Foreign Exchange Risk Management
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13
Transaction Exposure Example
– Monetary assets and liabilities are translated at current exchange rates.
– Non-monetary assets and liabilities are translated at historical rates.
– Income statement items are translated at the average exchange rate for the period.
2
Types of Foreign Exchange Exposure
❖ Changes in exchange rates can effect firm value through:
3
Example
A Taiwanese company has the following USD exposures: 1. Owns a factory in Texas worth US$5 million. 2. Agreement to buy goods worth US$2 million. 3. Biggest competitor is a US company.
6
Current Rate Method
❖The current rate method is the most prevalent in the world today.
– Assets and liabilities are translated at the current rate of exchange.
Foreign Exchange Risk Management
Readings: Chapters 8, 9 and 10 (p335-352)
1
Lecture Outline
❖ Introduction to foreign exchange exposures ❖ Translation exposure ❖ Transaction exposure ❖ To hedge or not? ❖ Hedging techniques ❖ Operating exposure ❖ Managing Operating exposure
– Income statement items are translated at the exchange rate on the dates they were recorded or an appropriately weighted average rate for the period.
7
Temporal Method
❖ Under the temporal method, specific assets are translated at exchange rates consistent with the timing of the item’s creation.
❖ This method assumes that a number of individual line item assets such as inventory and net plant and equipment are restated regularly to reflect market value.
❖ Thus, this type of exposure deals with changes in cash flows that result from existing contractual obligations.
11
Sources of Transaction Exposure
❖ Transaction exposure arises from:
12
Transaction Exposure Example
❖ Suppose a U.S. firm, Trident, sells merchandise on account to a Belgian buyer for: ▪ €1,800,000 payment to be made in 60 days. ▪ S0 = $0.9000/€ ▪ The U.S. seller expects to exchange the €1,800,000 for $1,620,000 when payment is received.
❖ Regardless of which method is employed, a translation method must not only designate at what exchange rate individual balance sheet and income statement items are remeasured, but also designate where any imbalance is to be recorded (current income or an equity reserve account).
▪ Purchasing or selling on credit goods or services whose prices are stated in foreign currencies.
▪ Borrowing or lending funds when repayment is to be made in a foreign currency.
– The biggest advantage of the current rate method is that the gain or loss on translation does not pass through the income statement but goes directly to a reserve account (reducing variability of reported earnings).
❖ If this can be achieved for each foreign currency, net translation exposure will be zero.
❖ These hedges are a compromise in which the denomination of balance sheet accounts is altered, perhaps at a cost in terms of interest expense or operating efficiency, to achieve some degree of foreign exchange protection.
– Dividends (distributions) are translated at the exchange rate on the date of payment.
– Equity items are translated at historical rates.
9
Managing Translation Exposure
❖ The accounting process of translation, involves converting these foreign subsidiaries financial statements into home currency-denominated statements.
10
Transaction Exposure
❖ Transaction exposure measures changes in the value of outstanding financial obligations incurred prior to a change in exchange rates but not due to be settled until after the exchange rates change.
8
Monetary / Non-monetary Method
❖ If these items were not restated but were instead carried at historical cost, the temporal method becomes the monetary/non-monetary method of translation.
❖ The main technique to minimize translation exposure is called a balance sheet hedge.
❖ A balance sheet hedge requires an equal amount of exposed foreign currency assets and liabilities on a firm’s consolidated balance sheet.
4
Translation Exposure
❖ Translation exposure, also called accounting exposure, arises because financial statements of foreign subsidiaries – which are stated in foreign currency – must be restated in the parent’s reporting currency for the firm to prepare consolidated financial statements.
5
Translation Methods
❖ Two basic methods for the translation of foreign subsidiary financial statements are employed worldwide: – The current rate meห้องสมุดไป่ตู้hod – The temporal method
❖ Gains or losses resulting from remeasurement are carried directly to current consolidated income, and not to equity reserves (increased variability of consolidated earnings).
1. What happens if the NT dollar appreciates? 1. NT$ value of US factory goes down (translation). 2. NT$ cost of buying goods goes down (transaction). 3. Global competitiveness of Taiwanese company decreases (operating).
▪ Being a party to an unperformed foreign exchange forward contract.
▪ Otherwise acquiring assets or incurring liabilities denominated in foreign currencies.
❖ Translation exposure is the potential for an increase or decrease in the parent’s net worth and reported net income caused by a change in exchange rates since the last translation.
