p.g.apte international financial management1 international financial management p g apte
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P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT 1
International Financial Management
P G Apte
P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT 2
SOME TYPICAL CURRENCY RISK SITUATIONS
P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT 3
• It is December 1, 2009. An Indian pharmaceutical company
has cleared a shipment of imported chemicals. The invoice is
for $500,000 payable on March 3, 2010. The current
exchange rate is Rs.46.60 per dollar. The recent history of
the exchange rate shows a mixed trend with moderate
volatility. During the latter half of 2007 dollar had shown
considerable weakness against all currencies including the
rupee. During early 2008, the rate was almost flat around
Rs.40.00. Dollar was rising against the rupee in early 2009.
An adverse movement in exchange rate will affect the firm’s
cash flows. There is also the problem of how to value the
imports for the purpose of product costing and pricing
decisions. What should the firm do?
P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT 4
RUPEE-DOLLAR EXCHANGE RATE NOVEMBER 2006-NOVEMBER 2009
0.0000
10.0000
20.0000
30.0000
40.0000
50.0000
60.0000
P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT 5
RUPEE-DOLLAR EXCHANGE RATE MARCH 1 - NOVEMBER 27 2009
42.000044.000046.000048.000050.000052.000054.0000
3/2/
2009
4/2/
2009
5/2/
2009
6/2/
2009
7/2/
2009
8/2/
2009
9/2/
2009
10/2
/200
9
11/2
/200
9
P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT 6
• A US firm has exported some computer peripherals to a German buyer. For customer relationship reasons the sale has been invoiced in buyer’s currency viz. Euro. The invoice is for €1,000,000 to be settled 90 days from now. The current exchange rate is $1.4715 per Euro. The recent history of the dollar-euro rate shows a mixed down - up trend with some fluctuations. The firm’s bankers are fairly bullish about the Euro despite the recessionary conditions in the major European economies viz. Germany and France. However US treasury secretary has expressed concern about the weak dollar.
• What should the firm do?
P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT 7
EURO-US DOLLAR EXCHANGE RATE JANUARY 2006 - NOVEMBER 2009
0.0000
0.5000
1.0000
1.5000
2.0000
P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT 8
EURO-US DOLLAR EXCHANGE RATE MARCH 2 - NOVEMBER 27 2009
0.00000.20000.40000.60000.80001.00001.20001.40001.6000
P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT 9
Caterpillar is an American firm which manufactures heavy construction equipment. At the start of the 1980’s all its manufacturing operations were located in the US while it sold its products around the world priced in local currencies. Its nearest competitor was Komatsu of Japan. Around mid-1981 the US dollar started rising against all currencies and continued rising month after month. Caterpillar found that its revenues measured in dollars were shrinking while costs kept pace with US inflation. Margins shrank. It could not compensate by raising local currency prices in export markets because Komatsu was holding the price line.
How could Caterpillar cope with this?
P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT 10
French Franc and Deutschemark per USD January 1980 - December 1990
0.0000
2.0000
4.0000
6.0000
8.0000
10.0000
12.0000
1979-05-25
1980-10-06
1982-02-18
1983-07-03
1984-11-14
1986-03-29
1987-08-11
1988-12-23
1990-05-07
1991-09-19
FFr per USD
DEM per USD
P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT 11
Japanese Yen per USD January 1980 - December 1990
0.00
50.00
100.00
150.00
200.00
250.00
300.00
1979-05-25
1980-10-06
1982-02-18
1983-07-03
1984-11-14
1986-03-29
1987-08-11
1988-12-23
1990-05-07
1991-09-19
P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT 12
Gems and jewelry exporters from India face stiff competition from firms in Thailand, Indonesia and Malaysia. After the East Asian currency crisis in the summer of 1997, some of these currencies crashed against the US dollar by as much as 60-80%. While rupee also fell, its fall was much smaller. Indian exporters lost market share as the East Asian exporters reduced prices in the light of falling currencies. From time to time Indian exporters and their federations like FIEO clamor for steeper fall in the rupee to maintain their competitive position.
