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Lecture 7

Measuring & Managing Accounting Exposure. Lecture 7. FOREIGN EXCHANGE EXPOSURE. “Foreign exchange exposure” refers to the degree to which a company is affected by exchange rates changes Three basic types of forex exposure : Translation exposure Transaction exposure Operating exposure.

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Lecture 7

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  1. Measuring & Managing Accounting Exposure Lecture 7

  2. FOREIGN EXCHANGE EXPOSURE • “Foreign exchange exposure” refers to the degree to which a company is affected by exchange rates changes • Three basic types of forex exposure: • Translation exposure • Transaction exposure • Operating exposure

  3. Measuring Accounting Exposure • Accounting exposure arises from the need (for purposes of reporting and consolidation) to convert financial statements of foreign operations to local currency  i.e. from FC to HC. • If exchange rates have changed since the last accounting period, foreign exchange gains or losses will be reported

  4. MEASURING ACCOUNTING EXPOSURE (cont’d) Translation Exp.  simply the difference bet. exposed assets and exposed liabilities. Exposure that arises from the need to translate FC denom. financial stats into HC for purpose of consolidation Transaction Exp.  the extent to which a given Δ the value of forex denominated transactions already entered into. i.e. future gains / losses on transaction already agreed to. Accounting Exposure Under accounting exposure  its mostly translation exposure, less transaction exp.  the latter will be covered more under economic exposure.

  5. MEASURING ACCOUNTING EXPOSURE (cont’d) • The translation of foreign operation financial statements are governed by rules estblished by the FASB (Financial Accounting Standards Board). • These rules were meant to ensure consistency and standardize reporting / translation, but (1) the diff. avail. methods and (2) the question of which and when an asset / liability is exposed – has led to continuing controversy. • Whatever it is, we must keep in mind that the differences in the methods are of an accounting nature and need not necessarily mean  in cash flows. • Just as there are diff. methods used to measure the same thing in accounting  e.g. inventory or depreciation, there are 4 principal methods of translation.

  6. MEASURING ACCOUNTING EXPOSURE (cont’d) • 1. Current/Non-current method. • . Monetary/ Non-monetary method. • . Temporal method. • . Current rate method. Translation Methods • Current / Non-Current Method • Balance Sheet • Allcurrentassets &liabilities. translated at current exchange rate. • All non-current assets & liabilities. translated at historical exchange rate. i.e. the rate at time it was bought / sold etc. • *So translation gains/losses will arise solely due to whether it’s current asset & current liability. • if CA > CL then gain if LC of foreign subsidiary. appreciates; loss if LC depreciates • if CA < CL then loss if LC of foreign subsidiary appreciates; gain if LC depreciates • Income Statement • Translated at average exchange rate of the accounting period. • Except for items assoc. with non current assets/liab. e.g. depreciation  trans. at the same rates that were used for fixed assets in the balance sheet. (historical exchange rate)

  7. (current – exch. Rate) MEASURING ACCOUNTING EXPOSURE (cont’d) 2. Monetary / Non Monetary Method Eg. a/c. rec;. cash ( current exch. rate) Monetary assets/liab. A/c pay; bank OD etc. LT. debt Differentiates between Non monetary assets/liab. (historical rate) Physical assets - fixed asset. - inventory Ret. Earns etc. • Income Statement • Average exchange rate of period except for items related to non-monetary items of B. Sheet  eg. depreciation. And cost of goods  at rate applied to fixed assets. and Inventory in Balance Sheet. •  As such, under mon./ non-mon. method, COGs may be translated at historical rate (used for inventory), while sales at the average exchange rate of a/c period.

  8. TRANSLATION, OPERATING & TRANSACTION EXPOSURE COMPARISONS TRANSLATION EXPOSURE Operating EXPOSURE Changes in future operating cash flows (caused by an exchange rate change) Exchange gains & losses are real Impacts revenues and costs associated with future sales TRANSACTION EXPOSURE Affects value of outstanding forex denominated contracts Contracts entered into, but to be settled at a later date Changes in income statements & book value of assets and liabilities (caused by an exchange rate change) Exchange gains & losses arepaper only Impacts balance sheet assets and liabilities & income statements that already exist.

