Description
This is a presentation explains what is economic exposure and how to measure economic measure.
Managing Economic Exposure And Translation Exposure
Submitted by – Group 4
Economic Exposure
Economic exposure
• Economic exposure is the sensitivity of the future home currency value of the firm’s assets and liabilities and the firm’s operating cash flow to random changes in exchange rates • corporate cash flows can be affected by exchange rate movements in ways not directly associated with foreign transactions
• Exchange rate changes are often linked to variability in real growth, inflation, interest rates, governmental actions.If material, the changes may cause firms to adjust their financing and operating strategies • The importance of managing economic exposure can be seen from the case of the bankruptcy of Laker Airways, and from the 1997-98 Asian crisis
How to Measure Economic Exposure
• A firm can assess its economic exposure by determining the sensitivity of its expenses and revenues to various possible exchange rate scenarios • If a U.S. MNC were to run a regression on the dollar value (P) of its British assets on the dollar pound exchange rate, S($/£), the regression would be of the form:
P ? a ? b? S ? e
Where a is the regression constant and e is the random error term with mean zero. The regression coefficient b measures the sensitivity of the dollar value of the assets (P) to the exchange rate, S.
How to Measure Economic Exposure
The exposure coefficient, b, is defined as follows:
Cov( P, S ) b? Var( S )
Where Cov(P,S) is the covariance between the dollar value of the asset and the exchange rate, and Var(S) is the variance of the exchange rate.
So Var(P) = b2Var(S)+Var(e)
How to Measure Economic Exposure
• The exposure coefficient shows that there are two sources of economic exposure: the variance of the exchange rate and the covariance between the dollar value of the asset and exchange rate.
• The firm can then reduce its exposure by restructuring its operations to balance its exchange-rate-sensitive cash flows
Operating Exposure: Definition
• The effect of random changes in exchange rates on the firm’s competitive position, which is not readily measurable. • A good definition of operating exposure is the extent to which the firm’s operating cash flows are affected by the exchange rate.
An Illustration of Operating Exposure
• In the last decade, there was an enormous shortage in the shipping market from Asia, due to the Asian currency crisis. • This affected not only the shipping companies, which enjoyed “boom times”. • But also retailers, who experienced increased costs and delays.
An Illustration of Operating Exposure
• Note that the exposure for the retailers has two components:
– The Competitive Effect
• Difficulties and increased costs of shipping.
– The Conversion Effect
• Lower dollar prices of imports due to foreign currency exchange rate depreciation.
Determinants of Operating Exposure
• Recall that operating exposure cannot be readily determined from the firm’s accounting statements as can transaction exposure. • The market structure of inputs and products: how competitive or how monopolistic the markets facing the firm are. • The firm’s operating exposure is determined by: • The firm’s ability to adjust its markets, product mix, and sourcing in response to exchange rate changes.
Managing Operating Exposure
• • • • • • Selecting Low Cost Production Sites Flexible Sourcing Policy Diversification of the Market R&D and Product Differentiation Financial Hedging Increasing or decreasing foreign denominated debt
Selecting Low Cost Production Sites
• A firm may wish to diversify the location of their production sites to mitigate the effect of exchange rate movements.
– e.g. Honda built North American factories in response to a strong yen, but later found itself importing more cars from Japan due to a weak yen.
Flexible Sourcing Policy
• Sourcing does not apply only to components, but also to “guest workers”.
– Japan Air Lines hired foreign crews to remain competitive in international routes in the face of a strong yen, but later contemplated a reverse strategy in the face of a weak yen and rising domestic unemployment.
Diversification of the Market
• Selling in multiple markets to take advantage of economies of scale and diversification of exchange rate risk.
R&D and Product Differentiation
• Successful R&D that allows for
– cost cutting – enhanced productivity – product differentiation.
• Successful product differentiation gives the firm less elastic demand—which may translate into less exchange rate risk.
