Management of Exposure

Chapter-11

FX Exposure and FX risk

FX Exposure is a measure of sensitivity of a firms cash flows, market value and profitability to change as a result of changes in exchanges rates. FX Risk is the variance of the domestic currency value of assets , liabilities or operating incomes that is attributable to unanticipated changes in foreign exchange rates Fx risk depends on the exposure as well as the variability of the unanticipated changes in the exchange rate

Types of Exposure
Exposure to exchange rate fluctuations comes in three forms Transaction Exposure Translation or accounting Exposure and Economic Exposure

Transaction Exposure
The sensitivity of the firms contractual transactions in foreign currencies to exchange rate movements Major tasks: Identifying Net Transaction Exposure Decision whether to hedge this exposure Choosing from various hedging techniques available

Economic Exposure
The sensitivity of the firms cash flows to exchange rate movements(Operating Exposure) Refers to potential changes in all future cash flows of a firm that result from unanticipated changes in exchange rates Transaction Exposure is a subset of economic exposure

Translation Exposure
Also known as Accounting Exposure The exposure of the MNCs consolidated financial statements to exchange rate fluctuations Measures the effect of exchange rate change on published financial statements of a firm. Guidelines for Translation are set by FASB 52 Guidelines for valuing existing currency derivative contracts are set by FASB 133

FASB 8 and FASB 52

FASB No. 8:U.S. AS that requires US firms to translate their foreign affiliates' accounts by the temporal method; Reporting gains and losses from currency fluctuations in current income. It was in effect between 1975 and 1981 and became the most controversial accounting standard in the US. It was replaced by FASB NO.52 in 1981.

FASB 52
The US accounting standard that replaced FASB 8 (Dec 15th 1981) US companies are required to translate foreign accounts in terms of the current rate and Report the changes from currency fluctuations in a cumulative translation adjustment account in the equity section of the balance sheet. Differentiates between a foreign affiliates functional and reporting currency

Functional Currency
Currency of the primary economic environment in which the affiliate operates and in which it generates cash flows Local Currency of the country in which the entity conducts most of its business

Reporting Currency
Currency in which the parent firm prepares its own financial statements. Home country currency i.e the currency of the country in which the parent is located and conducts most of its business.

Identifying Functional Currency

If foreign affiliates operations are relatively self contained and integrated with a particular country then its functional currency is the local currency of that country If the foreign affiliates operations were an extension of the (US)parents operations, the functional currency could be the parent country currency(i.e US dollar)

Translation Methods
Current Rate Method of FAS 52 Monetary/Non-Monetary Method Temporal Method Current/Non-Current Method

Balance Sheet
If foreign affiliates currency is deemed to be the parents currency-translation of the statements is done in the temporal method of FAS #8 For other affiliates use the current rate method. Under FAS No.52 if temporal Method is usedtranslation gains or losses flow through the Income Statement as they did under FAS # 8 and are not charged to CTA account.

Current Rate Method of FAS 52

All assets and liabilities except common equity are translated at the current exchange rate Common equity at historical exchange rates Income statement items at a current exchange rate Any difference between the book value of the assets and liabilities is recorded as a separate equity account called the CTA(Cumulative Translation Adjustment)

Monetary/Non-Monetary method
Monetary balance sheet accounts-(cash , marketable securities etc) are translated at the current exchange rate Other non- monetary balance sheet accounts(Owners equity , land ) are translated at historical exchange rate

Current/Non-current Method
All CA and Cl of foreign affiliates are translated at current exchange rate All non current assets , non current liabilities and owners equity at historical exchange rates Most income statement items related to current items are translated at average Exchange rate Depreciation is related to real assets(non monetary)and are translated at historical Exchange rate

Temporal Method of FAS No.8

Monetary assets and Monetary liabilities at the current exchange rate Non Monetary assets and non monetary liabilities and owners equity are translated at historical rates(Inventory and fixed assets) Most income statement items related to current items are translated at average Exchange rate Depreciation and cost of goods sold are related to real assets(non monetary)and are translated at historical Exchange rate

Exchange rates used to translate Balance sheet

Balance Sheet Cash Accounts Receivable Pre-paid Exp Current/noncurrent C C C Monetary/nonmonetary C C C Temporal C C C Current Rate C C C

Accounts Payable Inventory/Stock

Land Fixed Assets Long-term debt Debentures Net worth Retained Earnings Equity Share Capital

C C
H H H H H H H

C H
H H C C H H H

C C or H
H H C C H H H

C C
C C C C H H H

Translation Exposure
Accounting Exposure = Exposed Exposed Assets - Liabilities Accounting Loss shown in CTA Account: Total Assets exposed Total liabilities exposed (including Equity or capital stock)