1

1

Measuring and Managing

Measuring and Managing

Translation and Transaction

Translation and Transaction

Exposure

Exposure

OVERVIEW

OVERVIEW

I.

I.

ALTERNATIVE MEASURES OF FOREIGN

ALTERNATIVE MEASURES OF FOREIGN

EXCHANGE EXPOSURE

EXCHANGE EXPOSURE

II.

II.

ALTERNATIVE CURRENCY

ALTERNATIVE CURRENCY

TRANSLATION METHODS

TRANSLATION METHODS

III.

III.

TRANSACTION EXPOSURE

TRANSACTION EXPOSURE

IV.

IV.

DESIGNING A HEDGING STRATEGY

DESIGNING A HEDGING STRATEGY

V.

V.

MANAGING TRANSLATION EXPOSURE

MANAGING TRANSLATION EXPOSURE

VI.

VI.

MANAGING TRANSACTION EXPOSURE

MANAGING TRANSACTION EXPOSURE

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PART I. ALTERNATIVE

PART I. ALTERNATIVE

MEASURES OF FOREIGN

MEASURES OF FOREIGN

EXCHANGE EXPOSURE

EXCHANGE EXPOSURE

I.

I.

ALTERNATIVE MEASURES

ALTERNATIVE MEASURES

A.

A.

TYPES

TYPES

1.

1.

Accounting Exposure:

Accounting Exposure:

arises when reporting and consolidating

arises when reporting and consolidating

financial

financial

statements require

statements require

conversion from subsidiary to

conversion from subsidiary to

parent

parent

currency

currency

(difficult to hedge an event that occurred

(difficult to hedge an event that occurred

in the

in the

past)

past)

2.

2.

Economic Exposure:

Economic Exposure:

arises because

arises because

unexpected

unexpected

exchange

exchange

rate changes

rate changes

alter the value of

alter the value of

future

future

revenues and costs.

revenues and costs.

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3

ALTERNATIVE MEASURES OF

ALTERNATIVE MEASURES OF

FOREIGN EXCHANGE EXPOSURE

FOREIGN EXCHANGE EXPOSURE

B.

B.

Economic Exposure

Economic Exposure

= Transaction Exposure +Operating

= Transaction Exposure +Operating

Exposure

Exposure

Operating Exposure defined:

Operating Exposure defined:

arises because exchange rate

arises because exchange rate

changes alter the value of

changes alter the value of

future revenues and

future revenues and

expenses.

expenses.

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4

PART II.

PART II.

ALTERNATIVE CURRENCY

ALTERNATIVE CURRENCY

TRANSLATION METHODS

TRANSLATION METHODS

I.

I.

FOUR METHODS OF TRANSLATION

FOUR METHODS OF TRANSLATION

A.

A.

Current/Noncurrent Method

Current/Noncurrent Method

1. Current accounts use current

1. Current accounts use current

exchange rate for

exchange rate for

conversion.

conversion.

2.

2.

Income statement accounts use

Income statement accounts use

average exchange rate for the

average exchange rate for the

period.

period.

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5

ALTERNATIVE CURRENCY

ALTERNATIVE CURRENCY

TRANSLATION METHODS

TRANSLATION METHODS

B.

B.

Monetary/Nonmonetary Method

Monetary/Nonmonetary Method

1.

1.

Monetary accounts use current

Monetary accounts use current

rate

rate

2.

2.

Pertains to

Pertains to

- cash

- cash

- accounts receivable

- accounts receivable

- accounts payable

- accounts payable

- current portion long term

- current portion long term

debt

debt

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6

ALTERNATIVE CURRENCY

ALTERNATIVE CURRENCY

TRANSLATION METHODS

TRANSLATION METHODS

3.

3.

Nonmonetary accounts

Nonmonetary accounts

- use historical rates

- use historical rates

- Pertains to

- Pertains to

inventory

inventory

fixed assets

fixed assets

long term investments

long term investments

4.

4.

Income statement accounts

Income statement accounts

- use average exchange rate for

- use average exchange rate for

the period.

the period.

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7

ALTERNATIVE CURRENCY

ALTERNATIVE CURRENCY

TRANSLATION METHODS

TRANSLATION METHODS

C.

C.

Temporal Method

Temporal Method

1.

1.