  9. MEASURING ACCOUNTING EXPOSURE (cont’d) • Temporal Method Balance Sheet • Really a variant of monetary/non-monetary method. Only diff. is that under this method, inventory can be valued in balance sheet at market values.  • Note : In monetary/non-monetary  inventory always at historical values • Income statement  again exactly same as monetary / non-monetary method ( average / historical)

  10. MEASURING ACCOUNTING EXPOSURE (cont’d) 4. Current Rate Method • All balance sheet and income statement items are translated at current exchange rate. • Thus if FC denominated assets > FC denominated liabilities Then FC appreciation gain FC depreciation  loss * The other way round, if FC-assets <FC-liabilities: loss if FC appreciates; gain if FC depreciates

  11. TACKLING ACCOUNTING EXPOSURE • As can be seen from Exhibit 10.2 in the text book there is wide variation in the reported gains/losses. • FASB 8 means that US companies had to use the temporal method  the Board’s reason in choosing this method over others was consistency with GAAP (Generally Accepted Accounting Principles) • FASB 8 also disallows the establishment of reserves against which companies previously added gains or deducted losses  thereby cushioning the impact of exch. rate Δ on reported numbers  esp. profits. • This led to widespread dissatisfaction with FASB 8, and was replaced by FASB 52

  12. Balance Sheet  firms must use current method for FC Allowed estb. Of “cumulative translation adjustment” in bal. Sheet in which trans. gains / losses can be adjusted.  i.e. brought back reserves a/c. FASB 52  3 MAIN CHARACTERISTICS Balance Sheet  firms must use current method for DC-denomin assets/liabilities. 1.FASB 52 Income stat.  all items to be translated at either the exchange rate on date the items are recognized or a weighted av. Exch. Rate for the period. 2. Allows establishment of “cumulative translation adjustment” in balance sheet in which transaction gains / losses can be adjusted. 3. FASB 52  also differentiates bet. functional currencyandreporting currency. Currency of primary econ. environ. of foreign subsidiary Parents’ HC currency

  13. FASB 52  3 MAIN CHARACTERISTICS • For a foreign subsidiary producing and selling within a foreign country, the functional currency would be FC; for assembly operations for exports  the functional currency could still be the USD - i.e. parent’s HC. Eg. Motorola, Intel, etc. • Occasionally, a foreign subsidiary’s functional currency could be a third currency. Eg. American subsidiary located in Singapore producing telephone equipment for China, etc. (SGD as functional currency). • FASB 52  also states that in the case of a hyperinflationary country, defined as country with more than 100% inflation, functional currency must be USD regardless.

  14. TRANSACTION EXPOSURE Transaction Exposure • Relates to the possibility of incurring future exchange gains or losses on transactions already entered into and denominated in a foreign currency. • A company’s transaction exposure is measured currency by currency, and equals the difference between contractually fixed future cash inflows and outflows in each currency. • Some of these unsettled transactions, such as long-term debts, etc. would already have shown up in the Bal. Sheet, but others esp. off bal. sheet items - like leasing agreements, agreements for future buying/selling in FC etc. - are not included. • *Thus, while a firm could show very little translation exposure, it could have substantial transaction exposure that may only show up later.

  15. ACCOUNTING EXPOSURE Accounting Exposure in Perspective • *Recall that accounting is by nature retrospective; • i.e. historical  tells what happened in past. • Often, accounting values may have little semblance to market values. • As a result, accounting exposure could give a misleading picture of a firm’s true-economic exposure  which is prospective. • So, emphasizing accounting exposure, esp. translation exposure, alone may be myopic. E.g. by translation exposure, you could get gains by  liabilities in a depreciating currency, however, if you did that, you face transaction exposure  since, the currency could begin to appreciate in the subsequent year!

