Measuring and Managing Translation and Transaction Exposure

CHAPTER 10 Measuring and Managing Translation and Transaction Exposure

The stream of time sweeps away errors, and leaves the truth for the inheritance of humanity.

George Brandes

LEARNING OBJECTIVES

• To define translation and transaction exposure and distinguish between the two

• To describe the four principal currency translation methods available and to calculate translation exposure using these different methods

• To describe and apply the current (FASB-52) currency translation method prescribed by the Financial Accounting Standards Board

• To identify the basic hedging strategy and techniques used by firms to manage their currency transaction and translation risks

• To explain how a forward market hedge works

• To explain how a money market hedge works

• To describe how foreign currency contract prices should be set to factor in exchange rate change expectations

• To describe how currency risk-sharing arrangements work

• To explain when foreign currency options are the preferred hedging technique

• To describe the costs associated with using the different hedging techniques

• To describe and assess the economic soundness of the various corporate hedging objectives

• To explain the advantages and disadvantages of centralizing foreign exchange risk management

KEY TERMS

accounting exposure

cross-hedge

currency call option

currency collar

currency options

currency put option

currency risk sharing

current exchange rate

current/noncurrent method

current rate method

cylinder

economic exposure

exposure netting

Financial Accounting Standards Board (FASB)

foreign exchange risk

forward market hedge

functional currency

funds adjustment

hard currency

hedging

historical exchange rate

hyperinflationary country

monetary/nonmonetary method

money market hedge

neutral zone

operating exposure

opportunity cost

price adjustment clause

range forward

reporting currency

risk shifting

soft currency

Statement of Financial Accounting Standards No. 52 (FASB 52)

Statement of Financial Accounting Standards No. 133 (FASB 133)

temporal method

transaction exposure

translation exposure

Foreign currency fluctuations are one of the key sources of risk in multinational operations. Consider the case of Dell Inc., which operates assembly plants for its computers within the United States as well as in Ireland, Malaysia, China, and Brazil; runs offices and call centers in several other countries; and markets its products in more than 100 countries. Dells currency problems are evident in the fact that it may manufacture a product in Ireland for sale in, say, Denmark and obtain payments in Danish krone. Dell would like to ensure that its foreign profits are not eroded by currency fluctuations. Also, at the end of the year, when Dell consolidates its financial statements for the year in U.S. dollars, it wants to ensure that exchange rate changes do not adversely impact its financial performance.

The pressure to monitor and manage foreign currency risks has led many companies to develop sophisticated computer-based systems to keep track of their foreign exchange exposure and aid in managing that exposure. The general concept of exposure refers to the degree to which a company is affected by exchange rate changes. This impact can be measured in several ways. As so often happens, economists tend to favor one approach to measuring foreign exchange exposure, whereas accountants favor an alternative approach. This chapter deals with the measurement and management of accounting exposure, including both translation and transaction exposure. Management of accounting exposure centers on the concept of hedging. Hedging a particular currency exposure means establishing an offsetting currency position so that whatever is lost or gained on the original currency exposure is exactly offset by a corresponding foreign exchange gain or loss on the currency hedge. Regardless of what happens to the future exchange rate, therefore, hedging locks in a dollar (home currency) value for the currency exposure. In this way, hedging can protect a firm from foreign exchange risk, which is the risk of valuation changes resulting from unforeseen currency movements.

10.1 Alternative Measures of Foreign Exchange Exposure

The three basic types of exposure are translation exposure, transaction exposure, and operating exposure. Transaction exposure and operating exposure combine to form economic exposure. Exhibit 10.1 illustrates and contrasts translation, transaction, and operating exposure. As can be seen, these exposures cannot always be neatly separated but instead overlap to some extent.

Translation Exposure

Translation exposure, also known as accounting exposure, arises from the need, for purposes of reporting and consolidation, to convert the financial statements of foreign operations from the local currencies (LC) involved to the home currency (HC). If exchange rates have changed since the previous reporting period, this translation, or restatement, of those assets, liabilities, revenues, expenses, gains, and losses that are denominated in foreign currencies will result in foreign exchange gains or losses. The possible extent of these gains or losses is measured by the translation exposure figures. The rules that govern translation are devised by an accounting association such as the Financial Accounting Standards Board (FASB) in the United States, the parent firm’s government, or the firm itself. Appendix 10A discusses Statement of Financial Accounting Standards No. 52 (FASB 52)—the present currency translation method prescribed by FASB.