Financial Hedging
• The goal is to stabilize the firm’s cash flows in the near term. • Financial Hedging is distinct from operational hedging. • Financial Hedging involves use of derivative securities such as currency swaps, futures, forwards, currency options, among others
Increasing or decreasing of foreign denominated debt
• This strategy has some limitations
– Need of debt in first place – Interest rates – It may not be a perfect hedge as amount required for hedging need may exceed the debt requirement
Managing Madison Inc.’s Economic Exposure
(in Millions) Sales: (1) U.S. (2) Canadian (3) Total Cost of gods sold: (4) U.S. (5) Canadian (6) Total (7) Gross profit Operating expenses: (8) U.S. - Fixed (9) U.S. - Variable (10) Total (11) EBIT Interest expense: (12) U.S. (13) Canadian (14) Total (15) EBT C$=$.75 $300.00 C$4= 3.0 $303.00 $ 50.00 C$200= 150.00 $200.00 $103.00 $ 30.00 30.30 $ 60.30 $ 42.70 C$=$.80 C$=$.85 $307.00 C$4= 3.40 $310.40 $ 50.00 C$200= 170.00 $220.00 $ 90.40 $ 30.00 31.04 $ 61.04 $ 29.36 $304.00 C$4= 3.20 $307.20 $ 50.00 C$200= 160.00 $210.00 $ 97.20 $ 30.00 30.72 $ 60.72 $ 36.48
$ C$10= $ $
3.00 7.50 10.50 32.20
$ C$10= $ $
3.00 8.00 11.00 25.48
$ C$10= $ $
3.00 8.50 11.50 17.86
Managing Madison Inc.’s Economic Exposure
• The amount of Madison’s earnings before taxes is inversely related to the strength of the Canadian dollar, since the higher expenses more than offset the higher revenue. • Madison may reduce its exposure by increasing Canadian sales, reducing orders of Canadian materials, and/or borrowing less from Canadian banks.
Translation Exposure
Translation Exposure
• Translation exposure results when an MNC translates each subsidiary’s financial data to its home currency for consolidated financial reporting. • Translation exposure does not directly affect cash flows, but some firms are concerned about it because of its potential impact on reported consolidated earnings.
Translation Methods
• • • • Current/Noncurrent Method Monetary/Nonmonetary Method Temporal Method Current Rate Method
Current/Noncurrent Method
• The underlying principal is that assets and liabilities should be translated based on their maturity.
– Current assets translated at the spot rate. – Noncurrent assets translated at the historical rate in effect when the item was first recorded on the books.
• This method of foreign currency translation was generally accepted in the United States from the 1930s until 1975, at which time FASB 8 became effective.
Current/Noncurrent Method
– Current assets translated at the spot rate. e.g. DM2=$1 – Noncurrent assets translated at the historical rate in effect when the item was first recorded on the books. e.g. DM3=$1
Balance Sheet Cash Inventory Net fixed assets Total Assets Current liabilities Long-Term debt Common stock Retained earnings CTA Total Liabilities and Equity Local Current/ Currency Noncurrent 2,100 DM $1,050 1,500 DM $750 3,000 DM $1,000 6,600 DM $2,800 1,200 DM $600 1,800 DM $600 2,700 DM $900 900 DM $700 --------------6,600 DM $2,800
Monetary/Nonmonetary Method
• The underlying principal is that monetary accounts have a similarity because their value represents a sum of money whose value changes as the exchange rate changes. • All monetary balance sheet accounts (cash, marketable securities, accounts receivable, etc.) of a foreign subsidiary are translated at the current exchange rate. • All other (nonmonetary) balance sheet accounts (owners’ equity, land) are translated at the historical exchange rate in effect when the account was first recorded.
Monetary/Nonmonetary Method
• All monetary balance sheet accounts are translated at the current exchange rate. e.g. DM2=$1 • All other balance sheet accounts are translated at the historical exchange rate in effect when the account was first recorded. e.g.DM3=$1
Balance Sheet Cash Inventory Net fixed assets Total Assets Current liabilities Long-Term debt Common stock Retained earnings CTA Total Liabilities and Equity Local Monetary/ Currency Nonmonetary 2,100 DM $1,050 1,500 DM $500 3,000 DM $1,000 6,600 DM $2,550 1,200 DM $600 1,800 DM $900 2,700 DM $900 900 DM $0 --------------6,600 DM $2,400
Temporal Method
• The underlying principal is that assets and liabilities should be translated based on how they are carried on the firm’s books. • Balance sheet account are translated at the current spot exchange rate if they are carried on the books at their current value. • Items that are carried on the books at historical costs are translated at the historical exchange rates in effect at the time the firm placed the item on the books.
