Professional Documents
Culture Documents
Gargi Sanati
NIBM
Classification
Transaction Exposure
Economic Exposure
Translation Exposure
Difference between Risk and Exposure
2
Transaction Exposure – When a firm faces contractual
cash flows that are fixed in foreign currencies.
Suppose that an Indian firm sold its product to a
German Firm on three months credit terms and invoiced Euro
1 million.
If the firm does nothing about its exposure then it is
effectively speculating on the future receivables as it does not
know if the Rupee depreciate or appreciate against Euro.
Using three months spot rate to convert Euro receivables may
lead some financial loss.
3
Japanese firm entering into a loan contract with a Swiss
bank that calls for the payment of SF 100 million for
principal and interest in one year.
As yen/swiss franc exchange rate is volatile the Japanese
firm does not know how much it would take to buy SF 100
million spot in year’s time.
Whenever a firm has foreign currency denominated
receivables or payables, it is subject to transaction
exposure and their settlement is likely to affect the firm’s
cash flow position.
4
Economic Exposure
Economic exposure defined as the extent to which the value of the
firm would be affected by unanticipated changes in exchange rate.
Market always has an allowance for anticipated change. An exporter
invoicing a foreign buyer in buyer’s currency will build an
allowance for the expected depreciation of that currency. Similarly,
a lender lending in foreign currency will build an allowance for the
expected depreciation.
Changes in exchange rates can have a profound effect on the firm’s
competitive position in the world market.
Changes in exchange rates can affect not only firms that are directly
engaged in international trade but also purely domestic firms.
Consider a U.S. bicycle manufacturer who sources and sells only
in the U.S. Since the firm’s product competes against imported
bicycles it is subjected to foreign exchange exposure.
Say, it faces competition from an importer, imports from
Taiwanese manufacturer. If Taiwanese dollar depreciates against
the US dollar importing bicycle becomes cheaper in Dollar
terms.
One bicycle cost TD 150
Exchange Rate TD50/$ = 3$
Exchange rate TD 75/$ = 2$
Measuring Forex Beta
Ex: Suppose one American Aircraft company exports a Jumbo Jet to British
Airways and billed £10 million payable in one year. The money market
interest rates and foreign exchange rates are given as follows:
If a US firm has an account receivable in Korean won and not able to hedge its
won position it will take a position in another currency with which Korean won
has a very high positive correlation
Since the won/dollar exchange rate is highly correlated with the yen/dollar
exchange rate, the US firm may sell a yen amount, which is equivalent to the
won receivable, forward against the dollar thereby cross hedging its won
position.
The effectiveness of cross hedging technique would depend on the stability and
the strength of the won/yen correlation.
Japanese Yen derivatives contracts are fairly effective in cross-hedging
exposure to minor Asian currencies such as the Indonesian Rupiah, Korean
Won, Philippine Peso and Thai Bhat.
Likewise, German mark derivatives can be effective in cross- hedging
exposures in some Central and East European currencies, such as the Czech
Koruna, Estonian Kroon and Hungarian Forint
Hedging through Invoice Currency
The Firm can shift, share, or diversify exchange risk by appropriately choosing
the currency of invoice.
Shifting
If in the above example American exporter invoices $15 million rather than
£10 million for the sale of the aircraft, then it does not face exchange
exposure anymore.
However exchange exposure does not disappear; it has merely shifted to
British importer. British Airways now has an account payable denominated
in US dollars.
Sharing
Instead of shifting the exchange exposure entirely to British Airways,
American exporter may invoice half of the bill in the US $ and half in
pound. In this situation there is always a chance of market loss. Only an
exporter with substantial market power can use this approach.
Diversifying
SDR currency portfolio also may be used. SDR currency portfolio
comprises four currency: the US dollar, the Euro, the Japanese Yen, the
British Pound.
Hedging via Lead and Lag
Lead: To pay/collect early. The firm would prefer to lead soft
currency receivable and hard currency payable.
Lag: To pay or collect late. The firm would prefer to lag hard
currency receivable and soft currency payable
Soft currency: Likely to depreciate
Hard Currency: Likely to appreciate
Example: American exporter would prefer to lead the pound
receivable or British airways to pay early in dollar because of likely
depreciation of pound.