How can firms cope with this?
P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT 13
KOREAN WON-DOLLAR EXCHANGE RATE JANUARY 1995 - DECEMBER 2000
(WON PER USD)
0.00
500.00
1000.00
1500.00
2000.00
1994-06-15 1995-10-28 1997-03-11 1998-07-24 1999-12-06 2001-04-19
P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT 14
DOLLAR - THAI BAHT EXCHANGE RATE JANUARY 1995 - DECEMBER 2000
(BAHT PER USD)
0.000
10.000
20.000
30.000
40.000
50.000
60.000
1994-06-15 1995-10-28 1997-03-11 1998-07-24 1999-12-06 2001-04-19
P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT 15
DOLLAR-MALAYSIAN RINGGIT EXCHANGE RATE
JANUARY 1995 - DECEMBER 2000 (RINGGIT PER USD)
0.0000
1.0000
2.0000
3.0000
4.0000
5.0000
1994-06-15 1995-10-28 1997-03-11 1998-07-24 1999-12-06 2001-04-19
P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT 16
RUPEE-KOREAN WON EXCHANGE RATE JANUARU 1995 - DECEMBER 2000
(WON PER INR)
0
10
20
30
40
50
1994-06-15 1995-10-28 1997-03-11 1998-07-24 1999-12-06 2001-04-19
P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT 17
RUPEE-THAI BAHT EXCHANGE RATE JANUARY 1995-DECEMBER 2000
0
0.2
0.4
0.6
0.8
1
1.2
1.4
1.6
1994-06-15 1995-10-28 1997-03-11 1998-07-24 1999-12-06 2001-04-19
P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT 18
RUPEE-MALAYSIAN RINGGIT EXCHANGE RATE JANUARY 1995 - DECEMBER 2000
(RS. PER RINGGIT)
0
24
6
8
1012
14
16
1994-06-15 1995-10-28 1997-03-11 1998-07-24 1999-12-06 2001-04-19
P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT 19
• A Swiss pharmaceutical firm has a US subsidiary. Financial statements of the subsidiary are denominated in US dollars.
• The financial year of the Swiss parent firm is September-August. On the balance sheet date it must translate the balance sheet and P-L account of its US subsidiary from dollars to Swiss francs.
• During the last few months the US dollar has been weakening against the Swiss franc. On translation, the value of assets and liabilities would show a decline; if assets exceed liabilities, there would be a net loss.
• Can anything be done about it? Should anything be done? How should the gains/losses be accounted for?
P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT 20
DOLLAR-SWISS FRANC EXCHANGE RATE OCTOBER 2006-OCTOBER 2009
0.00000.20000.40000.60000.80001.00001.20001.4000
Oct-0
6De
c-06
Feb-
07Ap
r-07
Jun-
07Au
g-07
Oct-0
7De
c-07
Feb-
08Ap
r-08
Jun-
08Au
g-08
Oct-0
8De
c-08
Feb-
09Ap
r-09
Jun-
09Au
g-09
Oct-0
9
P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT 21
DOLLAR-SWISS FRANC EXCHANGE RATE MAY 1 - OCTOBER 30 2009
0.90000.95001.00001.05001.10001.1500
P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT 22
3.1 The Nature of Exposure and Risk
Macroeconomic environmental risks Core business risks While core business risks are specific to a firm,
macroeconomic uncertainties affect all firms in the economy
Extent and nature of impact of even macroeconomic risks crucially depend upon the nature of a firm's business
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3.1 The Nature of Exposure and Risk (contd.)
The firm is "exposed" to uncertain changes in a number of variables in its environment - Risk Factors
Long run response of the firm to these risks can involve significant changes in the firm's strategic posture
Exchange rates and interest rates are two of the key macroeconomic risk factors
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3.1 The Nature of Exposure and Risk (contd.)