Temporal Method
• Items carried on the books at their current value are translated at the spot exchange rate. e.g. DM2=$1 • Items that are carried on the books at historical costs are translated at the historical exchange rates. e.g. DM3=$1
Balance Sheet Cash Inventory Net fixed assets Total Assets Current liabilities Long-Term debt Common stock Retained earnings CTA Total Liabilities and Equity Local Currency 2,100 DM 1,500 DM 3,000 DM 6,600 DM 1,200 DM 1,800 DM 2,700 DM 900 DM -------6,600 DM Temporal $1,050 $900 $1,000 $2,950 $600 $900 $900 $0 -------$2,400
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.
Current Rate Method
• All balance sheet items (except for stockholder’s equity) are translated at the current exchange rate. • A “plug” equity account named cumulative translation adjustment is used to make the balance sheet balance
Balance Sheet Cash Inventory Net fixed assets Total Assets Current liabilities Long-Term debt Common stock Retained earnings CTA Total Liabilities and Equity Local Currency DM2,100 DM1,500 DM3,000 DM6,600 DM1,200 DM1,800 DM2,700 DM900 -------DM6,600 Current Rate $1,050 $750 $1,500 $3,300 $600 $900 $900 $360 $540 $3,300
Translation Exposure
• An MNC may attempt to avoid translation exposure by matching its foreign liabilities with its foreign assets. • To hedge translation exposure, forward or futures contracts can be used. Specifically, an MNC may sell the currency that its foreign subsidiary receive as earnings forward, thus creating an offsetting cash outflow in that currency.
Translation Exposure
• For example, a U.S.-based MNC that is concerned about the translated value of its British earnings may enter a one-year forward contract to sell pounds. • If the pound depreciates during the fiscal year, the gain generated from the forward contract position will help to offset the translation loss.
Translation Exposure
• Hedging translation exposure is limited by:
– inaccurate earnings forecasts, – inadequate forward contracts for some currencies, – accounting distortions (the choice of the translation exchange rate, taxes, etc.), and – increased transaction exposure (due to hedging activities).
Translation Exposure
• In particular, if the foreign currency depreciates during the fiscal year, the transaction loss generated by a forward contract position will somewhat offset the translation gain. • Note that the translation gain is simply a paper gain, while the loss resulting from the hedge is a real loss.
Translation Exposure
• Perhaps, the best way for MNCs to deal with translation exposure is to clarify how their consolidated earnings have been affected by exchange rate movements.
FASB Statement 52
• The Mechanics of the FASB 52 Translation Process
– Function Currency – Reporting Currency
• Highly Inflationary Economies
The Mechanics of FASB Statement 52
• Function Currency
– The currency that the business is conducted in.
• Reporting Currency
– The currency in which the MNC prepares its consolidated financial statements.
The Mechanics of FASB Statement 52
• Two-Stage Process
– First, determine in which currency the foreign entity keeps its books. – If the local currency in which the foreign entity keeps its books is not the functional currency, remeasurement into the functional currency is required. – Second, when the foreign entity’s functional currency is not the same as the parent’s currency, the foreign entity’s books are translated using the current rate method.
The Mechanics of FASB Statement 52
Parent’s currency Foreign entity’s books kept in?
Nonparent Currency
Functional Currency?
Third currency Temporal Remeasurement
Local currency Current Rate
Parent’s Currency
Translation
Parent’s Currency
Empirical Analysis of the Change from FASB 8 to FASB 52
• There did not appear to be a revaluation of firms’ values following the change. • This suggests that market participants do not react to cosmetic earnings changes. • Other researchers have found similar results when investigating other accounting changes. • This highlights the futility of attempting to manage translation gains and losses.
