IFM 6
15 flashcards · Other · by Daniel F.
Economic Exposure
The possibility that the value of the firm (the present value of all future cash flows) will be affected by unanticipated changes in exchange rates.
Who is effected by Economic Exposure
Effects MNCs as well domestic firms e.g. U.S. company that only sells in the U.S. will face tougher competition from German imports if the euro weakens against the dollar, as German goods become cheaper for American consumers
How is Economic Exposure measured
Currency risk: random changes in exchange rates currency exposure: measures “what is at risk” Asset Exposure: The sensitivity of the firm's assets and liabilities' home currency value. Operating Exposure: The sensitivity of the firm's future operating cash flows. how exchange rate changes affect a firm's competitive position and, therefore, its future revenues and costs In many cases, operating exposure may account for a larger portion of the firm’s total exposure than contractual exposure
Measuring Asset Exposure
Regresion where P = a + b x S + e P = Dollar value of the British asset. P* (Pound value of British asset) x S S = Dollar/pound exchange rate. b = The exposure coefficient. This is the key number. It measures how sensitive the asset's dollar value is to a change in the exchange rate. b = Cov (P, S) / Var (S) Case 1: Positively Correlated Risk (High Exposure) When pound strengthens against the dollar, price of asset goes up. strong pound might be associated with a strong British economy, which d…
Hedging Asset Exposure
if coefficient b is know: hedge it by selling that amount forward Goal: To reduce the variance (volatility) of the asset's dollar value Enter intro contract to deliver £1,000 to the bank on a specific future date, for specific exchange rate that you both agree on today (F, forward rate) 1 year later, either sell the asset or but at spot, hedge perfectly offset the loss on the asset Consequence b > P, high risk: hedging significantly reduces the variance of the dollar value, removes exchange rel…
Measuring Operating Exposure
The extent to which a firm's operating cash flows are affected by exchange rate changes US company has UK manufacturing subsidiary that bus chips from US, pound depreciates pound cost of the imported chips are higher: reduces pound cash flow and, when converted back to dollars, results in a large operating loss firm can raise its selling price in the U.K. because competing imported computers are now more expensive: price increase more than offsets the higher input cost, leading to a higher poun…
Hedging Operating Exposure
Select Low-Cost Production Sites: Proactively build factories in countries with undervalued currencies or low production costs (e.g., Nissan having plants in Japan, U.S., U.K., and Mexico). Flexible Sourcing Policy: Even for a purely domestic firm: Have the ability to switch suppliers for raw materials and components to whichever country is cheapest at the moment. Diversification of the Market: Sell products in many different countries so that a weak currency in one market can be offset by a st…
Translation Exposure
accounting-based exposure. It has no direct impact on cash flows but can affect reported earnings and financial ratios The effect that an unanticipated change in exchange rates has on the consolidated financial reports of an MNC When a parent company combines the financial statements of its foreign subsidiaries, the subsidiaries' assets and liabilities (which are in a foreign currency) must be translated into the parent's home currency. A change in the exchange rate between balance sheet dates…
Modern U.S. GAAP (FASB 52 / ASC 830) method to translation
The choice of method depends on the subsidiary's functional currency functional currency: the currency of its primary economic environment Two-Stage Process: Remeasurement: If the subsidiary's books are kept in a currency that is not its functional currency, they must first be "remeasured" into the functional currency using the Temporal Method. Translation: The functional currency financial statements are then "translated" into the parent's reporting currency using the Current Rate Method.
Measuring Translation Exposure
Net Exposure = (Exposed Assets) - (Exposed Liabilities) An "exposed" account is one whose value, when translated into the parent's currency, changes as the exchange rate changes. These are the accounts translated at the current exchange rate. An account that is not exposed is translated at a historical exchange rate (the rate that existed when the asset was acquired or liability incurred). Its translated value is fixed and does not change. Current/Noncurrent Method Current Rate: Applied to all…
Hedging Translation Exposure
Balance Sheet Hedge: The source of translation exposure is a mismatch between exposed assets and exposed liabilities. A firm can hedge by creating a liability to match its exposed assets (e.g., a U.K. subsidiary with net exposed assets could take out a pound-denominated loan). The problem is that this creates a real cash flow obligation (interest payments) to hedge a non-cash risk. Derivatives Hedge: Using a forward contract to hedge translation exposure is essentially speculation. You are bett…
translation exposure vs. Transaction Exposure
They are not the same, and hedging one can sometimes increase the other. Because transaction exposure involves real cash flows, it is considered far more important to manage. Surveys show firms place much more emphasis on hedging transaction exposure.
Translation vs. Operating Exposure
These two exposures can move in opposite directions. A depreciation of the local currency will almost always create a negative translation effect (the subsidiary's assets are worth less in the parent's currency). However, that same depreciation could have a favorable operating effect if it allows the subsidiary to raise prices and become more competitive. This conflict makes managing overall exposure very challenging.
Historical Methods of Translation
Current/Noncurrent Method: Current assets/liabilities are translated at the current exchange rate; noncurrent items are translated at the historical rate when they were acquired. United States from the 1930s until 1975 Monetary/Nonmonetary Method: Monetary items (e.g., cash, receivables, debt) are translated at the current rate; nonmonetary items (e.g., inventory, fixed assets, equity) are translated at historical rates. Compared to current/noncurrent method, this approach differs substantially…
Cumulative Translation Adjustment
When translated with some methods Assets wont equal liabilities + equity. difference needs to be recoded unrealized income that affects financial ratios Impact on Key Ratios: The CTA directly increases or decreases Total Stockholders' Equity. This affects important solvency ratios like Debt-to-Equity. A large negative CTA can make a company look much riskier by inflating this ratio. Debt Covenants: Many bank loans include covenants that require a company to maintain certain financial ratios (li…