  16. MANAGING TRANSACTION EXPOSURE • By “managing” we mean trying to anticipate and reduce the impact of transaction exposure. • Built around the concept of “hedging” broadly defined  i.e. not just using forward / futures contracts, but other actions to reduce impact. • So, “managing” really means first (1) identifying which exposures need to be managed (2) then, having identified, how do we reduce the impact.

  17. MANAGING TRANSACTION EXPOSURE (cont’d) Which exposure Managing Exposure How do we reduce the impact? Translation expo. Recall that Accounting Exposure Transaction expo.

  18. MANAGING TRANSACTION EXPOSURE (cont’d) How to Manage Transaction Exposure • Since transaction exposure is exposure arising from commitments made today that will have cash-flows in the future, protective measures will mean entering into FC transactions whose cash flow (CF) will exactly offset the CF of the transaction exposure.

  19. MANAGING TRANSACTION EXPOSURE (cont’d) • Illustration: Managing Transaction Exposure GE has sold turbine blades to Lufthansa. Contract awarded 1st January. Lufthansa will pay GE: DM 25 mil. on 31st December. • Obviously, this is a typical transaction exposure. How can GE protect itself from this exposure? Several alternatives are available.

  20. MANAGING TRANSACTION EXPOSURE (cont’d) • Forward Mkt. Hedge  GE can short 1 year DM forward • Currency Futures Contracts • Currency Options • Risk Shifting • Pricing Strategy • Exposure Netting • Currency Risk Sharing • Money Market Hedge • Currency Collars

  21. RISK SHIFTING • GE could have shifted all currency exposure risk on to Lufthansa, if Lufthansa had agreed to pay GE in USD. • Invoicing in USD does not eliminate risk, it merely shifts it to the customer. • So, risk-shifting is a zero sum game. Yet, in international business firms often try to invoice exports in a strong currency and imports in weak currencies. • *Unless, your customer is ill informed, customer will only agree to pay in USD if it is not going to cost much more in home currency. • Suppose Lufthansa agrees only to pay up to $ 9.57 mil (DM 25 mil. x 0.3828 = $9.57)

  22. RISK SHIFTING (cont’d) • *Note : If GE is also well-informed $9.57 mil. should also be acceptable to them since it is arrived at using the expected 1-year exchange rate (forward rate) • If GE had quoted DM25 mil, thinking it can get $10 mil. (using e0 i.e. spot rate) 1 year from now, they’ve been ignorant. • Thus, when both parties are well informed players, risk-shifting cannot work.

  23. PRICING STRATEGY • The idea here is to price the product in FC using the expected forward rate and not at current spot rate (e0). • For e.g. In this case, GE should have priced the turbine : if they wanted to be paid $10 million • So, where FC expected to , charge more using the lower expected rate, while if FC expected to , you can afford to charge the same or less. • We could use appropriate expected rates (forward rates) or take a weighted average. • Using the pricing decision (i.e. using ê1 rather than e0) to reduce transaction exposure is merely recognizing the fact that a DM today is not equal to DM received at a future date.

  24. EXPOSURE NETTING • Involves offsetting exposuresin one currency with exposures in the same currency or another currency where exchange rates are expected to move in such a way that losses (gains) on the initial position will be offset by gains (losses) on the second position. • For example, in the GE case, since they’relongDM 25 mil to be received in a year, this could be offset by creating a liability that will be payable in exactly 1 year for the same amount. (25 mil. DM). In this case, a long position risk is offset by entering into a short position counter transaction of equal size. • E.g. GE could buy the tungsten (or any other needed supply) from German Supplier, worth DM 25 mil. repayable in one year. Since they are receiving 25 mil. DM from Lufthansa, use it to pay the other German supplier.

  25. EXPOSURE NETTING (cont’d) • The basic idea is that, the asset (a/c receivable) is offset by the liability created (a/c payable). • An alternative is to use an offsetting position in another currency. E.g. If there’s another currency that is positively correlated with DM  then a short position in that currency e.g. SFR. would give the same ‘hedging’/offsetting effect. • If there’s another currency that is negatively correlated,then GE could offset is current long position in DM by taking a long position in the negatively correlated currency. • *Note: depending on the strength of the correln. we may have to use more of the other currency. E.g. If SFR is perfectly positively corr. (  = 1.0) then a short position of exactly [25 mil. / e0] would be sufficient.

