A2. (1) Difference between the “current rate” translation method and the temporal method:
Most countries today specify the translation method used by a foreign subsidiary based on the
subsidiary’s business operations. A foreign subsidiary’s business can be categorized as either an
integrated foreign entity or a self-sustaining foreign entity. For international standard, if foreign
operation is integral to parent operations, use temporal method, and exchange gains and losses are
income; If foreign operation is self-sustaining, use current rate method and exchange differences
are equity until disposal.
The main differences between current date method and the temporal method are:
(a) The current rate method.
• Translate assets and liabilities using the current rate.
• Translate revenues and expenses at the average rate
• Translate equity and dividends at historical rate.
• Calculate ending retained earnings and place in balance sheet.
• Determine the translation adjustment in equity necessary to “balance” the balance sheet.
(b) Temporal Method:
• Translate cash, receivables, and liabilities at current rate
• Translate inventory / CoGS, fixed assets / depreciation, and equity / dividends at historical
• Translate revenues and other expenses at average rate
• Calculate ending retained earnings and place in balance sheet.
• Determine the remeasurement gain or loss in the income statement that will make retained
earnings the amount that “balances” the balance sheet.
However, the US differentiates foreign subsidiaries on the basis of functional currency, not
• If the financial statements of the foreign subsidiary are maintained in US dollars, translation
is not required.
• If the statements are maintained in the local currency, and the local currency is the functional
currency, they are translated by the current rate method.
• If the statements are maintained in local currency, and the US dollar is the functional
currency, they are remeasured by the temporal method.
• If the statements are in local currency and neither the local currency nor the US dollar is the
functional currency, the statements must first be remeasured into the functional currency by
the temporal method, and then translated into US dollars by the current rate method.
(2) For subsidiaries operating in low inflation countries, FAS #52 uses the current rate method as
the basic translation rule. At the same time it mitigates the consequences by allowing companies
to move translation losses directly to a special subaccount in the net worth section of the balance
sheet, instead of adjusting current income. Solving the true profitability often disguised by
exchange rate volatility under FAS#8. FAS#8 uses temporal method and report translation gains
or loses on income statement. As a result, the net income is greatly affected by exchange rate
A more significant innovation of FAS #52 is the quot;functionalquot; currency concept, which gives a
company the opportunity to identify the primary economic environment and select the
appropriate (functional) currency for each of the corporation's foreign entities. In essence, FAS 52
allows management much more flexibility to present the impact of exchange rate variations in
accordance with perceived economic reality; by the same token, it provides greater scope for
manipulation of reported earnings and it reduces comparability of financial data for different
However, FAS#52 has a special provision for translating statements of foreign subsidiaries of
U.S. companies operating in countries where cumulative inflation has been approximately 100%
or more over a three-year period. Financial statement of these subsidiaries must be translated into
the reporting currency using the temporal method which is like under FAS#8.
Operating exposure, also called economic exposure, competitive exposure, or strategic exposure,
measures any changes in present values of a firm resulting from changes in future operating cash
flows caused by any unexpected change in exchange rates.
Operating exposures can be partially managed by adopting operating or financing policies that
offset anticipated foreign exchange exposures. Six of the most commonly employed proactive
policies are: Matching currency cash flows; Risk-sharing agreements; Back-to-back or parallel
loans; Currency swaps; Leads and lags; Reinvoicing center.
Numerical example: using a Cross-Currency Swap to hedge currency exposure
Two companies in different countries; Japanese corporation and United States corporation. They
want to hedge their revenues due to the change in exchange rates between Japanese yen and US
dollars. Assume that now exchange rate between two currencies is 100 ¥ /1 $ and exchange
become 90¥ /1$ one year later. Both the Japanese corporation and the US corporation would like
to enter into cross- currency swap that would allow them to use foreign currency cash flows to
service debt. Japanese corporation sale its products in US. They get US dollar for its revenues,
but base on the assumption that dollar become weaker after one year period Japanese
corporation want to hedge if the situation happens. For example the sales for Japanese
corporation in US are 10 million they want swap with one US corporation which also worry
about the devaluation of yen. Dealer will make money for some percentage The Japanese
corporation pay dollar to dealer and receive yen given by the US corporation. Whatever the
exchange rate is what after one year. Dealer can control the amount and timing of the desired
swap. They make agreement that dealer will get dollars from the Japanese company for 10
million and give back the yen for forward exchange rate 95¥/1$ one year later. The total amount
of Japanese company receives will be 950 million yen to pay its own debt. It is better when the
exchange rate become 90¥/1$ because at that time they only get 900 million yen at the end of
year. It same as forward contract, but they are entered in firm’s footnotes rather than as balance
sheet items. The result is that both translation and operating exposures are avoided.
