price level changes can alter the amounts and riskiness of a firms future revenues and costs. Represents change in the PV of the firm (real exchange rates)
Real exchange gains or losses Prospective in nature Long-term in nature
Tax Exposure
The tax consequence of foreign exposure varies by countries. As a general rule:
Only realized foreign exchange losses are tax deductible. Only realized foreign exchange gains create taxable income
t0 t1
t2
t3
t0 t1 t2 t3
- order price quoted - order placed - few days later - order shipped - 2 - 3 weeks - order settled - 90 days
outflows in each foreign currency, and determine the overall risk of exposure to those currencies.
Managing Exposure
Managing exposure centers around the concept of hedging, which means:
Entering into an offsetting currency position so whatever is lost/gained on the original currency exposure is exactly offset by a corresponding currency gain/loss on the currency hedge. The coordinated buying or selling of a currency to minimize exchange rate risk.
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Why Hedge ?
hedging
reduces volatility of cash flows incurs costs
not hedging
exposure to risk by speculating that exchange rates will not move against you
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Objectives of Hedging
Minimize translation exposure. Minimize quarter-to-quarter earnings fluctuations arising from exchange rate changes. Minimize transaction exposure. Minimize economic exposure. Minimize foreign exchange risk management costs. Avoid surprises.
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Financial Hedges
Swaps leads & lags
Operating Strategies
Risk Shifting Price adjustment clauses Exposure Netting Risk Sharing
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8.01%-7.98%
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Let us assume that SR0 = $0.6433 (Spot Rate day 0) FR180 = $0.6578 (Forward rate day 180)
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To hedge in the forward market, American Airlines will enter into a 180-day forward contract to sell 70 million for dollars today (t=0).
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1 = $0.64
1= $0.6578
$46,046,000
$46,046,000
1 = $0.67
$46,900,000 -854,000
$46,046,000
1 = $0.70
To hedge in the money market, American Airlines has to borrow today (t=0) sufficient euros for 180 days which, when exchanged today for dollars and invested for 180 days in the U.S., will be paid off with exactly the euro receivable of 70 million. Amount of euros borrowed in Germany for 180 days: Amount of dollars to be invested today in the U.S.:
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Cross hedge
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CROSS-HEDGING
1. Often forward contracts not available in a certain currency. 2. Solution: a cross-hedge
a forward contract in a related currency.
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Drawback:
it is not possible with informed customers or suppliers
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Exposure Netting
Offsetting exposures in one currency with exposures in the same or another currency. A firms currency exposures can be viewed as a portfolio. Exposure netting depends on the correlation between currencies. Exposure netting strategies: Negatively correlated currencies Positively correlated currencies
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Currency Collars
Contract bought to protect against currency moves outside the neutral zone. Firm would convert its foreign currency denominated receivable at the zone forward rate. Providing protection if the currency moves outside an agreed-on range.
Range forward Cylinder
Combined put purchase and call sale Limits upside potential Provides downside risk protection Lowers hedging cost
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A put option
allows the company to insure its profit margin against
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Translation Exposure
Translation exposure results when an MNC translates each subsidiarys financial data to its home currency for consolidated financial reporting. Translation exposure does not directly affect cash flows, but some firms are concerned about it because of its potential impact on reported consolidated earnings Translation exposure arises when
financial statements are denominated in another currency lines on income statement
accrued at different times accrued at different exchange rates
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Functional Currency
The currency of the primary economic environment in which the subsidiary operates and in which it generates and expends cash.