Exhibit 10.1 Comparison of Translation, Transaction, and Operating Exposures

Transaction Exposure

Transaction exposure results from transactions that give rise to known, contractually binding future foreign-currency-denominated cash inflows or outflows. As exchange rates change between now and when these transactions settle, so does the value of their associated foreign currency cash flows, leading to currency gains and losses. Examples of transaction exposure for a U.S. company would be the account receivable associated with a sale denominated in euros or the obligation to repay a Japanese yen debt. Although transaction exposure is rightly part of economic exposure, it is usually lumped under accounting exposure. In reality, transaction exposure overlaps with both accounting and operating exposure. Some elements of transaction exposure, such as foreign-currency-denominated accounts receivable and debts, are included in a firm’s accounting exposure because they already appear on the firm’s balance sheet. Other elements of transaction exposure, such as foreign currency sales contracts that have been entered into but the goods have not yet been delivered (and so receivables have not yet been created), do not appear on the firm’s current financial statements and instead are part of the firm’s operating exposure.

Operating Exposure

Operating exposure measures the extent to which currency fluctuations can alter a company’s future operating cash flows—that is, its future revenues and costs. Any company whose revenues or costs are affected by currency changes has operating exposure, even if it is a purely domestic corporation and has all its cash flows denominated in home currency.

The two cash-flow exposures—operating exposure and transaction exposure—combine to equal a company’s economic exposure. In technical terms, economic exposure is the extent to which the value of the firm—as measured by the present value of its expected cash flows—will change when exchange rates change.

10.2 Alternative Currency Translation Methods

Companies with international operations will have foreign-currency-denominated assets and liabilities, revenues, and expenses. However, because home country investors and the entire financial community are interested in home currency values, the foreign currency balance sheet accounts and income statement must be assigned HC values. In particular, the financial statements of an MNC’s overseas subsidiaries must be translated from local currency to home currency before consolidation with the parent’s financial statements.

If currency values change, foreign exchange translation gains or losses may result. Assets and liabilities that are translated at the current (postchange) exchange rate are considered to be exposed; those translated at a historical (prechange) exchange rate will maintain their historical HC values and, hence, are regarded as not exposed. Translation exposure is simply the difference between exposed assets and exposed liabilities. The controversies among accountants center on which assets and liabilities are exposed and on when accounting-derived foreign exchange gains and losses should be recognized (reported on the income statement). A crucial point to realize in putting these controversies in perspective is that such gains or losses are of an accounting nature—that is, no cash flows are necessarily involved.

Four principal translation methods are available: the current/noncurrent method, the monetary/nonmonetary method, the temporal method, and the current rate method. In practice, there are also variations of each method.

Current/Noncurrent Method

At one time, the current/noncurrent method, whose underlying theoretical basis is maturity, was used by almost all U.S. multinationals. With this method, all the foreign subsidiary’s current assets and liabilities are translated into home currency at the current exchange rate. Each noncurrent asset or liability is translated at its historical exchange rate—that is, at the rate in efffect at the time the asset was acquired or the liability was incurred. Hence, a foreign subsidiary with positive local currency working capital will give rise to a translation loss (gain) from a devaluation (revaluation) with the current/noncurrent method, and vice versa if working capital is negative.

The income statement is translated at the average exchange rate of the period, except for those revenues and expense items associated with noncurrent assets or liabilities. The latter items, such as depreciation expense, are translated at the same rates as the corresponding balance sheet items. Thus, it is possible to see different revenue and expense items with similar maturities being translated at different rates.

Monetary/Nonmonetary Method

The monetary/nonmonetary method differentiates between monetary assets and liabilities—that is, those items that represent a claim to receive, or an obligation to pay, a fixed amount of foreign currency units—and nonmonetary, or physical, assets and liabilities. Monetary items (e.g., cash, accounts payable and receivable, and long-term debt) are translated at the current rate; nonmonetary items (e.g., inventory, fixed assets, and long-term investments) are translated at historical rates.