A6. The steps in a typical letter of credit financed trade transaction are:
1. The importer places an order with the exporter, asking if the exporter is willing to ship
under an L/C.
2. The exporter agrees to ship under an L/C and specifies relevant information such as
prices and terms.
3. The importer applies to the issuing bank for an L/C to be issued in favor of the exporter
for the merchandise it wishes to buy.
4. The importer’s bank(the issuing bank) issues the L/C in favor of the exporter and sends it
to the exporter’s bank.
5. The exporter’s bank advises the exporter of the opening of an L/C in the exporter’s favor.
It may or may not confirm the L/C to add its own guarantee to the document.
6. The exporter ships the goods to the importer and gets the bill of lading from the carrier of
7. The exporter presents to exporter’s bank a time draft and other documents as required,
including the bill of lading.
8. The exporter’s bank presents the draft and documents to the importer’s bank for
9. The importer’s bank returns the accepted draft to the exporter’s bank.
10. The exporter’s bank, having received the accepted draft, may sell the acceptance in the
open market at a discount to a portfolio investor or hold the acceptance in its own
11. The exporter’s bank pays exporter. The exporter can receive the discounted cash value of
the acceptance at once or receive the amount of the acceptance when it is maturity.
12. The importer’s bank notifies the importer of the arrival of the documents. The importer
signs a note to pay the importer’s bank in the maturity day. The importer’s bank releases
13. On the maturity day, this bank receives from the importer funds to pay the maturing
14. On the same day, the holder of the matured acceptance presents it for payment and
receives its face value.
Tradecard is another type approach to financing foreign trade. TradeCard provides a hosted
technology platform comprised of online services and a global network of trade experts that
connect buyers, suppliers and service providers. This unique offering ensures members have the
data and tools needed to automate and optimize transactions in the extended supply chain.
The buyer creates and sends TradeCard a purchase order through their EDI, ERP, or user
interface on their Internet browser. The seller receives an automatic email notice from TradeCard
stating that a purchase order is quot;pendingquot;. The seller then approves the purchase order or
renegotiates its terms with the buyer, if necessary. Upon approval by the seller, the purchase
order is stored in TradeCard. At this point in the transaction, the seller can select payment
protection, if available. Once the goods are ready for shipment, the seller creates an invoice and
packing list on TradeCard. Since most of the invoice data are found on the original purchase
order, TradeCard automatically pre-populates the invoice document, so that the seller only needs
to fill in new data.
The TradeCard compliance engine then matches the invoice and other optional documents such
as the packing list, proof of delivery and proof of inspection against the purchase order to confirm
documentary compliance. Both buyer and seller are notified if there are any discrepancies and
have the option of negotiating them free of charge online. Once documentary compliance has
been achieved, TradeCard automatically sends payment instructions to a participating financial
institution, which debits the buyer's account and credits the seller's account
Compared to LC-based trade finance, Tradecard approach can
Reduces transaction times and avoiding delays caused by paper-based bank operations
Eliminates costs associated with traditional L/Cs, including charges for transfer, amendments
and checks, protecting the interests of clients and suppliers’ profit margins
Reduces the need for repeated data entry, allows information to be accessed instantly,
increases productivity and efficiency of operations
Letter of credit (L/C): is a bank’s promise to pay issued by a bank at the request of an importer
(the applicant/buyer), in which the bank promises to pay an exporter (the beneficiary of the letter)
upon presentation of documents specified in the L/C. An L/C reduces the risk of noncompletion,
because the bank agrees to pay against documents rather than actual merchandise.