  26. MONEY MARKET HEDGE • Involves simultaneous borrowing & lending in 2 diff. currencies to lock-in the dollar value of a future foreign currency Cash Flow. • Suppose German int. = 15%, US int. = 10%, e0 = 1 DM = 0.40, e1 =0.3828 (expected 1 yr from today) *Useful for currencies that don’t have forward contracts (note that the outcome is same as in forward hedge).

  27. SELECTIVE HEDGING • Money Market Hedge Example 2: GE has 1-year EUR 10 m receivable from Lufthansa. GE borrows EUR 10 m at 7% interest rate = EUR 9.35 m (10/1.07). Convert this into USD 14.02 million in spot market (1EUR = $1.5) and invest it for 1 year at 5.5%. 1 year later, GE will receive $14.79 m (14.02 x 1.055). GE will use its EUR 10 m proceeds from Lufthansa to pay off EUR 10 million it owes in principal and interest Note: exchange gain or loss on the borrowing and lending transactions exactly offset the dollar loss or gain on GE’s euro receivable. ($14.79 = EUR 10m @ EUR = $1.479) At old XR of 1.5, 10m euro = $15m; at new XR it equals $14.79m • Cross-Hedging: similar to hedging with futures; where the exact futures contract a firm seeks is unavailable, it may cross-hedge its exposure by using futures on another currency that is correlated with the currency of interest

  28. FORWARD MARKET HEDGE • Let’s return to the case (Money Market Hedge Example) where GE sells turbine blades to Lufthansa: this time valued at EUR 10 m • Suppose current spot rate is USD 1.500/EUR and 1 year forward rate is USD 1.479/EUR • Forward sale of EUR 10 m for delivery 1 yr later will yield USD 14.79 m • Regardless of what happens to future spot rate, GE will get US 14.79 m • Any exchange gain or loss on forward contract will be offset by corresponding exchange loss or gain on the receivable

  29. FORWARD MARKET HEDGE (cont’d) • Cost of hedging depends on future spot rate and therefore can’t be calculated in advance. Consider 3 scenarios: 1. If future spot rate turns out to be USD 1.500/EUR, the receivable could have been USD 15 m and the “cost” of hedging would be USD 210,000 (15,000,000 – 14,790,000) [with no hedging $15m; with hedging $14.79m] 2 . If future spot rate were USD 1.479 (same as forward rate); no diff in receivable (USD 14.79 m) and thus the “cost” of hedging would be zero [proceeds with hedging = proceeds with no hedging] 3. If future spot rate were USD 1.400, the value of the receivable would have been USD 14 m if not hedged, and the “cost” of hedging would be ‘negative’ USD 790,000 (14,790,000 – 14,000,000 = 790,000) [gains $790,000, thanks to hedging]

  30. FORWARD MARKET HEDGE (cont’d) • In all the above 3 scenarios, total cash flow (CF) would be USD 14,790,000 (Exhibit 10.6 in the text book) • Scenario 1: If GE did not hedge, it could have received USD 15 m; by hedging GE “loses” $ 210,000 (15,000,000 – 210,000 = 14,790,000 CF) • Scenario 2: if GE did not hedge, it would still have received $ 14,790,000 CF (neither loss nor gain) • Scenario 3: if GE did not hedge, it would have received only USD 14 m. By hedging it has “gained” $ 790,000 (14,000,000 + 790,000 = 14,790,000 CF)

  31. CURRENCY RISK SHARING ARRANGEMENT (CRSA) • CRSA is a customized hedge contract embedded in the underlying trade transaction. • Usually as a “price-adjustment clause”. – whereby a base price is adjusted to reflect certain exchange rate changes. • E.g. the base price could be set at DM 25 mil. but both parties agree to share the currency risk beyond a “neutral zone”. • E.g. Neutral Zone $0.39 – 0.41 per DM  with a base rate of $0.40 per DM. • So, within the “neutral zone”, Lufthansa will pay $10 mil  (25 mil DM x 0.40) – Thus, Lufthansa’s cost could vary from DM24.39 mil (10/0.41) to DM 25.64 mil (10/.039) • *But, if DM falls below or rises above the neutral zone both parties share the risk.