Thank you
doc_221212636.pptx
This is a presentation explains what is economic exposure and how to measure economic measure.
Managing Economic Exposure And Translation Exposure
Submitted by – Group 4
Economic Exposure
Economic exposure
• Economic exposure is the sensitivity of the future home currency value of the firm’s assets and liabilities and the firm’s operating cash flow to random changes in exchange rates • corporate cash flows can be affected by exchange rate movements in ways not directly associated with foreign transactions
• Exchange rate changes are often linked to variability in real growth, inflation, interest rates, governmental actions.If material, the changes may cause firms to adjust their financing and operating strategies • The importance of managing economic exposure can be seen from the case of the bankruptcy of Laker Airways, and from the 1997-98 Asian crisis
How to Measure Economic Exposure
• A firm can assess its economic exposure by determining the sensitivity of its expenses and revenues to various possible exchange rate scenarios • If a U.S. MNC were to run a regression on the dollar value (P) of its British assets on the dollar pound exchange rate, S($/£), the regression would be of the form:
P ? a ? b? S ? e
Where a is the regression constant and e is the random error term with mean zero. The regression coefficient b measures the sensitivity of the dollar value of the assets (P) to the exchange rate, S.
How to Measure Economic Exposure
The exposure coefficient, b, is defined as follows:
Cov( P, S ) b? Var( S )
Where Cov(P,S) is the covariance between the dollar value of the asset and the exchange rate, and Var(S) is the variance of the exchange rate.
So Var(P) = b2Var(S)+Var(e)
How to Measure Economic Exposure
• The exposure coefficient shows that there are two sources of economic exposure: the variance of the exchange rate and the covariance between the dollar value of the asset and exchange rate.
• The firm can then reduce its exposure by restructuring its operations to balance its exchange-rate-sensitive cash flows
Operating Exposure: Definition
• The effect of random changes in exchange rates on the firm’s competitive position, which is not readily measurable. • A good definition of operating exposure is the extent to which the firm’s operating cash flows are affected by the exchange rate.
An Illustration of Operating Exposure
• In the last decade, there was an enormous shortage in the shipping market from Asia, due to the Asian currency crisis. • This affected not only the shipping companies, which enjoyed “boom times”. • But also retailers, who experienced increased costs and delays.
An Illustration of Operating Exposure
• Note that the exposure for the retailers has two components:
– The Competitive Effect
• Difficulties and increased costs of shipping.
– The Conversion Effect
• Lower dollar prices of imports due to foreign currency exchange rate depreciation.
Determinants of Operating Exposure
• Recall that operating exposure cannot be readily determined from the firm’s accounting statements as can transaction exposure. • The market structure of inputs and products: how competitive or how monopolistic the markets facing the firm are. • The firm’s operating exposure is determined by: • The firm’s ability to adjust its markets, product mix, and sourcing in response to exchange rate changes.
Managing Operating Exposure
• • • • • • Selecting Low Cost Production Sites Flexible Sourcing Policy Diversification of the Market R&D and Product Differentiation Financial Hedging Increasing or decreasing foreign denominated debt
Selecting Low Cost Production Sites
• A firm may wish to diversify the location of their production sites to mitigate the effect of exchange rate movements.
– e.g. Honda built North American factories in response to a strong yen, but later found itself importing more cars from Japan due to a weak yen.
Flexible Sourcing Policy
• Sourcing does not apply only to components, but also to “guest workers”.
– Japan Air Lines hired foreign crews to remain competitive in international routes in the face of a strong yen, but later contemplated a reverse strategy in the face of a weak yen and rising domestic unemployment.
Diversification of the Market
• Selling in multiple markets to take advantage of economies of scale and diversification of exchange rate risk.
R&D and Product Differentiation
• Successful R&D that allows for
– cost cutting – enhanced productivity – product differentiation.
• Successful product differentiation gives the firm less elastic demand—which may translate into less exchange rate risk.