Similar to

Similar to

monetary/nonmonetary

monetary/nonmonetary

method.

method.

2.

2.

Use current method for

Use current method for

inventory.

inventory.

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D. Current Rate Method

D. Current Rate Method

all statements use current exchange

all statements use current exchange

rate for conversions

rate for conversions

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PART III.

PART III.

TRANSACTION EXPOSURE

TRANSACTION EXPOSURE

I. Transaction Exposure

I. Transaction Exposure

A. Often included as accounting

A. Often included as accounting

exposure

exposure

B. As a cash-flow exposure, it is

B. As a cash-flow exposure, it is

rightly

rightly

part of economic exposure

part of economic exposure

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10

PART IV.

PART IV.

DESIGNING A HEDGING

DESIGNING A HEDGING

STRATEGY

STRATEGY

I. DESIGNING A HEDGING STRATEGY

I. DESIGNING A HEDGING STRATEGY

A.

A.

Strategies

Strategies

a management objective

a management objective

B.

B.

Hedging’s basic objective:

Hedging’s basic objective:

reduce/eliminate volatility of

reduce/eliminate volatility of

earnings as a result of

earnings as a result of

exchange rate changes.

exchange rate changes.

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11

DESIGNING A HEDGING

DESIGNING A HEDGING

STRATEGY

STRATEGY

C.

C.

Hedging exchange rate risk

Hedging exchange rate risk

1.

1.

Is a cost-center

Is a cost-center

2.

2.

Should be evaluated as a

Should be evaluated as a

purchase of insurance.

purchase of insurance.

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12

DESIGNING A HEDGING

DESIGNING A HEDGING

STRATEGY

STRATEGY

D.

D.

Centralization is key

Centralization is key

1.

1.

Important aspects:

Important aspects:

a.

a.

Degree of centralization

Degree of centralization

b.

b.

Responsibility for its

Responsibility for its

development

development

c.

c.

Implementation

Implementation

2.

2.

Maximum benefits accrue from

Maximum benefits accrue from

centralizing policy-making,

centralizing policy-making,

formulation,

formulation,

and implementation.

and implementation.

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PART V.

PART V.

MANAGING TRANSLATION

MANAGING TRANSLATION

EXPOSURE

EXPOSURE

I.

I.

MANAGING TRANSLATION EXPOSURE

MANAGING TRANSLATION EXPOSURE

A.

A.

Choices faced by the MNC:

Choices faced by the MNC:

1.

1.

Adjusting fund flows altering

Adjusting fund flows altering

either

either

the amounts or the

the amounts or the

currencies of the

currencies of the

planned cash

planned cash

flows of the parent or

flows of the parent or

its

its

subsidiaries to reduce the firm’s

subsidiaries to reduce the firm’s

local currency accounting exposure.

local currency accounting exposure.

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MANAGING TRANSLATION

MANAGING TRANSLATION

EXPOSURE

EXPOSURE

2.

2.

Forward contracts

Forward contracts

reducing a firm’s translation

reducing a firm’s translation

exposure by creating an

exposure by creating an

offsetting

offsetting

asset or liability

asset or liability

in the foreign

in the foreign

currency.

currency.

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15

MANAGING TRANSLATION

MANAGING TRANSLATION

EXPOSURE

EXPOSURE

3.

3.

Exposure netting

Exposure netting

a.

a.

offsetting exposures in one

offsetting exposures in one

currency with exposures

currency with exposures

in the

in the

same or

same or

another currency

another currency

b.

b.

gains and losses on the two

gains and losses on the two

currency positions will offset

currency positions will offset

each other.

each other.

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MANAGING TRANSLATION

MANAGING TRANSLATION

EXPOSURE

EXPOSURE

B.

B.

Basic hedging strategy for reducing

Basic hedging strategy for reducing

translation exposure:

translation exposure:

1.

1.

increasing hard-currency(likely to

increasing hard-currency(likely to

appreciate) assets

appreciate) assets

2.

2.

decreasing soft-currency(likely to

decreasing soft-currency(likely to

depreciate) assets

depreciate) assets

3.

3.

decreasing hard-currency

decreasing hard-currency

liabilities

liabilities

4.