Exchange rates, interest rates and inflation rates are intimately interrelated
Exposure and Risk Exposure is a measure of the sensitivity of the
value of a performance measure to changes in the relevant risk factor
risk is a measure of the variability of the value of the performance measure attributable to the risk factor
P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT 25
3.1 The Nature of Exposure and Risk (contd.)
The magnitude of risk is determined by the magnitude of exposure and the degree of variability in the relevant risk factor e.g.
Exchange rate risk depends on how sensitive is the performance indicator to exchange rate fluctuations and what is the extent of likely fluctuations in the exchange rate.
P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT 26
Risk Management and Wealth Maximization
• What should be the attitude of the firm's management regarding firm-specific risks?
• Risks arising out of fluctuations in exchange rates, interest rates and commodity prices are pervasive; however they affect different firms in different ways and are therefore firm-specific or idiosyncratic.
• Should the firm spend resources to manage such risks?
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Why Hedge?• The value of a firm, according to financial
theory, is the net present value of all expected future cash flows.
• Currency risk is defined roughly as the variance in expected cash flows arising from unexpected exchange rate changes.
• A firm that hedges these exposures reduces some of the variance in the value of its future expected cash flows.
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Arguments against active hedging:
• Removing unsystematic risks does not add value. Stockholders can diversify
• M&M thesis: Shareholders can do it themselves
• Firm cannot beat efficient markets
• Risk removal is costly – those who take on the risk must be compensated. Will there be value addition after paying these costs?
• Active risk management must alter character of cash flows in a manner beneficial to shareholders and do it cheaper than what they can do on their own.
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Why Hedge? Reasons not to hedge
• However, is a reduction in the variability of cash flows sufficient reason for currency risk management? Opponents of hedging state (among other things):– Currency risk management reduces the variance
of the cash flows of the firm, but also uses valuable resources.
– Management often conducts hedging activities that benefit management at the expense of the shareholders (agency conflict), i.e., large FX loss are more embarrassing than the large cost of hedging.
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Arguments for Hedging:
• Investment-Internal Finance linkage
• Costs of being perceived as being in financial distress
• Agency theoretic arguments
• Convex tax schedules
• Managers have better information and access to various financial markets than shareholders
For an MNC with global shareholders with different currency habitats it is not clear that hedging benefits all shareholders
P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT 31
Why Hedge? Reasons to hedge
• Proponents of hedging cite:– Reduction in risk in future cash flows improves
the planning capability of the firm
– Reduction of risk in future cash flows reduces the likelihood that the firm’s cash flows will fall below a necessary minimum (the point of financial distress)
– Management has a comparative advantage over the individual shareholder in knowing the actual currency risk of the firm
– Management is in better position to take advantage of disequilibrium conditions in the market
P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT 32
Is Exchange Rate Risk Relevant?
• Purchasing Power Parity Argument:Exchange rate movements will be matched by
price movements.PPP does not necessarily hold.
• The Investor Hedge Argument:MNC shareholders can hedge against exchange
rate fluctuations on their own.The investors may not have complete
information on corporate exposure. They may not have the capabilities to correctly insulate themselves too.
P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT 33
Is Exchange Rate Risk Relevant?
• Currency Diversification Argument:An MNC that is well diversified should not be
affected by exchange rate movements because of offsetting effects.
This is a naive presumption.
• Stakeholder Diversification Argument:Well diversified stakeholders will be somewhat
insulated against losses experienced by an MNC due to exchange rate risk.
MNCs may be affected in the same way because of exchange rate risk.