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Translation Methods
Methods for the translation of foreign subsidiary financial statements:
Current / non current Monetary / non monetary The temporal method The current rate method
Current / non-current
Current accounts use current exchange rate for conversion. Non-Current accounts use the historical exchange rates (at the time the asset or liability showed up on balance sheet). Income statement accounts use average exchange rate for the period. This method of foreign currency translation was generally accepted in the United States from the 1930s until 1975, at which time FASB 8 became effective.
balance sheet items - stock statement current assets & liabilities - current rate non-current assets & liabilities historical rate income statement items - flow statement most items - average rate except cashflows associated with non-current assets or liabilities translated - historical rate depreciation
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Current / non-current
Example Current Spot S$/dm=.50 Historic Spot S$/dm = .333
Balance Sheet Cash Inventory Net fixed assets Total Assets Current liabilities Long-Term debt Common stock Retained earnings CTA Total Liabilities and Equity Local Current/ Currency Noncurrent 2,100 DM $1,050 1,500 DM $750 3,000 DM $1,000 6,600 DM $2,800 1,200 DM $600 1,800 DM $600 2,700 DM $900 900 DM $700 --------------6,600 DM $2,800
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Monetary / nonmonetary
The underlying principal is that monetary accounts have a similarity because their value represents a sum of money whose value changes as the exchange rate changes. All monetary balance sheet accounts (cash, marketable securities, accounts receivable, etc.) of a foreign subsidiary are translated at the current exchange rate. All other (nonmonetary) balance sheet accounts (owners equity, land) are translated at the historical exchange rate in effect when the account was first recorded. balance sheet items - stock statement monetary assets (claims) - current rate non-monetary (physical) assets historical rate income statement items - flow statement most items - average rate except cashflows associated with noncurrent assets or liabilities translated historical rate depreciation, cost of goods sold
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Monetary / nonmonetary
Example Current Spot S$/dm=.50 Historic Spot S$/dm = .333
Balance Sheet Cash Inventory Net fixed assets Total Assets Current liabilities Long-Term debt Common stock Retained earnings CTA Total Liabilities and Equity
Local Monetary/ Currency Nonmonetary 2,100 DM $1,050 1,500 DM $500 3,000 DM $1,000 6,600 DM $2,550 1,200 DM $600 1,800 DM $900 2,700 DM $900 900 DM $150 --------------6,600 DM $2,550
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Temporal method
The underlying principal is that assets and liabilities should be translated based on how they are carried on the firms books. Balance sheet account are translated at the current spot exchange rate if they are carried on the books at their current value. Items that are carried on the books at historical costs are translated at the historical exchange rates in effect at the time the firm placed the item on the books. balance sheet items - stock statement
monetary assets (claims) - current rate inventories current rate / historical rate non-monetary (physical) assets - historical rate
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Current method
All financial statement items are translated at the current exchange rate.
Assets & liabilities Income statement items Dividends Equity account
Unrealized translation gains or losses are recorded in a separate equity account on the parents consolidated balance sheet called the Cumulative Translation Adjustment (CTA) account balance sheet items at current rate income statement items
exchange rate in effect on dates incurred average exchange rate over the period
Balance Sheet Cash Inventory Net fixed assets Total Assets Current liabilities Long-Term debt Common stock Retained earnings CTA Total Liabilities and Equity
Local Currency DM2,100 DM1,500 DM3,000 DM6,600 DM1,200 DM1,800 DM2,700 DM900 -------DM6,600
Current Rate $1,050 $750 $1,500 $3,300 $600 $900 $900 $360 $540 $3,300
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US Translation Procedures
The US differentiates foreign subsidiaries on the basis of the functional currency, not subsidiary characterization. This, in turn, determines which translation method is used:
Local currency
Temporal method
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Hyperinflation Countries
A hyperinflationary country is one which has cumulative inflation of approximately 100% or more over a three year period.
Functional currency
U.S. dollar
Translation method
Temporal method
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offsetting exposures in one currency with exposures in the same or another currency
gains and losses on the two currency positions will offset each other.
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3. 4.
i.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.
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Forward Hedge Uncovered or open hedge. Not a hedge but an attempt to gain by forward speculation a sum equal to the book loss in translation. Success depends on precise prediction of future exchange rates. Such a hedge will increase the tax burden.
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