Transaction Exposure Example
– Monetary assets and liabilities are translated at current exchange rates.
– Non-monetary assets and liabilities are translated at historical rates.
– Income statement items are translated at the average exchange rate for the period.
2
Types of Foreign Exchange Exposure
❖ Changes in exchange rates can effect firm value through:
3
Example
A Taiwanese company has the following USD exposures: 1. Owns a factory in Texas worth US$5 million. 2. Agreement to buy goods worth US$2 million. 3. Biggest competitor is a US company.
6
Current Rate Method
❖The current rate method is the most prevalent in the world today.
– Assets and liabilities are translated at the current rate of exchange.
Foreign Exchange Risk Management
Readings: Chapters 8, 9 and 10 (p335-352)
1
Lecture Outline
❖ Introduction to foreign exchange exposures ❖ Translation exposure ❖ Transaction exposure ❖ To hedge or not? ❖ Hedging techniques ❖ Operating exposure ❖ Managing Operating exposure
– Income statement items are translated at the exchange rate on the dates they were recorded or an appropriately weighted average rate for the period.
7
Temporal Method
❖ Under the temporal method, specific assets are translated at exchange rates consistent with the timing of the item’s creation.
❖ This method assumes that a number of individual line item assets such as inventory and net plant and equipment are restated regularly to reflect market value.
❖ Thus, this type of exposure deals with changes in cash flows that result from existing contractual obligations.
11
Sources of Transaction Exposure
❖ Transaction exposure arises from:
12
Transaction Exposure Example
❖ Suppose a U.S. firm, Trident, sells merchandise on account to a Belgian buyer for: ▪ €1,800,000 payment to be made in 60 days. ▪ S0 = $0.9000/€ ▪ The U.S. seller expects to exchange the €1,800,000 for $1,620,000 when payment is received.
❖ Regardless of which method is employed, a translation method must not only designate at what exchange rate individual balance sheet and income statement items are remeasured, but also designate where any imbalance is to be recorded (current income or an equity reserve account).
▪ Purchasing or selling on credit goods or services whose prices are stated in foreign currencies.
▪ Borrowing or lending funds when repayment is to be made in a foreign currency.
– The biggest advantage of the current rate method is that the gain or loss on translation does not pass through the income statement but goes directly to a reserve account (reducing variability of reported earnings).
❖ If this can be achieved for each foreign currency, net translation exposure will be zero.
❖ These hedges are a compromise in which the denomination of balance sheet accounts is altered, perhaps at a cost in terms of interest expense or operating efficiency, to achieve some degree of foreign exchange protection.
– Dividends (distributions) are translated at the exchange rate on the date of payment.
– Equity items are translated at historical rates.
9
Managing Translation Exposure
❖ The accounting process of translation, involves converting these foreign subsidiaries financial statements into home currency-denominated statements.
10
Transaction Exposure
❖ Transaction exposure measures changes in the value of outstanding financial obligations incurred prior to a change in exchange rates but not due to be settled until after the exchange rates change.
8
Monetary / Non-monetary Method
❖ If these items were not restated but were instead carried at historical cost, the temporal method becomes the monetary/non-monetary method of translation.
❖ The main technique to minimize translation exposure is called a balance sheet hedge.
❖ A balance sheet hedge requires an equal amount of exposed foreign currency assets and liabilities on a firm’s consolidated balance sheet.
4
Translation Exposure
❖ Translation exposure, also called accounting exposure, arises because financial statements of foreign subsidiaries – which are stated in foreign currency – must be restated in the parent’s reporting currency for the firm to prepare consolidated financial statements.
5
Translation Methods
❖ Two basic methods for the translation of foreign subsidiary financial statements are employed worldwide: – The current rate meห้องสมุดไป่ตู้hod – The temporal method
❖ Gains or losses resulting from remeasurement are carried directly to current consolidated income, and not to equity reserves (increased variability of consolidated earnings).
1. What happens if the NT dollar appreciates? 1. NT$ value of US factory goes down (translation). 2. NT$ cost of buying goods goes down (transaction). 3. Global competitiveness of Taiwanese company decreases (operating).
▪ Being a party to an unperformed foreign exchange forward contract.
▪ Otherwise acquiring assets or incurring liabilities denominated in foreign currencies.
❖ Translation exposure is the potential for an increase or decrease in the parent’s net worth and reported net income caused by a change in exchange rates since the last translation.