P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT 34
The Nature of Exposure and Risk• Core business risks • Macroeconomic “Environmental” Risks• Risk Factors• Exchange rates and interest rates are two of the
key macroeconomic risk factors• Long run response of the firm to these risks can
involve significant changes in the firm's strategic posture
• Exchange rates, interest rates and inflation rates are intimately interrelated
P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT 35
The Nature of Exposure and Risk• Exposure and Risk • Exposure is a measure of the sensitivity of the value
of a performance measure to changes in the relevant risk factor
• Risk is a measure of the variability of the value of the performance measure attributable to the risk factor
The magnitude of risk is determined by the magnitude of exposure and the degree of variability in the relevant risk factor e.g. exchange rate
P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT 36
Exposure and Risk: A Formal
Approach • Exposure of a firm to a risk factor is the sensitivity
of the real value of a firm's assets, liabilities or operating income, expressed in its functional currency, to unanticipated changes in the risk factor V : Change in the real domestic currency value
of an item – S : The current value of the risk factor Su : Unanticipated change in the value of the
risk factor e.g. exchange rate Then exposure = V/ Su
P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT 37
An Example : A company has a US$ 500000 receivable from an American customer to be received 3 months from today. The current rupee-dollar rate is 47.50; The market is quoting a 3- month forward rate at 48.00;
The forward rate can be taken as market’s expectation of what the rupee-dollar rate will be 3 months from now. Thus the expected change in exchange rate is (48.00-47.50) or +0.50.
Three months later, the rupee-dollar rate falls to 46.80.
Total change: (46.80-47.50) = -0.70; Expected change : +0.50
Unexpected change : -1.20
Change in the value of receivable: (46.80-48.00)(500000)
Exposure : [(46.80-48.00)($500000)]/(-1.20) = $500000
P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT 38
Currency Exposure: A Foreign Currency Liability
P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT 39
Currency Exposure: A Foreign Currency Asset
P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT 40
Exposure and Risk: A Formal Approach
• The relation between V and Su can be represented by the following equation V = 0 + 1(Su)
1 is a measure of the sensitivity of V to
changes in S – “Exposure” V is in million rupees and Su is in rupees
per dollar, the units of measurement for the exposure, 1, are millions of dollars
P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT 41
Exposure and Risk: A Formal Approach
• Risk is the variance of the real domestic currency value of assets, liabilities or operating income attributable to unanticipated changes in exchange rates
Vs = 0 + 1(Su)
Vs is the change in value attributable to unanticipated change in the exchange rate
• Foreign exchange risk is defined as the variance of Vs
var(Vs) = 12[var(Su)]
P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT 42
Effect of exchange rate changes on anticipated transactions
TAXONOMY OF CURRENCY EXPOSURE
P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT 43
Taxonomy of Currency Exposure
Contractual(Transactions)
Anticipated
Cash Flow Accounting(Translation)
Short Term
Strategic Operating
LongTerm
Currency Exopsure
P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT 44
Moment in time whenexchange rate changes
Translation exposure
Transaction exposure
Operating exposure
Time
Changes in reported owners’ equityin consolidated financial statementscaused by a change in exchange rates
Change in expected future cash flows arising from an unexpected change inexchange rates
Impact of settling outstanding obligations entered into before changein exchange rates but to be settled after change in exchange rates
Conceptual Comparison of Transaction, Operating and Accounting Foreign Exchange
Exposure
P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT 45
Exchange Rates Used in Various Translation Methods Current Temporal Monetary Current
NonCurrent NonMonetary Rate
Cash, Current
Receivables &
Payables C C C C
Inventory C C or H H C
Fixed Assets H H H C
Long-Term
Receivables &
Payables H C C C
Note : "C" denotes current rate, "H" denotes historical rate.
P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT 46
Translation Exposure: Illustration
In the illustration, it is assumed that an Indian company is translating the balance sheet of a foreign entity into rupees. The "current rate", which is the rate on the balance sheet date of the parent is assumed to be LC 1 = Rs.1.50 while the "historical rate" is assumed to be LC 1 = Rs.1.00. Here "LC" stands for "Local Currency” and “HC” for parent’s home currency
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LC Current Monetary Current Temporal Non - Non- Rate Method Current Monetary (Rs.) (Rs.) (Rs.) (Rs.)______________________________________________________Cash 200 300 300 300 300Inv. 300 450 300 450 450FixedAssets 800 800 800 1200 800 ------- ------- ------- --------- -------- 1300 1550 1400 1950 1550 Curr.