Financial Hedging
• The goal is to stabilize the firm’s cash flows in the near term. • Financial Hedging is distinct from operational hedging. • Financial Hedging involves use of derivative securities such as currency swaps, futures, forwards, currency options, among others
Increasing or decreasing of foreign denominated debt
• This strategy has some limitations
– Need of debt in first place – Interest rates – It may not be a perfect hedge as amount required for hedging need may exceed the debt requirement
Managing Madison Inc.’s Economic Exposure
(in Millions) Sales: (1) U.S. (2) Canadian (3) Total Cost of gods sold: (4) U.S. (5) Canadian (6) Total (7) Gross profit Operating expenses: (8) U.S. - Fixed (9) U.S. - Variable (10) Total (11) EBIT Interest expense: (12) U.S. (13) Canadian (14) Total (15) EBT C$=$.75 $300.00 C$4= 3.0 $303.00 $ 50.00 C$200= 150.00 $200.00 $103.00 $ 30.00 30.30 $ 60.30 $ 42.70 C$=$.80 C$=$.85 $307.00 C$4= 3.40 $310.40 $ 50.00 C$200= 170.00 $220.00 $ 90.40 $ 30.00 31.04 $ 61.04 $ 29.36 $304.00 C$4= 3.20 $307.20 $ 50.00 C$200= 160.00 $210.00 $ 97.20 $ 30.00 30.72 $ 60.72 $ 36.48
$ C$10= $ $
3.00 7.50 10.50 32.20
$ C$10= $ $
3.00 8.00 11.00 25.48
$ C$10= $ $
3.00 8.50 11.50 17.86
Managing Madison Inc.’s Economic Exposure
• The amount of Madison’s earnings before taxes is inversely related to the strength of the Canadian dollar, since the higher expenses more than offset the higher revenue. • Madison may reduce its exposure by increasing Canadian sales, reducing orders of Canadian materials, and/or borrowing less from Canadian banks.
Translation Exposure
Translation Exposure
• Translation exposure results when an MNC translates each subsidiary’s financial data to its home currency for consolidated financial reporting. • Translation exposure does not directly affect cash flows, but some firms are concerned about it because of its potential impact on reported consolidated earnings.
Translation Methods
• • • • Current/Noncurrent Method Monetary/Nonmonetary Method Temporal Method Current Rate Method
Current/Noncurrent Method
• The underlying principal is that assets and liabilities should be translated based on their maturity.
– Current assets translated at the spot rate. – Noncurrent assets translated at the historical rate in effect when the item was first recorded on the books.
• This method of foreign currency translation was generally accepted in the United States from the 1930s until 1975, at which time FASB 8 became effective.
Current/Noncurrent Method
– Current assets translated at the spot rate. e.g. DM2=$1 – Noncurrent assets translated at the historical rate in effect when the item was first recorded on the books. e.g. DM3=$1
Balance Sheet Cash Inventory Net fixed assets Total Assets Current liabilities Long-Term debt Common stock Retained earnings CTA Total Liabilities and Equity Local Current/ Currency Noncurrent 2,100 DM $1,050 1,500 DM $750 3,000 DM $1,000 6,600 DM $2,800 1,200 DM $600 1,800 DM $600 2,700 DM $900 900 DM $700 --------------6,600 DM $2,800
Monetary/Nonmonetary Method
• The underlying principal is that monetary accounts have a similarity because their value represents a sum of money whose value changes as the exchange rate changes. • All monetary balance sheet accounts (cash, marketable securities, accounts receivable, etc.) of a foreign subsidiary are translated at the current exchange rate. • All other (nonmonetary) balance sheet accounts (owners’ equity, land) are translated at the historical exchange rate in effect when the account was first recorded.
Monetary/Nonmonetary Method
• All monetary balance sheet accounts are translated at the current exchange rate. e.g. DM2=$1 • All other balance sheet accounts are translated at the historical exchange rate in effect when the account was first recorded. e.g.DM3=$1
Balance Sheet Cash Inventory Net fixed assets Total Assets Current liabilities Long-Term debt Common stock Retained earnings CTA Total Liabilities and Equity Local Monetary/ Currency Nonmonetary 2,100 DM $1,050 1,500 DM $500 3,000 DM $1,000 6,600 DM $2,550 1,200 DM $600 1,800 DM $900 2,700 DM $900 900 DM $0 --------------6,600 DM $2,400
Temporal Method
• The underlying principal is that assets and liabilities should be translated based on how they are carried on the firm’s books. • Balance sheet account are translated at the current spot exchange rate if they are carried on the books at their current value. • Items that are carried on the books at historical costs are translated at the historical exchange rates in effect at the time the firm placed the item on the books.
