1. Measuring and Managing Foreign Exchange Exposure
International Financial Management
Dr. A. DeMaskey

2. Learning Objectives
What are the three different types of foreign exchange exposures?
How is translation and transaction exposure measured?
What are the two primary methods of converting foreign currency denominated financial statements into the reporting currency of the U.S. parent company?
What are the basic hedging strategies and techniques used by firms to manage their currency transaction and translation risks?

3. Foreign Exchange Risk Management
Exposure refers to the degree to which a company is affected by exchange rate changes.
Exchange rate risk is defined as the variability of a firm’s value due to uncertain changes in the rate of exchange.

4. Foreign Exchange Risk Management
Managing accounting exposure centers around the concept of hedging, which means:
Entering into an offsetting currency position so whatever is lost/gained on the original currency exposure is exactly offset by a corresponding currency gain/loss on the currency hedge.
The coordinated buying or selling of a currency to minimize exchange rate risk.

5. Types of Exposures Translation Exposure Transaction Exposure
Operating Exposure
Tax Exposure
Economic Exposure

6. Translation Exposure
It arises from the need, for purposes of reporting and consolidation, to convert the results of foreign operations from the local currency to the home currency.
Paper exchange gains or losses
Retrospective in nature
Short-term in nature

7. Transaction Exposure
It stems from the possibility of incurring exchange gains or losses on transactions already entered into and denominated in a foreign currency.
Real exchange gains or losses
Mixes retrospective and prospective
Short-term in nature

8. Operating Exposure
It arises because currency fluctuations combined with price level changes can alter the amounts and riskiness of a firm’s future revenues and costs.
Real exchange gains or losses
Prospective in nature
Long-term in nature

9. Economic Exposure
It is defined as the extent to which the value of the firm, as measured by the present value of all expected future cash flows, will change when exchange rates change.

10. Tax Exposure
The tax consequence of foreign exposure varies by countries.
As a general rule:
Only realized foreign exchange losses are tax deductible.
Only realized foreign exchange gains create taxable income

11. Measuring Translation Exposure
The difference between exposed assets and exposed liabilities.
Exposed assets and liabilities are translated at the current exchange rate.
Non-exposed assets and liabilities are translated at the historical exchange rate.

12. Currency Translation Methods
Translation methods differ by country along two dimensions.
Subsidiary Characterization
Integrated foreign entity
Self-sustained entity
Functional Currency
The currency of the primary economic environment in which the subsidiary operates and in which it generates and expends cash.

13. Translation Methods
Two basic methods for the translation of foreign subsidiary financial statements:
The current rate method
The temporal method
Regardless of which is used, either method must designate
The exchange rate at which individual balance sheet and income statement items are remeasured
Where any imbalances are to be recorded

14. Current Rate Method
All financial statement items are translated at the “current” exchange rate.
Assets & liabilities
Income statement items
Dividends
Equity account
Unrealized translation gains or losses are recorded in a separate equity account on the parent’s consolidated balance sheet called the “Cumulative Translation Adjustment (CTA)” account.

15. Temporal Method
Specific assets and liabilities are translated at exchange rates consistent with the timing of the item’s creation.
It assumes that a number of line items such as inventories and net plant and equipment are restated to reflect market value.
If these items were not restated and carried at historical costs, then the temporal method becomes the monetary/non-monetary method.

16. Temporal Method Line items included in this method are
Monetary balance sheet items
Non-monetary balance sheet items
Income statement items
Dividends
Equity account
Unrealized translation gains or losses are recorded within the income statement, not to equity reserves, thereby affecting net income.

17. US Translation Procedures
The US differentiates foreign subsidiaries on the basis of the functional currency, not subsidiary characterization.
This, in turn, determines which translation method is used:
Local currency
Current rate method
U.S. dollar
Temporal method

18. Hyperinflation Countries
A hyperinflationary country is one which has cumulative inflation of approximately 100% or more over a three year period.
Functional currency
U.S. dollar
Translation method
Temporal method

19. Measuring Translation Exposure: Illustration
Zapata Auto Parts, the Mexican affiliate of American Diversified, Inc., had the following balance sheet on January 1:
Assets (Ps million) Liabilities (Ps million)
Cash, marketable securities 1,000 Current liabilities ,000
Accounts receivables ,000 Long-term debt ,000
Inventory ,000 Equity ,000
Fixed assets ,000
194, ,000
______________________________________________________________
The exchange rate on January 1 was Ps 8,000/$ and on December 31 is Ps 12,000/$

20. Transaction Exposure
It arises from the various types of transactions that require settlement in a foreign currency.
Purchasing or selling on credit goods or services denominated in foreign currency.
Borrowing and lending funds with repayment made in foreign currency.
Acquiring assets denominated in foreign currency.

21. Net Transaction Exposure
Is measured currency by currency.
Is the difference between contractually fixed future cash inflows and cash outflows in each currency.
It represents real gains and losses.

22. Designing a Hedging Strategy
Management of Foreign Exchange Exposure
Organizational Policies for Managing Exposure
Degree of centralization
Responsibility
Statement of Objectives

23. Hedging Strategy Objectives
Minimize translation exposure.
Minimize quarter-to-quarter earnings fluctuations arising from exchange rate changes.
Minimize transaction exposure.
Minimize economic exposure.
Minimize foreign exchange risk management costs.
Avoid surprises.

24. Managing Translation Exposure
Assets
Liabilities
______________________________________________
Hard currencies
Increase
Decrease
Soft currencies
Decrease
Increase
______________________________________

25. Balance Sheet Hedge
It requires an equal amount of exposed foreign currency assets and liabilities on a firm’s consolidated balance sheet
A change in exchange rates will change the value of exposed assets but offset that with an opposite change in liabilities.
This is termed the monetary balance.
The cost of this method depends on relative borrowing costs in the varying currencies.