Some difficulties
British airways would prefer to lag the payment of pound and has no incentive
to prepay unless exporter offers a substantial discount
It may hamper future sale of American Exporter
Lead/lag more effective in case of intra firm trade
Indian Importer American Exporter
Invoice in Rupees (soft currency)
American exporter has to convert it back into $. Wants to take lead
because if Rs depreciate exporter would get less amount in $ for a
certain amount of RS.
Invoice in $ (hard currency)
importer lead the hard currency payable, If $ appreciates importer has
to pay more in terms of Indian Rs for a fixed amount of US$
McGraw-Hill/Irwin 13-26 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights
Exposure Netting: an Example
Consider a U.S. MNC with three subsidiaries and the
following foreign exchange transactions:
$20
$30
$40
$10 $35 $10 $30 $40
$25
$60
$20
$30
McGraw-Hill/Irwin 13-27 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights
Exposure Netting: an Example
With this:
$15
$40
McGraw-Hill/Irwin 13-28 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights
Translation Exposure
Current Rate Method: All balance sheet items (except for stockholder’s
equity) are translated at the current exchange rate.
Very simple method in application.
A “plug” equity account named cumulative translation adjustment is used to
make the balance sheet balance.
How Various Translation Methods Deal with
a Change from DM3 to DM2 = $1
Balance Sheet Local Current/ Monetary/ Temporal Current
Currency Noncurrent Nonmonetary Rate
Cash 2,100 DM $1,050 $1,050 $1,050 $1,050
Inventory 1,500 DM $750 $500 $900 $750
Net fixed assets 3,000 DM $1,000 $1,000 $1,000 $1,500
Total Assets 6,600 DM $2,800 $2,550 $2,950 $3,300
Current 1,200 DM $600 $600 $600 $600
liabilities
Long-Term 1,800 DM $600 $900 $900 $900
debt
Common stock 2,700 DM $900 $900 $900 $900
Retained 900 DM $700 $150 $550 $360
earnings
earnings
CTA -------- -------- -------- -------- $540
Total 6,600 DM $2,800 $2,550 $2,950 $3,300
Liabilities and
Equity Spot exchange rate 14-32
McGraw-Hill/Irwin
Copyright © 2001 by The McGraw-
How Various Translation Methods Deal with a Change from
DM3 to DM2 = $1
Current value of Inventory = 1800DM
Balance Sheet Local Current/ Monetary/ Temporal Current
Currency Noncurrent Nonmonetary Rate
Cash 2,100 DM $1,050 $1,050 $1,050 $1,050
Inventory 1,500 DM $750 $500 $900 $750
Net fixed assets 3,000 DM $1,000 $1,000 $1,000 $1,500
Total Assets 6,600 DM $2,800 $2,550 $2,950 $3,300
Current 1,200 DM $600 Book $600 $600 $600
liabilities value of
Long-Term 1,800 DM $600 inventor $900 $900 $900
debt y
historic
Common stock 2,700 DM $900 $900 $900 $900
rate
Retained 900 DM $700 $150 $550 $360
earnings
earnings
CTA -------- -------- -------- -------- $540
Total 6,600 DM $2,800 $2,550 $2,950 $3,300
Liabilities and
Book value of Current value of
Equity
inventory at spot inventory at spot 14-33
McGraw-Hill/Irwin
exchange rate© 2001 by The McGraw- exchange rate.
Copyright
How Various Translation Methods Deal with
a Change from DM3 to DM2 = $1
Balance Sheet Local Current/ Monetary/ Temporal Current
Currency Noncurrent Nonmonetary Rate
Cash 2,100 DM $1,050 $1,050 $1,050 $1,050
Inventory 1,500 DM $750 $500 $900 $750
Net fixed assets 3,000 DM $1,000 $1,000 $1,000 $1,500
Total Assets 6,600 DM $2,800 $2,550 $2,950 $3,300
Current 1,200 DM $600 $600 $600 $600
liabilities
Long-Term 1,800 DM $600 $900 $900 $900
debt
Common stock 2,700 DM $900 $900 $900 $900
Retained earnings 900 DM $700 $150 $550 $360
earnings
CTA -------- -------- -------- -------- $540
Total 6,600 DM $2,800 $2,550 $2,950 $3,300
Liabilities and histori spot exchange rate.