Temporal Method
• Items carried on the books at their current value are translated at the spot exchange rate. e.g. DM2=$1 • Items that are carried on the books at historical costs are translated at the historical exchange rates. e.g. DM3=$1
Balance Sheet Cash Inventory Net fixed assets Total Assets Current liabilities Long-Term debt Common stock Retained earnings CTA Total Liabilities and Equity Local Currency 2,100 DM 1,500 DM 3,000 DM 6,600 DM 1,200 DM 1,800 DM 2,700 DM 900 DM -------6,600 DM Temporal $1,050 $900 $1,000 $2,950 $600 $900 $900 $0 -------$2,400
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.
Current Rate Method
• All balance sheet items (except for stockholder’s equity) are translated at the current exchange rate. • A “plug” equity account named cumulative translation adjustment is used to make the balance sheet balance
Balance Sheet Cash Inventory Net fixed assets Total Assets Current liabilities Long-Term debt Common stock Retained earnings CTA Total Liabilities and Equity Local Currency DM2,100 DM1,500 DM3,000 DM6,600 DM1,200 DM1,800 DM2,700 DM900 -------DM6,600 Current Rate $1,050 $750 $1,500 $3,300 $600 $900 $900 $360 $540 $3,300
Translation Exposure
• An MNC may attempt to avoid translation exposure by matching its foreign liabilities with its foreign assets. • To hedge translation exposure, forward or futures contracts can be used. Specifically, an MNC may sell the currency that its foreign subsidiary receive as earnings forward, thus creating an offsetting cash outflow in that currency.
Translation Exposure
• For example, a U.S.-based MNC that is concerned about the translated value of its British earnings may enter a one-year forward contract to sell pounds. • If the pound depreciates during the fiscal year, the gain generated from the forward contract position will help to offset the translation loss.
Translation Exposure
• Hedging translation exposure is limited by:
– inaccurate earnings forecasts, – inadequate forward contracts for some currencies, – accounting distortions (the choice of the translation exchange rate, taxes, etc.), and – increased transaction exposure (due to hedging activities).
Translation Exposure
• In particular, if the foreign currency depreciates during the fiscal year, the transaction loss generated by a forward contract position will somewhat offset the translation gain. • Note that the translation gain is simply a paper gain, while the loss resulting from the hedge is a real loss.
Translation Exposure
• Perhaps, the best way for MNCs to deal with translation exposure is to clarify how their consolidated earnings have been affected by exchange rate movements.
FASB Statement 52
• The Mechanics of the FASB 52 Translation Process
– Function Currency – Reporting Currency
• Highly Inflationary Economies
The Mechanics of FASB Statement 52
• Function Currency
– The currency that the business is conducted in.
• Reporting Currency
– The currency in which the MNC prepares its consolidated financial statements.
The Mechanics of FASB Statement 52
• Two-Stage Process
– First, determine in which currency the foreign entity keeps its books. – If the local currency in which the foreign entity keeps its books is not the functional currency, remeasurement into the functional currency is required. – Second, when the foreign entity’s functional currency is not the same as the parent’s currency, the foreign entity’s books are translated using the current rate method.
The Mechanics of FASB Statement 52
Parent’s currency Foreign entity’s books kept in?
Nonparent Currency
Functional Currency?
Third currency Temporal Remeasurement
Local currency Current Rate
Parent’s Currency
Translation
Parent’s Currency
Empirical Analysis of the Change from FASB 8 to FASB 52
• There did not appear to be a revaluation of firms’ values following the change. • This suggests that market participants do not react to cosmetic earnings changes. • Other researchers have found similar results when investigating other accounting changes. • This highlights the futility of attempting to manage translation gains and losses.
Thank you
doc_221212636.pptx