26. Funds Adjustment
Altering either the amounts or the currencies or both of the planned cash flows of the parent and/or subsidiary.
Funds Adjustment Methods
Direct
Indirect

27. Forward Market Hedge Uncovered or open hedge.
Not a hedge but an attempt to gain by forward speculation a sum equal to the book loss in translation.
Success depends on precise prediction of future exchange rates.
Such a hedge will increase the tax burden.

28. Managing Transaction Exposure
A transaction exposure arises whenever a company is committed to a foreign currency denominated transaction.
Protective measures to guard against transaction exposure involve entering into foreign currency transactions whose cash flows exactly offset in whole or in part the cash flows of the transaction exposure.

29. Managing Transaction Exposure
Contractual Hedges
Forward Market Hedge
Money Market Hedge
Options Market Hedge
Futures Market Hedge
Financial Hedges
Swaps
Operating Strategies
Risk Shifting
Price adjustment clauses
Exposure Netting
Risk Sharing

30. Managing Transaction Exposure: Illustration
American Airlines is trying to decide how to go about hedging €70 million in ticket sales receivable in 180 days. The following exchange/ interest rates are available:
Spot rate $ /€
180-day forward rate $ /€
Euro 180-day interest rate (p.a.) %-3.97%
U.S.$ 180-day interest rate (p.a.) %-7.98%

31. Alternative Use of Hedging Techniques
Remain unhedged.
Hedge in the forward market.
Hedge in the money market.

32. Unhedged Position
American Airlines will wait 180 days and receive an unknown amount of U.S. dollars, depending on the spot rate prevailing in 180 days, for €70 million of the ticket sales.

33. Future Spot Rate Scenarios
Spot rate in 180 days
Receivables in dollar terms
____________________________________________
€ 1 = $0.64
€ 1 = $0.67
€ 1 = $0.70
____________________________________________
SR0 = $0.6433
FR180 = $0.6578

34. Forward Market Hedge
Involves a forward contract and a source of funds to fulfill that contract.
The forward contract is entered at the time the transaction exposure is created.
Offsetting receivables/payables denominated in a foreign currency with a forward contract to sell/buy that currency.
Covered hedge
Uncovered or open hedge
Cost of forward cover

35. Forward Market Hedge
To hedge in the forward market, American Airlines will enter into a 180-day forward contract to sell €70 million for dollars today (t=0).

36. Evaluation of Forward Market Hedge
Future
Spot Rate
Value of
Receivable (e1)
Gain/Loss on
Forward (f180)
Net Cash Flow
____________________________________________________________
€ 1 = $0.64
$46,046,000
€ 1 = $0.6578 $0
€ 1 = $0.67
$46,046,000
€ 1 = $0.70
$49,000,000
_________________________________________________________

37. Money Market Hedge
Involves a contract and a source of funds to fulfill that contract. In this case, the contract is a loan agreement.
Reversing foreign currency receivables/payables by creating matching payables/receivables through borrowing in the money markets.
Covered hedge
Uncovered or open hedge
Cost of money market hedge
Covered interest arbitrage

38. Money Market Hedge
To hedge in the money market, American Airlines has to borrow today (t=0) sufficient euros for 180 days which, when exchanged today for dollars and invested for 180 days in the U.S., will be paid off with exactly the euro receivable of €70 million.
Amount of euros borrowed in Germany for 180 days:
Amount of dollars to be invested today in the U.S.:
Amount of dollars received from U.S. investment in 180 days:

39. Comparison of Alternative Hedging Strategies
Future Forward Money
Spot Rate Unhedged Market Market
€ 1 = $ $44,800,000
€ 1 = $0.6578
€ 1 = $ $46,900,000
€ 1 = $ ____________________________________

40. Covered Interest Arbitrage
IRP does not hold:
Interest rate differential is not equal to forward discount/premium on foreign currency.
Effective forward rate:

41. Futures Market Hedge Similar to hedging with forwards Limitations:
Limited number of currencies
Limited number of maturity dates
Standardized contract size
Cross hedge

42. Options Market Hedge
Offsetting a foreign currency denominated receivable/payable with a put option or a call option in that currency.
Valuable hedging tool when:
Waiting on the outcome of a bid denominated in foreign currency
Using of foreign currency price list
Shifts in competitor’s currency

43. General Hedging Rule Future foreign currency cash outflow
Certain: Go long futures or forwards
Uncertain: Buy a call option
Future foreign currency cash inflow
Certain: Go short futures or forwards
Uncertain: Buy a put option

44. Currency Risk Shifting
Risk shifting: Invoice in U.S. dollar
Strategy for risk shifting
Denominating exports in a strong currency.
Denominating imports in a weak currency.
Outcome depends on:
Bargaining power or parties involved.
Competitiveness of firm’s particular business

45. Exposure Netting
Offsetting exposures in one currency with exposures in the same or another currency.
A firm’s currency exposures can be viewed as a portfolio.
Exposure netting depends on the correlation between currencies.
Exposure netting strategies:
Negatively correlated currencies
Positively correlated currencies

46. Currency Risk Sharing Agreement to share currency risk
Risk sharing arrangements
Price adjustment clause
Neutral zone
Outside neutral zone

47. Currency Collars
Providing protection if the currency moves outside an agreed-on range.
Range forward
Cylinder
Combined put purchase and call sale
Limits upside potential
Provides downside risk protection
Lowers hedging cost

48. Choosing Which Exposure to Minimize
As a general matter, firms seeking to reduce both types of exposures typically reduce transaction exposure first.
They then recalculate translation exposure and then decide if any residual translation exposure can be reduced without creating more transaction exposure.