Income statement items are translated at the average exchange rate during the period, except for revenue and expense items related to nonmonetary assets and liabilities. The latter items, primarily depreciation expense and cost of goods sold, are translated at the same rate as the corresponding balance sheet items. As a result, the cost of goods sold may be translated at a rate different from that used to translate sales.

Temporal Method

The temporal method appears to be a modified version of the monetary/nonmonetary method. The only difference is that under the monetary/nonmonetary method, inventory is always translated at the historical rate. Under the temporal method, inventory is normally translated at the historical rate, but it can be translated at the current rate if it is shown on the balance sheet at market values. Despite the similarities, the theoretical bases of the two methods are different. The choice of exchange rate for translation is based on the type of asset or liability in the monetary/nonmonetary method; in the temporal method, it is based on the underlying approach to evaluating cost (historical versus market). Under a historical cost-accounting system, as the United States now has, most accounting theoreticians probably would argue that the temporal method is the appropriate method for translation.

Income statement items normally are translated at an average rate for the reporting period. However, cost of goods sold and depreciation and amortization charges related to balance sheet items carried at past prices are translated at historical rates.

Current Rate Method

The current rate method is the simplest: All balance sheet and income items are translated at the current rate. This method is widely employed by British companies. With some variation, it is the method mandated by the current U.S. translation standard—FASB 52. Under the current rate method, if a firm’s foreign-currency-denominated assets exceed its foreign-currency-denominated liabilities, a devaluation must result in a loss and a revaluation must result in a gain.

Exhibit 10.2 applies the four methods to a hypothetical balance sheet that is affected by both a 25% devaluation and a 37.5% revaluation. Depending on the method chosen, the translation results for the LC devaluation can range from a loss of $205,000 to a gain of $215,000; LC revaluation results can vary from a gain of $615,000 to a loss of $645,000. The assets and liabilities that are considered exposed under each method are the ones that change in dollar value. Note that the translation gains or losses for each method show up as the change in the equity account. For example, the LC devaluation combined with the current rate method results in a $205,000 reduction in the equity account ($1,025,000 − $820,000), which equals the translation loss for this method. Another way to calculate this loss is to take the net LC translation exposure, which equals exposed assets minus exposed liabilities (for the current rate method, this figure is LC 4,100,000, which, not coincidentally, equals its equity value) and multiply it by the $0.05 ($0.25 − $0.20) change in the exchange rate. This calculation yields a translation loss of $205,000 ($0.05 × 4,100,000), the same as calculated in Exhibit 10.2. Another way to calculate this loss is to multiply the net dollar translation exposure by the fractional change in the exchange rate, or $1,025,000 × 0.05/0.25 = $205,000. Either approach gives the correct answer.

10.3 Transaction Exposure

Companies often include transaction exposure as part of their accounting exposure, although as a cash-flow exposure, it is rightly part of a company’s economic exposure. As we have seen, transaction exposure stems from the possibility of incurring future exchange gains or losses on transactions already entered into and denominated in a foreign currency. For example, when IBM sells a mainframe computer to Royal Dutch Shell in England, it typically will not be paid until a later date. If that sale is priced in pounds, IBM has a pound transaction exposure.

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, including foreign-currency-denominated debt and accounts receivable, are already listed on the firm’s balance sheet. However, other obligations, such as contracts for future sales or purchases, are not.

Application Computing Transaction Exposure for Boeing 

Suppose Boeing Airlines sells five 747s to Garuda, the Indonesian airline, in rupiahs. The rupiah price is Rp 140 billion. To help reduce the impact on Indonesias balance of payments, Boeing agrees to buy parts from various Indonesian companies worth Rp 55 billion.

a. If the spot rate is $0.004/Rp, what is Boeing’s net rupiah transaction exposure?

Solution. Boeing’s net rupiah exposure equals its projected rupiah inflows minus its projected rupiah outflows, or Rp 140 billion − Rp 55 billion = Rp 85 billion. Converted into dollars at the spot rate of $0.004/Rp, Boeing’s transaction exposure equals $340 million.

b. If the rupiah depreciates to $0.0035/Rp, what is Boeing’s transaction loss?

