Measuring and Managing

Foreign Exchange Exposure

International Financial Management
Dr. A. DeMaskey

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?

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 firms value due to uncertain
changes in the rate of exchange.

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.

Types of Exposures
Translation Exposure
Transaction Exposure
Operating Exposure

Economic Exposure

Tax Exposure

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

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

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

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.

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

10

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.

11

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.

12

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

13

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 parents
consolidated balance sheet called the
Cumulative Translation Adjustment (CTA)
account.

14

Temporal Method
Specific assets and liabilities are translated at
exchange rates consistent with the timing of
the items 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.

15

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.

16

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

17

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

18

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
47,000
Accounts receivables
50,000
Long-term debt
12,000
Inventory
32,000
Equity
135,000
Fixed assets
111,000
194,000 194,000
______________________________________________________________
The exchange rate on January 1 was Ps 8,000/$ and on December 31 is Ps 12,000/$

19

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.

20

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.

21

Designing a Hedging Strategy

Management of Foreign Exchange
Exposure
Organizational Policies for Managing
Exposure
Degree of centralization
Responsibility

Statement of Objectives

22

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.

23

Managing Translation Exposure

Assets

Liabilities

Hard currencies

Increase

Decrease

Soft currencies

Decrease

Increase

______________________________________________

______________________________________

24

Balance Sheet Hedge

It requires an equal amount of exposed
foreign currency assets and liabilities on a
firms 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.

25

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

26

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.

27

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.

28

Managing Transaction Exposure

Contractual Hedges
Forward Market Hedge
Money Market Hedge
Options Market Hedge
Futures Market Hedge

Financial Hedges

Operating Strategies
Risk Shifting
Price adjustment
clauses
Exposure Netting
Risk Sharing

Swaps

29

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.)
U.S.$ 180-day interest rate (p.a.)

$0.6433-42/
$0.6578-99/
4.01%-3.97%
8.01%-7.98%

30

Alternative Use of Hedging

Techniques
Remain unhedged.
Hedge in the forward market.
Hedge in the money market.

31

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.

32

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

33

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

34

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).

35

Evaluation of Forward Market

Hedge
Future
Value of
Gain/Loss on
Spot
Rate
Receivable (e1)
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
_________________________________________________________

36

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

37

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:

38

Comparison of Alternative
Hedging Strategies
Future
Spot Rate

Forward
Unhedged Market

Money
Market

1 = $0.64
$44,800,000
1 = $0.6578
1 = $0.67
$46,900,000
1 = $0.70

____________________________________

39

Covered Interest Arbitrage

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

Effective forward rate:

40

Futures Market Hedge

Similar to hedging with forwards
Limitations:
Limited number of currencies
Limited number of maturity dates
Standardized contract size

Cross hedge

41

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 competitors currency

42

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

43

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 firms particular business

44

Exposure Netting
Offsetting exposures in one currency with
exposures in the same or another currency.
A firms 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

45

Currency Risk Sharing

Agreement to share currency risk
Risk sharing arrangements
Price adjustment clause
Neutral zone
Outside neutral zone

46

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

47

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.

48