Translation and Transaction Exposure.ppt

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1、Translation and Transaction Exposure,International Corporate FinanceP.V. ViswanathFor use with Alan Shapiro “Multinational Financial Management”,P.V. Viswanath,2,Learning Objectives,To define translation and transaction exposure To describe the four principal currency translation methods. To describ

2、e and apply the FASB-52 currency translation method Different Hedging Strategies,P.V. Viswanath,3,Exchange Risk,Definition: A gain/loss that results due to an exchange rate change. Only unanticipated exchange rate changes constitute risk. Question: Whose gain or loss? Ans: The subsidiarys? The paren

3、ts? No, the shareholders. However, the link between exchange risk and shareholder value is weak. If a shareholder has a diversified portfolio, then the negative effect of exchange rate changes on one firm might be offset by the positive effect on another firm. Also, even if there is no offset, let t

4、he shareholder do the hedging.,P.V. Viswanath,4,Justifications for Corporate Hedging,Assessment of exposure to exchange rate risk requires estimates of susceptibility of net cashflows to unexpected exchange rate changes. Operating managers can make these estimates more precisely. The firm can hedge

5、cheaper. Nominal exchange rate changes should not translate into real exchange rate changes if PPP holds; however, deviations from PPP can persist. Increased firm level exposure to exchange risk can lead to bankruptcy and its attendant costs; hence it may be optimal for firms to hedge against exchan

6、ge rate risk.,P.V. Viswanath,5,Translation Exposure,There are three kinds of exposure. Translation (accounting) exposure, arises from the need for purposes of reporting and consolidation to convert the financial statements of foreign subsidiaries from local currencies (LC) to the home currency (HC).

7、 If exchange rates have changed since the previous reporting period, translation/restatement of those assets/liabilities, revenues/expenses that are denominated in foreign currencies will result in foreign exchange gains or losses.,P.V. Viswanath,6,Transaction Exposure,Transaction exposure results f

8、rom transactions that give rise to known, contractually binding future foreign-currency-denominated cash flows. As exchange rages change between now and when these transactions settle, so does the value of their associated foreign currency cashflows, leading to currency gains and losses For example,

9、 accounts receivable associated with a sale denominated in euros or the obligation to repay a Japanese yen debt.,P.V. Viswanath,7,Operating Exposure,The extent to which currency fluctuations can alter a companys future operating cash flows, i.e. its future revenues and costs. Any company whose reven

10、ues or costs are affected by currency changes has operating exposure, even if it is a purely domestic corporation and has all of its cashflows denominated in the home currency. Operating and Transactions Exposure together are referred to as Economic Exposure,P.V. Viswanath,8,Types of Exposure: Accou

11、nting, Operating and Transaction,P.V. Viswanath,9,Comparison of Exposure Types,P.V. Viswanath,10,Translation Methods,Income statements of foreign affiliates are usually translated according to the following rules: Sales revenue and interest are translated at the average historical exchange rate that

12、 prevailed during the period Depreciation is translated at the appropriate historical exchange rate. Some of the general and administrative expenses as well as cost-of-goods-sold are translated at historical exchange rates, others at current rates. This is based on when the expenses were incurred. H

13、owever, there are different methods for translating assets and liabilities. The various methods differ in terms of how exchange rate changes are presumed to impact the value of individual categories of assets and liabilities.,P.V. Viswanath,11,Current/Noncurrent Currency Translation Method,Maturity

14、is used to divided assets into two categories. Not in general use at the moment. All the foreign subsidiarys current assets/liabilities are translated to the HC at the current exchange rate; only these are presumed to change in value when the local currency appreciates/depreciates. The underlying as

15、sumption is that rates are essentially fixed but subject to occasional adjustments that correct themselves in time. This was generally true in the Bretton Woods era. Each non-current asset/liability is translated at its historical exchange rate the rate at the time the asset was acquired or the liab

16、ility incurred. The income statement is translated at the average exchange rate of the period, except for revenues and expense items associated with noncurrent assets or liabilities. These latter, such as depreciation expense, are translated at the same rate as the corresponding balance sheet items.