4.

increasing soft-currency

increasing soft-currency

liabilities

liabilities

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MANAGING TRANSLATION

MANAGING TRANSLATION

EXPOSURE

EXPOSURE

4. (cont’d) How to increase soft-currency

4. (cont’d) How to increase soft-currency

liabilities:

liabilities:

reduce the level of cash,

reduce the level of cash,

tighten credit terms to decrease

tighten credit terms to decrease

accounts receivable,

accounts receivable,

increase LC borrowing,

increase LC borrowing,

delay accounts payable

delay accounts payable

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PART VI.

PART VI.

MANAGING TRANSACTION

MANAGING TRANSACTION

EXPOSURE

EXPOSURE

I.

I.

METHODS OF HEDGING

METHODS OF HEDGING

A.

A.

Risk shifting

Risk shifting

B.

B.

Currency risk sharing

Currency risk sharing

C. Currency collars

C. Currency collars

D. Cross-hedging

D. Cross-hedging

E.

E.

Exposure netting

Exposure netting

F.

F.

Forward market hedge

Forward market hedge

G.

G.

Foreign currency options

Foreign currency options

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MANAGING TRANSACTION

MANAGING TRANSACTION

EXPOSURE

EXPOSURE

A. RISK SHIFTING

A. RISK SHIFTING

1. home currency invoicing

1. home currency invoicing

2. zero sum game

2. zero sum game

3. common in global business

3. common in global business

4. firm will invoice exports in strong

4. firm will invoice exports in strong

currency, import in weak

currency, import in weak

currency

currency

5. Drawback:

5. Drawback:

it is not possible with informed

it is not possible with informed

customers or suppliers.

customers or suppliers.

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MANAGING TRANSACTION

MANAGING TRANSACTION

EXPOSURE

EXPOSURE

B. CURRENCY RISK SHARING

B. CURRENCY RISK SHARING

1. Developing a customized hedge

1. Developing a customized hedge

contract

contract

2. The contract typically takes the

2. The contract typically takes the

form

form

of a

of a

Price Adjustment

Price Adjustment

Clause,

Clause,

whereby a base

whereby a base

price is adjusted to

price is adjusted to

reflect

reflect

certain exchange rate changes.

certain exchange rate changes.

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MANAGING TRANSACTION

MANAGING TRANSACTION

EXPOSURE

EXPOSURE

B. CURRENCY RISK SHARING (con’t)

B. CURRENCY RISK SHARING (con’t)

3. Parties would share the currency risk

3. Parties would share the currency risk

beyond

beyond

a neutral zone of exchange

a neutral zone of exchange

rate changes.

rate changes.

4. The neutral zone represents the

4. The neutral zone represents the

currency range in which risk is

currency range in which risk is

not

not

shared.

shared.

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MANAGING TRANSACTION

MANAGING TRANSACTION

EXPOSURE

EXPOSURE

C. CURRENCY COLLARS

C. CURRENCY COLLARS

1. Contract bought to protect

1. Contract bought to protect

against

against

currency moves

currency moves

outside the neutral

outside the neutral

zone.

zone.

2. Firm would convert its foreign

2. Firm would convert its foreign

currency denominated

currency denominated

receivable

receivable

at the zone forward rate.

at the zone forward rate.

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MANAGING TRANSACTION

MANAGING TRANSACTION

EXPOSURE

EXPOSURE

D.

D.

CROSS-HEDGING

CROSS-HEDGING

1. Often forward contracts not available

1. Often forward contracts not available

in a certain currency.

in a certain currency.

2. Solution: a cross-hedge

2. Solution: a cross-hedge

- a forward contract in a related

- a forward contract in a related

currency.

currency.

3. Correlation between 2 currencies is

3. Correlation between 2 currencies is

critical to success of this hedge.

critical to success of this hedge.

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MANAGING TRANSACTION

MANAGING TRANSACTION

EXPOSURE

EXPOSURE

E.

E.

EXPOSURE NETTING

EXPOSURE NETTING

1.

1.

Protection can be gained by

Protection can be gained by

selecting currencies that minimize

selecting currencies that minimize

exposure

exposure

2.

2.

Netting:

Netting:

MNC chooses currencies that are

MNC chooses currencies that are

not

not

perfectly positively correlated.

perfectly positively correlated.

3.

3.

Exposure in one currency can be

Exposure in one currency can be

offset by the exposure in another.

offset by the exposure in another.