Multinational Financial Management
Alan Shapiro
10th Edition
John Wiley & Sons, Inc.
PowerPoints by
Joseph F. Greco, Ph.D.
California State University, Fullerton
1
CHAPTER 10
Measuring and Managing
Translation and
Transaction Exposure
ALTERNATIVE MEASURES OF
FOREIGN EXCHANGE EXPOSURE
I.
ALTERNATIVE MEASURES
A. TYPES
1. Accounting or Translation Exposure:
arises when reporting and consolidating
financial statements require conversion
from subsidiary to parent currency.
3
3
How Translation Risk Arises
Translation Risk:
United States
Japan
Subsidiary
Financials
¥
£ Headquarters'
Consolidated
Financials
£
Subsidiary
Financials
$
£
Subsidiary Financials
4
€
Germany
4
Economic Exposure
2.
5
Economic Exposure:
arises because exchange rate
changes alter the value of
future revenues and costs.
5
ALTERNATIVE MEASURES OF
FOREIGN EXCHANGE EXPOSURE
Economic Exposure
= Transaction Exposure + Operating Exposure
Operating Exposure:
arises because exchange rate
changes alter the value of
future revenues and costs.
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6
ALTERNATIVE CURRENCY
TRANSLATION METHODS
I.
7
FOUR METHODS OF TRANSLATION
A.
Current/Noncurrent Method
1.
Current accounts use current
exchange rate for conversion.
2.
Income statement accounts
use average exchange rate for
the period.
7
ALTERNATIVE CURRENCY
TRANSLATION METHODS
B.
Monetary/Nonmonetary Method
1.
2.
8
Monetary accounts use current
rate
Pertains to
- cash
- accounts receivable
- accounts payable
- long term debt
8
ALTERNATIVE CURRENCY
TRANSLATION METHODS
3.
4.
9
Nonmonetary accounts
- use historical rates
- Pertains to
inventory
fixed assets
long term investments
Income statement accounts
- use average exchange rate
for the period.
9
ALTERNATIVE CURRENCY
TRANSLATION METHODS
C. Temporal Method
10
1.
Similar to monetary/nonmonetary
2.
method.
Use current method for
inventory.
10
ALTERNATIVE CURRENCY
TRANSLATION METHODS
D.
Current Rate Method
all statements use current exchange
rate for conversions.
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DESIGNING A HEDGING
STRATEGY
I.
DESIGNING A HEDGING STRATEGY
A. Strategies
a management objective
B. Hedging: basic objective:
reduce/eliminate volatility of earnings as a
result of exchange rate changes
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12
DESIGNING A HEDGING
STRATEGY
C.
Hedging exchange rate risk
1.
2.
13
Hedging is a cost, not a profitcenter
Hedging should be evaluated as
a purchase of insurance.
13
DESIGNING A HEDGING
STRATEGY
D.
14
Centralization is key
1.
Important aspects:
a.
Degree of centralization
b.
Responsibility for its
development
c.
Implementation
2.
Maximum benefits accrue from
centralizing policy-making,
formulation, and implementation
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MANAGING TRANSLATION
EXPOSURE
I.
MANAGING TRANSLATION EXPOSURE
A. Choices faced by the MNC:
1. Adjusting fund flows
altering either the amounts or the
currencies of the planned cash
flows of the parent or its
subsidiaries to reduce the firm’s
local currency accounting exposure.
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15
MANAGING TRANSLATION
EXPOSURE
2.
Forward contracts
reducing a firm’s translation
exposure by creating an offsetting
asset or liability in the foreign
currency
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16
MANAGING TRANSLATION
EXPOSURE
3. Exposure netting
17
a.
offsetting exposures in one
currency with exposures in the
same or another currency
b.
gains and losses on the two
currency positions will offset
each other.
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MANAGING TRANSLATION
EXPOSURE
B.
Basic hedging strategy for
reducing translation exposure:
1.
2.
3.
4.
18
increasing hard-currency (likely to
appreciate) assets
decreasing soft-currency (likely to
depreciate) assets
decreasing hard-currency
liabilities
increasing soft-currency
liabilities
18
MANAGING TRANSLATION
EXPOSURE
C.
How to increase soft-currency
liabilities?
reduce the level of cash
tighten credit terms to decrease accounts
receivable
increase LC borrowing
delay accounts payable
sell the weak currency forward
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19
MANAGING TRANSACTION
EXPOSURE
I.
Methods of Hedging
A.
B.
C.
D.
E.
F.
G.
20
Risk shifting
Currency risk sharing
Currency collars
Cross-hedging
Exposure netting
Forward market hedge
Foreign currency options
20
MANAGING TRANSACTION
EXPOSURE
A.
RISK SHIFTING
1.
2.
3.
4.
home currency invoicing
zero sum game
common in global business
firm will invoice exports in strong
currency, import in weak currency
5. Drawback:
it is not possible with informed
customers or suppliers.
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21
MANAGING TRANSACTION
EXPOSURE
B.
CURRENCY RISK SHARING
1. Developing a customized hedge
contract
2. The contract typically takes the form
of a Price Adjustment Clause, whereby
a base price is adjusted to reflect
certain exchange rate changes
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22
The Zone
$1.50/£
$1.60/£
Take no
action
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MANAGING TRANSACTION
EXPOSURE
B. CURRENCY RISK SHARING (con’t)
3. Parties would share the currency risk
beyond a neutral zone of exchange
rate changes.
4. The neutral zone represents the
currency range in which risk is not
shared.
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MANAGING TRANSACTION
EXPOSURE
C. CURRENCY COLLARS
1. Contract
bought to protect against currency
moves outside the neutral zone.
2. Firm would convert its foreign
currency denominated receivable
at the zone forward rate.
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25
MANAGING TRANSACTION
EXPOSURE
D.
CROSS-HEDGING
1. Often forward contracts not available
in a certain currency.
2. Solution: a cross-hedge
- a forward contract in a related currency.
3. Correlation between 2 currencies is
critical to success of this hedge.
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26
MANAGING TRANSACTION
EXPOSURE
E.
EXPOSURE NETTING
1.
2.
3.
27
Protection can be gained by
selecting
currencies that minimize exposure
Netting:
MNC chooses currencies that are not
perfectly positively correlated.
Exposure in one currency can be
offset by the exposure in another.
27
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