17、,P.V. Viswanath,12,Monetary/Nonmonetary Method,Monetary assets/liabilities are those items that represent a claim to receive or an obligation to pay a fixed amount of foreign currency, e.g. cash, A/P, A/R, long-term debt; they are translated at the current rate. Nonmonetary refers to physical assets

18、 or liabilities (e.g. inventory, fixed assets, long-term investments); they are translated at at historical rates. I/S items are translated at the average exchange rate during the period except for revenue and expense items related to nonmonetary assets/liabilities. These are translated at the same

19、rate as the corresponding B/S items. The underlying assumption is that the local currency value of monetary assets increases immediately after a devaluation so that there is full compensation for the exchange rate change (Law of One Price).,P.V. Viswanath,13,Temporal Method,The choice of exchange ra

20、te for translation is based on the underlying approach to evaluating cost (historical/market). If an item is carried on the balance sheet of the affiliate at its current value, it is translated using the current exchange rate. Items carried at historical cost are translated at the historical rate. M

21、odified version of the monetary/nonmonetary method. 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 the inventory is shown

22、 on the balance sheet at market value. I/S items are normally translated at an average rate for the reporting period. However, cost of goods sold and depreciation charges related to balance sheet items carried at past prices are translated at historical rates.,P.V. Viswanath,FASB 8,In 1975, FASB 8 r

23、equired the temporal method: Monetary assets/liabilities at current exchange-rate Fixed assets at historical exchange rate Translation gains affected by rate changes Hence, enormous translation exposure and volatile earnings statements,P.V. Viswanath,15,Current/Current Method,At the end of 1981, FAS

24、B 52 required the current/current method to allow more flexibility. All B/S items are translated at the current rate; I/S translated at current rate or appropriately weighted average exchange rate for period. (See Sterling case.) A variation is to translate all items except net fixed assets at the c

25、urrent rate; net fixed assets are translated at the historical rate. If a firms foreign-currency denominated assets exceed its foreign-currency denominated liabilities, a devaluation results in a loss and a revaluation in a gain. Translation losses moved to special sub-account in the net worth secti

26、on of balance sheet, reducing income volatility.,P.V. Viswanath,16,Impact of Translation Alternatives,P.V. Viswanath,17,Impact of Translation Alternatives,P.V. Viswanath,18,FASB 52 and the functional currency,Under FASB 52, affiliates financial statements must be first converted to the functional cu

27、rrency using the temporal method and then translated into the home currency before being included in the parents statements. This gives firms the opportunity to identify the primary economic environment and select the appropriate functional currency for each subsidiary. An affiliates functional curr

28、ency is the currency of the primary economic environment in which the affiliate generates and expends cash. Location does not automatically indicate the right functional currency. For example, the functional currency is the dollar for a HK assembly plant for radios that sources components in the US

29、and sells the assembled radios in the US. However, in the case of a hyperinflationary environment, the dollar must be used as the functional currency. In practice, all US firms either use the local foreign currency (80%) or the dollar (20%)as the functional currency.,P.V. Viswanath,19,P.V. Viswanath

30、,20,Functional Currency/ Reporting Currency,The reporting currency is the currency in which the parent firm prepares its own financial statements. At each balance sheet date, any assets/liabilities denominated in a currency other than the functional currency of the affiliate must be adjusted to refl

31、ect the current exchange rate on that date. If the dollar is the functional currency, then local currency accounts are translated into dollars using the temporal method. Transaction gains/losses from such adjustments must appear on the affiliates income statement, with some exceptions. Obviously, if

32、 the functional currency is judiciously chosen, these will be minimal. After all financial statements have been converted into the functional currency, these are then translated into dollars translation gains/losses flow directly into the parents foreign exchange equity account.,P.V. Viswanath,21,Ex

33、ample of FASB-52 Translation,Sterling Ltd. is the British subsidiary of a US company; started business and acquired fixed assets when the exchange rate was 1=$1.50. The average exchange rate for the period was $1.40 The rate at the end of the period was $1.30. The historical rate for investory was $

34、1.45. During the year, Sterling has income after tax of 20m. which goes into retained earnings. No dividends are paid.,P.V. Viswanath,22,Example of FASB-52 Translation,P.V. Viswanath,23,Example of FASB-52 Translation,P.V. Viswanath,24,Example of FASB-52 Translation,We see that if the pound is the fu

