08-05-2012, 02:49 PM
Foreign Exchange Risk Management
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Translation Exposure
Translation exposure, also called accounting exposure, arises because financial statements of foreign subsidiaries – which are stated in foreign currency – must be restated in the parent’s reporting currency for the firm to prepare consolidated financial statements.
Translation exposure is the potential for an increase or decrease in the parent’s net worth and reported net income caused by a change in exchange rates since the last translation.
The accounting process of translation, involves converting these foreign subsidiaries financial statements into home currency-denominated statements.
Current Rate Method
The current rate method is the most prevalent in the world today.
Assets and liabilities are translated at the current rate of exchange.
Income statement items are translated at the exchange rate on the dates they were recorded or an appropriately weighted average rate for the period.
The biggest advantage of the current rate method is that the gain or loss on translation does not pass through the income statement but goes directly to a reserve account (reducing variability of reported earnings).
Managing Translation Exposure
The main technique to minimize translation exposure is called a balance sheet hedge.
A balance sheet hedge requires an equal amount of exposed foreign currency assets and liabilities on a firm’s consolidated balance sheet.
If this can be achieved for each foreign currency, net translation exposure will be zero.
These hedges are a compromise in which the denomination of balance sheet accounts is altered, perhaps at a cost in terms of interest expense or operating efficiency, to achieve some degree of foreign exchange protection.
Boeing’s Money Market Hedge
Money Market Hedge: Borrow (or lend) in the foreign currency to hedge foreign currency receivables (payables) – this matches FC assets & liabilities in the same currency.
Borrow the PV of £10m (£ 9,174,312)
Convert £ into $ at $1.50/£ ($13,761,468)
Invest $ in the US at 6.1% for one year ($14,600,918)
Collect £10m in one-year and repay the loan (the £ receivable offsets the loan)