  32. CRSA (cont’d) • E.g. if DM falls to $0.35  which is $0.04 lower than lowest rate of Neutral Zone, the 4¢ is split to 2¢ for each party. • So, Lufthansa will pay $0.40 – 0.02 = $0.38 x 25 mil DM = $9.5 mil. • Note : at $ 0.35 per DM, GE should get $8.75 mil. but Lufthansa pays $0.75 mil. more. • Likewise if DM  to $0.45 per DM  which is again 4¢ higher than upper boundary of neutral zone, the 4¢ is again split  with Lufthansa paying (25 DM mil x 0.42) = $10.5 mil.  which means that, in DM terms, Lufthansa only pays 23.33 mil DM ($10.5 mil / $0.45). • So, when DM  beyond neutral zone Lufthansa gains partly (since they could have gotten DM 25 mil. x 0.45 = $11.25 mil) GE loses partly. • When DM  beyond neutral zone Lufthansa loses partly GE gains partly.

  33. USING DERIVATIVES INSTRUMENTS • Currency forwards • Currency options • Currency futures • Currency collars (Range Forward) • Collars: a contract that provides protection against currency moves outside an agreed-upon range (e.g $1.45 to $1.55 per EUR). Company wants protection if the rate were to move below $1.45 or rise above $1.55 (ceiling price invoked if spot rate breaks ceiling; floor price invoked if spot rate breaks floor) • Company agrees to sell euro proceeds at future spot rate to the bank should the rate fall within the above range. If that rate exceeds $1.55, it will convert euro proceeds at $1.55, in which case the bank makes profit. If future spot rate falls below $1.45, it will convert euro proceeds at $1.45, in which case the bank suffers a loss

  34. CURRENCY COLLARS • Example • Let’s revisit GE selling turbine blades to Lufthansa • GE enters into a currency collar contract with a bank (a) to sell EUR 10 m @ future spot rate, if that falls within the range of $1.45 to $1.55 per EUR; (b) to sell EUR 10 m at $1.55 if future spot rate > $1.55; and (c) to sell EUR 10 m at $1.45 if future spot rate < $1.45

  35. CURRENCY COLLARS (cont’d) • In Scenario (a), the bank neither gains nor loses as the risk is borne entirely by GE: if future spot rate for euro were $1.49, GE converts EUR 10 m into USD 14.9 m at the spot market • In Scenario (b), the bank makes a profit: if the future spot rate were $1.56, GE converts EUR 10 m at $1.55 into USD 15.5 m , while the bank gains $100,000 (15,600,000 – 15,500,000) • In Scenario (c), the bank suffers a loss: if the future spot rate were $1.44, GE converts EUR 10 m at $1.45 into USD 14.5 m, while the bank loses $100,000 (14,500,000 – 14,400,000)

  36. MANAGING TRANSLATION EXPOSURE • The basic strategy of translation exposure management involves increasing hard currency assets and decreasing soft currency assets, while simultaneously decreasing hard currency liabilities, and increasing soft-currency liabilities. • For e.g. if you expect a LC devaluation; reduce cash levels, tighten credit terms to reduce a/c receivable, increase local borrowing, delay a/c payable and other such things.

  37. MANAGING TRANSLATION EXPOSURE • To carry out this basic strategy, 3 methods are often used: 1. adjusting fund flows 3 Common Methods 2. entering into forward contracts. 3. exposure netting *Since, forward contracts, and exposure netting have already been discussed, we’ll only cover only (1) adjusting fund flows.