Solution. Boeing will lose an amount equal to its rupiah exposure multiplied by the change in the exchange rate, or 85 billion X (0.004 − 0.0035) = $42.5 million. This loss can also be determined by multiplying Boeing’s exposure in dollar terms by the fractional change in the exchange rate, or 340 million X (0.0005/0.004) = $42.5 million.

Exhibit 10.2 Financial Statement Impact of Translation Alternatives (U.S. $ Thousands)

Although translation and transaction exposures overlap, they are not synonymous. Some items included in translation exposure, such as inventories and fixed assets, are excluded from transaction exposure, whereas other items included in transaction exposure, such as contracts for future sales or purchases, are not included in translation exposure. Thus, it is possible for transaction exposure in a currency to be positive and translation exposure in that same currency to be negative and vice versa.

10.4 DESIGNING A HEDGING STRATEGY

We now come to the problem of managing exposure by means of hedging. As mentioned earlier, hedging a particular currency exposure means establishing an offsetting currency position so as to lock in a dollar (home currency) value for the currency exposure and thereby eliminate the risk posed by currency fluctuations. A variety of hedging techniques are available for managing exposure, but before a firm uses them it must decide on which exposures to manage and how to manage them. Addressing these issues successfully requires an operational set of goals for those involved in exchange risk management. Failure to set out objectives can lead to possibly conflicting and costly actions on the part of employees. Although many firms do have objectives, their goals are often so vague and simplistic (e.g., “eliminate all exposure” or “minimize reported foreign exchange losses”) that they provide little realistic guidance to managers.1 For example, should an employee told to eliminate all exposure do so by using forward contracts and currency options or by borrowing in the local currency? And if hedging is not possible in a particular currency, should sales in that currency be forgone even if it means losing potential profits? The latter policy is likely to present a manager with the dilemma of choosing between the goals of increased profits and reduced exchange losses. Moreover, reducing translation exposure could increase transaction exposure and vice versa. What trade-offs, if any, should a manager be willing to make between these two types of exposure?

These and similar questions demonstrate the need for a coherent and effective strategy. The following elements are suggested for an effective exposure management strategy:2

1. Determine the types of exposure to be monitored.

2. Formulate corporate objectives and give guidance in resolving potential conflicts in objectives.

3. Ensure that these corporate objectives are consistent with maximizing shareholder value and can be implemented.

4. Clearly specify who is responsible for which exposures, and detail the criteria by which each manager is to be judged.

5. Make explicit any constraints on the use of exposure-management techniques, such as limitations on entering into forward contracts.

6. Identify the channels by which exchange rate considerations are incorporated into operating decisions that will affect the firm’s exchange risk posture.

7. Develop a system for monitoring and evaluating exchange risk management activities.

Objectives

The usefulness of a particular hedging strategy depends on both acceptability and quality. Acceptability refers to approval by those in the organization who will implement the strategy, and quality refers to the ability to provide better decisions. To be acceptable, a hedging strategy must be consistent with top management’s values and overall corporate objectives. In turn, these values and objectives are strongly motivated by management’s beliefs about financial markets and how its performance will be evaluated. The quality, or value to the shareholders, of a particular hedging strategy is, therefore, related to the congruence between those perceptions and the realities of the business environment.

The most frequently occurring objectives, explicit and implicit, in management behavior include the following:3

1. Minimize translation exposure. This common goal necessitates a complete focus on protecting foreign-currency-denominated assets and liabilities from changes in value resulting from exchange rate fluctuations. Given that translation and transaction exposures are not synonymous, reducing the former could cause an increase in the latter (and vice versa).

2. Minimize quarter-to-quarter (or year-to-year) earnings fluctuations owing to exchange rate changes. This goal requires a firm to consider both its translation exposure and its transaction exposure.

3. Minimize transaction exposure. This objective involves managing a subset of the firm’s true cash-flow exposure.

4. Minimize economic exposure. To achieve this goal, a firm must ignore accounting earnings and concentrate on reducing cash-flow fluctuations stemming from currency fluctuations.

5. Minimize foreign exchange risk management costs. This goal requires a firm to balance off the benefits of hedging with its costs. It also assumes risk neutrality.

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