Accounting Exposure. Translation exposure measures the change in the book value of the assets and liabilities excluding stockholders equity as residual due to changes in the exchange rate from the last translation.
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Translation exposure measures the change in the book value of the assets and liabilities excluding stockholders equity as residual due to changes in the exchange rate from the last translation.
Example: Consider a U.S. multinational company’s subsidiary in Great Britain whose balance sheet and income statement are translated to the parent’s functional currency—the U.S. dollar. The pound has devalued from $1.50/pound to $1.40/pound since the last translation.
In December 1998 DuPont entered into a forward contract in the acquisition of the performance coating business of Hoechst AG for 3.1 billion deutsche marks (DM) at $1.9 billion.
The forward contract effectively locked the company at the forward exchange rate of 1.6316DM/$, insulating DuPont from adverse exchange rate movements that would likely have increased the dollar price of the acquisition.
Value at risk (VAR) provides a framework for analysis of the maximum potential loss in the fair value of an exposed position over a specific period assuming normal market conditions and a given confidence interval.
MNCs have various exposures due to interest rate changes, foreign exchange rate changes, as well as to the changes in the commodity prices that could adversely affect the value of the firm.
VAR analysis uses simulation models by assuming various scenarios to generate the amount of maximum loss that could be realized in a given period for a given confidence interval.
For example, a bond portfolio with market value of $250 million might have VAR at 95 percent confidence interval of $15.6176 million over the next 10 days assuming standard deviation of the exposed portfolio is equal to 16 percent per annum.
The volatility is usually quoted in year, however, for the purpose of estimating the VAR of an asset, the volatility of the asset is quoted on a daily basis as volatility per day as follows:
σd = σy / (252) ½
VAR= amount of exposure*volatility*confidence interval
Lufthansa by agreeing to pay dollars for the aircrafts accepted all the exchange rate risk and reward for the above contract.
To manage exposure to dollar appreciation the company decided to leave half of the liability exposed to foreign exchange risk and purchased the other half, $250 million, in the forward market at the forward rate of $.3125/deutsche mark or 3.2 DM/$. By hedging half of the exposure the company effectively locked at the forward rate of $.3125/deutsche mark, to pay DM800 million for buying $250 million forward.
Hedged $250 million at $.3125 for DM800 million
Exposed $250 million at the prevailing exchange rate in January 1986.
By January 1986, the deutsche mark appreciated and the dollar weakened to $.45/deutsche mark and the forward hedging turned out to be very costly ex-post.
1. Remain unhedged
2. Fully cover the exposure: buy dollars forward
3. Manage some of the exposure, leaving some exposed
4. Use call options in dollar/deutsche mark or its equivalent the put options in deutsche mark/dollar
5. Buy caps in dollars or floors in deutsche marks (in the over the counter market from a bank or insurance company)
The operating exposure arises due to the impact of unexpected change in the exchange rate on the firm’s input price, that is, raw materials, labor costs, and out put prices such as prices of the goods and services produced. Operating exposure is long term in nature and therefore can only be managed through operating hedges..
Operating hedges can be achieved as follows:
1) Increasing Flexibility of Operating Net Works:Provide MNCs the flexibility to arbitrage institutional restrictions, such as regulatory impediments, various requirements by regulatory agencies as well as to arbitrage taxes and factors of productions across international boundaries.]
2) Diversifying Operations:This type of diversification naturally hedges cash flow derived from various operations overseas; however, it is expensive in terms of cost and lengthy in implementation.
3) Diversifying Financing with Matching Cash Flows:This approach is similar to the money market hedging discussed earlier in the chapter. The exporter selling goods and services overseas in this scenario has accepted the foreign currency for the receivables and therefore is exposed to foreign exchange risk.