  38. MANAGING TRANSLATION EXPOSURE Fund Adjustment • Involves altering either the amounts or the currencies (or both) of the planned cash flows of the parent and / or its subsidiaries to reduce the firm’s local currency accounting exposure. • For e.g. if an LC devaluation is anticipated, direct funds–adjustment methods include pricing exports in hard-currencies, and replacinghard-currency loans with local currency loans. • Other methods include (a) adjusting transfer prices on sale of goods between affiliates,(b) speeding up the payment of dividends, fees and royalties and (c) adjusting the leads and lags of inter-subsidiary accounts.

  39. OBJECTIVE OF HEDGING STRATEGY • *Note: if financial markets are efficient, firms cannot hedge expected in exchange rates. • Interest rates, forward rates and sales-contract prices should already reflect anticipated s. **So, the objective of a firm’s fund adjustment strategy should be to protect itself only against unexpectedcurrency changes. *Also, many of the techniques outlined earlier  esp. funds adjustment techniques (like transfer–prices, borrowing in devaluing currency etc. are widely known and can often hurt business relationships  since your suppliers / customers may not like it.

  40. BASIC HEDGING TECHNIQUES Depreciation of LC Appreciation of LC Buy LC forward Buy LC call option RelaxLC credit terms (increase LC receivables) Delay payment of int-subs a/c payable Borrow abroad Hasten pmt of a/c pay Delay div/fee remittances Speed up collec of FC rec InvoiceX in LC; M in FC • SellLC forward • Buy LC put option • Tighten LC credit (reduce LC receivables) • Speed uppayment of int-subs a/c payable • Borrowlocally • Delaypayment of a/c pay • Hastendiv/fee remittance • Delay collection of FC rec • InvoiceX in FC; M in LC

  41. SUMMARY & CONCLUSION • Accounting exposure consists of (1) translation exposure and (2) transaction exposure (more of the former) • Economic exposure comprises of (1) transaction exposure and (2) operating exposure • Translation exposure impacts on balance sheet assets & liabilities, and existing income statement items • Transaction exposure impacts on FC denominated contracts already signed but to be settled at a future date

  42. SUMMARY & CONCLUSION (cont’d) • Operating exposure impacts on revenues and costs associated with future sales and cash flows • Translation exposure is simply the difference between exposed assets and exposed liabilities • There are many ways to measure and manage accounting exposure [esp. translation exposure] using (a)current exchange rates, (b)historical rates, and (c) averagerates for the reporting period

  43. SUMMARY & CONCLUSION (cont’d) • Transaction and operating exposure calls for hedging mane0vers which include currency forwards, currency options, currency futures, cross-hedging, currency collars, money market hedge, currency risk-sharing, exposure netting, etc. • Exposure management goal is to arrange a multinational firm’s financial affairs in such a way as to minimize the effects of exchange rate movements on dollar returns

  44. 2011 EXAMINATION QUESTION (4) (a) What would a multinational firm do if it expects the local currency to depreciate in the near term? Underline the correct answers (focus on the italics) in what follows: • *buy/sell foreign currency forward • *go for local currency call/put option • *reduce/increase local currency cash and marketable securities. • relax/tighten local currency credit terms • hasten/delay collection of hard currency receivables • borrow locally/abroad • delay/speed up payment of accounts payable abroad • delay/speed up dividend and fee remittances to parent company and other subsidiaries (9 marks)

  45. 2011 EXAM QUESTION (4) cont’d (b) An American pension fund buys euro bonds worth EUR 10 million (upon maturity a year later) for USD 13.3 million at the current rate of USD 1.40 per EUR. In addition, it makes a forward sale of EUR 10 million at the forward rate of USD 1.379 per EUR • What is the cost of hedging if the future spot rate turns out to be: *EUR 1 = USD 1.40 *EUR 1 = USD 1.379 *EUR1 = USD 1.30 (6 marks)

  46. 2011 EXAM QUESTION (4) cont’d • Show how an exchange gain (loss) on the forward contract is offset by a corresponding exchange loss (gain) in the value of receivable, with a total cash flow of USD 13.79 million in all the above three instances, resulting in a net gain of USD 490,000 (USD 13.79 m -13.3 m). (3 marks)

  47. END OF LECTURE 7 TAKE IT EASY & REST WELL!

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