35、nctional currency, Sterling will have a translation loss of $22m., which bypasses the I/S and appears on the B/S as a separate item. The translation loss is calculated as the number that reconciles the equity account with the remaining translated accounts to balance assets with liabilities and equit

36、y. If the dollar is the functional currency, there is a gain of $108m., which appears on Sterlings income statement. This is calculated as the difference between translated income before currency gains ($23m.) and the retained earnings figure ($131m.),P.V. Viswanath,25,Implications of FASB 52,Fluctu

37、ations in local reported earnings are reduced significantly under FASB-52 when the local currency is the functional currency, compared to when the US dollar is used as the functional currency. When the $ is the functional currency, translation losses/gains show up in the Income Statement. Key financ

38、ial ratios and relationships remain the same after translation into dollars under FASB-52, when the local currency is used as the functional currency, as they are in the local currency financial statements. This is because the current/current method is used to convert into dollars; hence the same ex

39、change rate is used for all items in the B/S (exchange rate on reporting date) and the same exchange rate for all items in the I/S (average rate for period in Sterling case).,P.V. Viswanath,Exception to functional currency losses,Under FASB 52, the following gains/losses need not be included on the

40、foreign units income statement: Gains/losses due to foreign currency transaction that is designated as an economic hedge of a net investment in a foreign entity included in shareholders equity component. Gains/losses due to inter-company foreign currency transactions that are of a long-term investme

41、nt nature included in shareholders equity component. Gains/losses due to foreign currency transactions that hedge identifiable foreign currency commitments are to be deferred and included in the measurement of the basis of the related foreign transactions.,P.V. Viswanath,27,US Accounting Standards,P

42、.V. Viswanath,28,Managing Translation Exposure,Three major techniques: Adjusting Funds flows Entering into forward contracts Exposure Netting,P.V. Viswanath,29,Funds Adjustment,Funds Adjustment involves altering the amounts or the currencies or both of the planned cashflows of the parent or its subs

43、idiaries to reduce the firms local currency accounting exposure. If an LC devaluation is anticipated, direct funds-adjustment methods include pricing exports in hard currencies Pricing imports in the local currency investing in hard currency securities Replacing hard currency loans with local curren

44、cy loans Indirect methods include Adjusting transfer prices on the sale of goods between affiliaties Speeding up the payment of dividends, fees, and royalties Adjusting the leads and lags of intersubsidiary accounts, viz. speeding up the payment of intersubsidiary A/P and delaying the collection of

45、intersubsidiary A/R,P.V. Viswanath,30,Forward Contracts,The translation exposure is reduced by creating an offsetting asset or liability in the foreign currency. For example, if IBM UK has translation exposure in an asset of 40m, it can sell 40m forward. Any loss (gain) on its translation exposure w

46、ill be offset by a corresponding gain (loss) on the forward contract. However, the gain/loss on the forward contract is a cashflow, while this is not true of the accounting exposure. Presumably, these hedges would not be designated as economic hedges under FASB 52.,P.V. Viswanath,31,Managing Transac

47、tion Exposure,Transaction exposure stems from the possibility of incurring future exchange gains or losses on transactions already entered into and denominated in a foreign currency. Its measured currency by currency and equals the difference between contractually fixed future cash inflows and outfl

48、ows in each currency Some of these unsettled transactions, such as foreign currency denominated debt and accounts receivable are already on the balance sheet; others such as contracts for future sales are not. Some actions taken to hedge against translation exposure could increase transaction exposu

49、re. For example, if a currency is expected to weaken, then translation exposure for the current period could be reduced by deferring the sale to a future period; this would reduce A/R in the current period, but if there is a contract for the sale to take place in the future, it would increase transa

50、ction exposure.,P.V. Viswanath,32,Hedging Strategies,The objective underlying hedging should be made explicit. Trying to manage accounting exposure is inconsistent with empirical evidence; since it doesnt affect cashflows, it amounts to assuming that investors cannot see beyond financial statements.

51、 If this assumption is false, hedging for this purpose would have positive costs and no benefits. Selective hedging may end up increasing cashflow variances, rather than reduce them, if the firm has no predictive abilities. All costs of hedging should be taken into account. For example, the cost of increasing LC borrowings is the cost of the LC loan less the profit generated from those funds, such as prepaying a hard currency loan. Interest rates on loans in local currencies may be higher because of anticipated devaluations.,