Equity c rate 14-34
McGraw-Hill/Irwin
Copyright © 2001 by The McGraw-
How Various Translation Methods Deal with
a Change from DM3 to DM2 = $1
Balance Sheet Local Current/ Monetary/ Temporal Current
Currency Noncurrent Nonmonetary Rate
Cash 2,100 DM $1,050 $1,050 $1,050 $1,050
Inventory 1,500 DM $750 $500 $900 $750
Net fixed assets 3,000 DM $1,000 $1,000 $1,000 $1,500
Total Assets 6,600 DM $2,800 $2,550 $2,950 $3,300
Current 1,200 DM $600 $600 $600 $600
liabilities
Long-Term 1,800 DM $600 $900 $900 $900
debt
Common stock 2,700 DM $900 $900 $900 $900
Retained earnings 900 DM $700 $150 $550 $360
earnings
CTA -------- -------- -------- -------- $540
Total 6,600 DM $2,800 $2,550 $2,950 $3,300
Liabilities and spot rate
Equity 14-35
McGraw-Hill/Irwin
Copyright © 2001 by The McGraw-
How Various Translation Methods Deal with
a Change from DM3 to DM2 = $1
Balance Sheet Local Current/ Monetary/ Temporal Current
Currency Noncurrent Nonmonetary Rate
Cash 2,100 DM $1,050 $1,050 $1,050 $1,050
Inventory 1,500 DM $750 $500 $900 $750
Net fixed assets 3,000 DM $1,000 $1,000 $1,000 $1,500
Total Assets 6,600 DM $2,800 $2,550 $2,950 $3,300
Current 1,200 DM $600 $600 $600 $600
liabilities
Long-Term 1,800 DM $600 $900 $900 $900
debt
Common stock 2,700 DM $900 $900 $900 $900
Retained earnings 900 DM $700 $150 $550 $360
earnings
CTA -------- -------- -------- -------- $540
Total 6,600 DM $2,800 $2,550 $2,950 $3,300
Liabilities and
historical spot rate
Equity 14-36
rate McGraw-Hill/Irwin
Copyright © 2001 by The McGraw-
How Various Translation Methods Deal with
a Change from DM3 to DM2 = $1
Balance Sheet Local Current/ Monetary/ Temporal Current
Currency Noncurrent Nonmonetary Rate
Cash 2,100 DM $1,050 $1,050 $1,050 $1,050
Inventory 1,500 DM $750 $500 $900 $750
Net fixed assets 3,000 DM $1,000 $1,000 $1,000 $1,500
Total Assets 6,600 DM $2,800 $2,550 $2,950 $3,300
Current 1,200 DM $600 $600 $600 $600
liabilities
Long-Term 1,800 DM $600 $900 $900 $900
debt
Common stock 2,700 DM $900 $900 $900 $900
Retained earnings 900 DM $700 $150 $550 $360
earnings
CTA -------- -------- -------- -------- $540
Total 6,600 DM $2,800 $2,550 $2,950 $3,300
Liabilities and
historical
Equity 14-37
rate McGraw-Hill/Irwin
Copyright © 2001 by The McGraw-
How Various Translation Methods Deal with
a Change from DM3 to DM2 = $1
Balance Sheet Local Current/ Monetary/ Temporal Current
Currency Noncurrent Nonmonetary Rate
Cash 2,100 DM $1,050 $1,050 $1,050 $1,050
Inventory 1,500 DM $750 $500 $900 $750
Net fixed assets 3,000 DM $1,000 $1,000 $1,000 $1,500
Total Assets 6,600 DM $2,800 $2,550 $2,950 $3,300
Current 1,200 DM $600 $600 $600 $600
liabilities
Long-Term 1,800 DM $600 $900 $900 $900
debt
Common stock 2,700 DM $900 $900 $900 $900
Retained earnings 900 DM $700 $150 $550 $360
earnings
CTA -------- -------- -------- -------- $540
Total 6,600 DM $2,800 $2,550 $2,950 $3,300
Liabilities and
From income statement
Equity 14-38
McGraw-Hill/Irwin
Copyright © 2001 by The McGraw-
How Various Translation Methods Deal with a Change
from DM3 to DM2 = $1