Liab. 200 300 300 300 300
LT
Debt 300 300 450 450 450
NW 800 950 650 1200 800
P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT 48
t1 t2 t3 t4
Seller quotesa price to buyer
(in verbal or written form)
Buyer placesfirm order withseller at price
offered at time t1
Seller shipsproduct andbills buyer
(becomes A/R)
Buyer settles A/Rwith cash in
amount of currencyquoted at time t1
QuotationExposure
BacklogExposure
BillingExposure
Time between quotinga price and reaching a
contractual sale
Time it takes tofill the order aftercontract is signed
Time it takes toget paid in cash after
A/R is issued
Time and Events
The life span of a transaction exposure
P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT 49
Classification of Currency Exposure
•An alternative but similar in spirit approach to classification of currency exposure focuses on the length of the time horizon and whether or not the exposure impacts on the end-of-the horizon financial statements
– Accounting exposure is used for short-term exposures which will have an impact on the financial results
– Operating exposure is defined as the sensitivity of future operating profits to unanticipated changes in the exchange rate and is horizon is medium term
– Strategic exposure refers to a still longer horizon and contemplates longer-term operational flexibility such as changing product-market mix, shifting location of operations and adopting new technologies
P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT 50
Classification of Currency Exposure
– “Value-based" exposure which focuses on the impact of currency fluctuations on market value of the firm that takes into account both short-term accounting exposures as well as operating and strategic flexibility in responding to currency movements
P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT 51
A survey of corporate treasurers and financial officers
Do you agree or disagree with the following statements?
Mean Score “Managing transaction exposure is important.” 1.4
“Managing economic exposure is important.” 1.8
“Managing translation exposure is important.” 2.4
Key: 1= strongly agree, ... 3=neutral, ... 5= strongly disagree
Transaction exposure is viewed as the most
important currency risk exposure
P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT 52
3.3 Exposure and Risk: A Formal Approach
Denote the spot rate by S0, and the spot rate 90-days from today by S3. The total change in exchange rate from today to 90-days from today is (S3 - S0). This can be broken down into
S3 - S0 = [S3 - E(S3)] + [E(S3) - S0] = Su + Sa
E(S3) means "expected value of S3"
Su is the unanticipated component of the change and Sa is the anticipated component
P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT 53
3.3 Exposure and Risk: A Formal Approach (contd.)
Suppose the spot rate 90 days hence is 28.90
The total change is Rs.0.90 (S3-S0), anticipated change is 0.50 [E(S3)-S0] and unanticipated change is 0.40 [S3-E(S3)]
Since S3 has a normal distribution with mean 28.50 and standard deviation Rs.0.05, [S3 - E(S3)] will have a normal distribution with mean zero and standard deviation of Rs.0.05
P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT 54
3.3 Exposure and Risk: A Formal Approach (contd.)
Since the unanticipated change in the rupee value of the payable is given by 100000(Su), it will also have a normal distribution with mean zero and standard deviation of Rs.5000
One can say with 95% confidence that the unanticipated change in the value of the payable will lie between -10000 and +10000.
P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT 55
3.3 Exposure and Risk: A Formal Approach (contd.)
Instead of variance, one can estimate the possible range i.e. the difference between the highest and lowest values of the item given certain assumptions about the possible range of variation in the exchange rate
One can construct alternative scenarios of exchange rate movements
The "best case" and the "worst case" scenarios
P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT 56
3.4 Classification of Foreign Exchange Exposure and Risk (contd.)
Transactions Exposures result from an unanticipated change in the exchange rate which has an impact - favorable or adverse - on the firm’s cash flows during the upcoming accounting period. Most often, the term is used to denote exposures on items the foreign currency values of which are contractually fixed – export receivables, import payables, interest payable etc.
