Chapter 9-13
Discuss the determinants of operating exposure.
The main determinants of a firm's operating exposure are (1) the structure of the markets in which the firm sources its inputs, such as labor and materials, and sells its products, and (2) the firm's ability to mitigate the effect of exchange rate changes by adjusting its markets, product mix, and sourcing.
Economic exposure
The extent to which the value of the firm would be affected by unexpected changes in the exchange rate is
Absolute PPP
Absolute PPP holds that the price level in a country is equal to the price level in another country times the exchange rate between the two countries.
Who are the market participants in the foreign exchange market?
International banks Bank customers Non-bank dealers Fx brokers Central banks
Relative PPP
Relative PPP holds that the rate of exchange rate change between a pair of countries is about equal to the difference in inflation rates of the two countries.
How are translation gains and losses handled differently according to the current rate method in comparison to the other three methods, that is, the current/noncurrent method, the monetary/nonmonetary method, and the temporal method?
Under the current rate method, translation gains and losses are handled only as an adjustment to net worth through an equity account named the "cumulative translation adjustment" account. Nothing passes through the income statement. The other three translation methods pass foreign exchange gains or losses through the income statement before they enter on to the balance sheet through the accumulated retained earnings account.
The International Fisher Effect suggests that
The nominal interest rate differential reflects the expected change in the exchange rate.
Transaction Exposure
The sensitivity of realized domestic currency values of the firm's contractual cash flows denominated in foreign currencies to unexpected exchange rate changes. E.g., Exchange rate risk of a foreign currency payable is an example of
Translation exposure
The sensitivity of the firm's consolidated financial statements to unexpected changes in the exchange rate is
Discuss which exposure might be viewed as the most important to effectively manage, if a conflict between controlling both arises. Also, discuss and critique the common methods for controlling translation exposure.
There are two common methods for controlling translation exposure: a balance sheet hedge and a derivatives hedge. The balance sheet hedge involves equating the amount of exposed assets in an exposure currency with the exposed liabilities in that currency, so the net exposure is zero. Thus when an exposure currency exchange rate changes versus the reporting currency, the change in assets will offset the change in liabilities. To create a balance sheet hedge, once transaction exposure has been controlled, often means creating new transaction exposure. This is not wise since real cash flow losses can result. A derivatives hedge is not really a hedge, but rather a speculative position, since the size of the "hedge" is based on the future expected spot rate of exchange for the exposure currency with the reporting currency. If the actual spot rate differs from the expected rate, the "hedge" may result in the loss of real cash flows.
Identify some instances under FASB 52 when a foreign entity's functional currency would be the same as the parent firm's currency.
Three examples under FASB 52, where the foreign entity's functional currency will be the same as the parent firm's currency, are: i) the foreign entity's cash flows directly affect the parent's cash flows and are readily available for remittance to the parent firm; ii) the sales prices for the foreign entity's products are responsive on a short-term basis to exchange rate changes, where sales prices are determined through worldwide competition; and, iii) the sales market is primarily located in the parent's country or sales contracts are denominated in the parent's currency.
Explain the difference in the translation process between the monetary/nonmonetary method and the temporal method.
Under the monetary/nonmonetary method, all monetary balance sheet accounts of a foreign subsidiary are translated at the current exchange rate. Other balance sheet accounts are translated at the historical rate exchange rate in effect when the account was first recorded. Under the temporal method, monetary accounts are translated at the current exchange rate. Other balance sheet accounts are also translated at the current rate, if they are carried on the books at current value. If they are carried at historical value, they are translated at the rate in effect on the date the item was put on the books. Since fixed assets and inventory are usually carried at historical costs, the temporal method and the monetary/nonmonetary method will typically provide the same translation.
Describe the remeasurement and translation process under FASB 52 of a wholly owned affiliate that keeps its books in the local currency of the country in which it operates, which is different than its functional currency.
For a foreign entity that keeps its books in its local currency, which is different from its functional currency, the translation process according to FASB 52 is to: first, remeasure the financial reports from the local currency into the functional currency using the temporal method of translation, and second, translate from the functional currency into the reporting currency using the current rate method of translation.
Should a firm hedge?
In a perfect capital market, firms may not need to hedge exchange risk. But firms can add to their value by hedging if markets are imperfect. First, if management knows about the firm's exposure better than shareholders, the firm, not its shareholders, should hedge. Second, firms may be able to hedge at a lower cost. Third, if default costs are significant, corporate hedging can be justifiable because it reduces the probability of default. Fourth, if the firm faces progressive taxes, it can reduce tax obligations by hedging which stabilizes corporate earnings.