P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT 57
3.4 Classification of Foreign Exchange Exposure and Risk (contd.)
Transaction risk can be defined as a measure of variability in the value of assets and liabilities when they are liquidated
Points to be noted are Transactions exposures usually have short time
horizons; Operating cash flows are affected; exchange
gains/losses have tax implications
P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT 58
3.4 Classification of Foreign Exchange Exposure and Risk (contd.)
• Anticipated cash flow exposure is the case when a transaction is being negotiated, all the terms have been more or less finalized but a contractual arrangement is yet to be entered into
• Translation Exposure also called Balance Sheet Exposure: It is the exposure on assets and liabilities appearing in the balance sheet but which are not going to be liquidated in the foreseeable future
P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT 59
3.4 Classification of Foreign Exchange Exposure and Risk (contd.)
Translation exposure arises when a firm has
A foreign operation such as a branch, a joint venture or 100% subsidiary in a foreign currency.
The home country law requires that the parent must translate financial statements of foreign operations from foreign to home currency and consolidate with parent financial statements.
Foreign currency fluctuations lead to translation gains or losses. No cash flow implications
P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT 60
3.4 Classification of Foreign Exchange Exposure and Risk (contd.)
Two relevant considerations:
- What rate to use for translation – current, historical, average?
- how to report translation gains/losses?Finance theorists argue that translation losses and
gains are only notional accounting losses and gains. No cash flow impact. Published financial statements are affected.
P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT 61
Translation Methods For translating a foreign entity's balance sheet into the parent's currency of reporting various methods can be followed
•Closing rate method uses the rate prevailing on the parent's balance sheet date •Current-non current method uses the closing rate for current assets and liabilities and historical rates for non-current assets and liabilities •Monetary-non monetary method translates monetary assets and liabilities at the closing rate while non- monetary assets and liabilities such as inventories are translated at historical rates•Temporal method – current rate for items reported at current market value; historical rate otherwise.
P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT 62
3.4 Classification of Foreign Exchange Exposure and Risk (contd.)
Exchange rate impact on future revenues, costs, operating cash flows – operating exposure
In the long run, exchange rate effects can even undermine a firm's competitive advantage by raising its costs above those of its competitors or affecting its ability to service its market in other ways
Such competitive exposure is often referred to as "Strategic Exposure" because it has significant implications for some strategic business decisions such as choice of markets, sourcing, location etc.
P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT 63
3.4 Classification of Foreign Exchange Exposure and Risk (contd.)
Even if a firm has no direct involvement in any cross-border transactions it is not immune to exchange rate exposure
“Indirect" exposure is also in the nature of operating exposure faced by the firm where changes in exchange rates will most likely have an impact on its customers, suppliers and competitors which in turn will force the firm to alter its operations and strategies
P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT 64
3.4 Classification of Foreign Exchange Exposure and Risk (contd.)
An alternative but similar in spirit approach to classification of currency exposure focuses on the length of the time horizon and whether or not the exposure impacts on the end-of-the horizon financial statements – Accounting exposure is used for short-term
exposures which will have an impact on the financial results
P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT 65
3.4 Classification of Foreign Exchange Exposure and Risk (contd.)
Operating exposure is defined as the sensitivity of future operating profits to unanticipated changes in the exchange rate and is horizon is medium term
Strategic exposure refers to a still longer horizon and contemplates longer-term operational flexibility such as changing product-market mix, shifting location of operations and adopting new technologies
P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT 66
3.4 Classification of Foreign Exchange Exposure and Risk (contd.)
“Value-based" exposure which focuses on the impact of currency fluctuations on market value of the firm that takes into account both short-term accounting exposures as well as operating and strategic flexibility in responding to currency movements
P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT 67
3.5 Accounting Treatment of Transaction and Translation Exposure (contd.)
Apart from the transparency and information content of the financial statements, the key consideration in choosing the accounting treatment of transaction and translation exposures is its tax implications for the company as whole