Forfaiting: is a specialized technique to eliminate the risk of nonpayment by importers in
instanced where the importing firm and/or its government is perceived by the exporter to be too
risky for open account credit.
International Financial Tools Preferred Condition
Forfaiting When the exporter has difficulty in ensuring that
the a importer will make payment regard for the
uncertain risk such as political risk, and credit
Forfaiting is Non-recourse.
Letter of Credit When both side (exporter and importer) have
good credit line.
• Exporter can offer credit to buyer but receive cash payment.
• Exporter receives cash immediately upon delivery of the goods or
• No country of origin restrictions as required by Sovereign Export
• Up to 100% of sale can be financed.
• Forfait financing is 100% non-recourse to the Exporter.
• Eliminates the two key risks – political and commercial credit
• Protects exporter from foreign exchange fluctuations, interest rate
• Simple documentation, rapid, flexible deal structuring.
• Improves competitive advantage by providing vendor financing.
• Facilitates expansion of markets to riskier countries.
• Commitments can be received within a few days depending on
country of import.
• No credit administration, collection efforts with related costs.
• No contingent liability, enhances balance sheet ratios.
• Eliminates export credit insurance premiums and commercial
• Financing is transacted confidentially, unlike commercial loans.
• Importer gains access to extended term financing with fixed or
floating interest rates.
• Forfait financing has simple documentation and is very flexible.
• Can receive financing for up to 100% of cost of goods.
• Provides access to major hard currency financing.
• Repayment can be tailored to the buyer’s cash flow profile.
• Goods from a variety of sources can be financed.
• There is no acceleration clause in the case of non-payment of one
bill, which is traditionally featured in commercial loan agreements.
Investor The receivable becomes a form of debt instrument that can be sold on the
secondary market, or are presented by bills of exchange or promissory
• Forfait financing does not cover pre-delivery risks.
• An export shipment is effectively open account until a
commitment is obtained from the forfaiter and exporter fulfills
• Exporter has the responsibility to ensure that the debt is legal and
• Exporter must insure that the debt instrument is properly
• The cost of forfait financing can be higher than commercial bank
• The importer must pay for both forfait financing and the fee for
• Cost for financing and bank guarantee can be more than direct
• The bank aval or guarantee may be counted against and reduce
availability of Importers bank credit lines.
• Importer may need to cover foreign exchange risk over repayment
Investor Have to bear all risks.
Exporter 1. The L/C can reduce the risk- the exporter can sell against at bank’s
promise to pay rather than against the promise of a commercial firm.
2. The exporter is in a more secure position as to the availability of foreign
exchange to pay for the sale.
3. an exporter may find that an order backed by an irrevocable L/C will
facilitate obtaining pre-export financing in the home country.
Importer Importer need not pay out finds until the documents have arrived at a local
port or airfield and unless all conditions stated in the credit have been
Investor (Banks) Earning service fee and interest fee.
If the amount is not collected, the bank can perform recourse to quire the
exporter to repay all funds.
Exporter 1. Should pay service fee and interest fee to the bank.
2. If the documents don’t comply with the terms or conditions of L/C, the
seller should subject fines.
It’s a competitive disadvantage for the exporter to demand automatically an
L/C from an importer who has a good credit record and there is no concern
regarding the economic or political conditions of the importer’s country
Importer The quality of goods can’t be guaranteed. If all export documents are
complied with the terms of L/C, importer should pay all the amount of the
The main disadvantages are the fee charged by the importer’s bank for
issuing its L/C and the possibility that the L/C reduces the importer’s
borrowing line of credit with its bank.
Investor More and more customers transact by telegraphic transfer (T/T)
Describe the uncovered interest arbitrage strategy proposed by the Mathieux brothers.
Your discussion of this strategy should be in reference to information provided on
pp.99-101 of the case.
Mathieux brother’s proposal is to combine extended credit terms to local distributors with
Brazil’s high domestic interest rates to effectively lower the diaper’s price to Brazilian
consumers. Foreign corporations (i.e., European automobile manufacturers and Chinese textile
firms) were successfully undercutting national companies’ prices by taking advantage of Brazil’s
high interest rates. Borrowing rates in the U.S. were substantially lower than deposit rates in
Brazil, and given the stable exchange rate, this created an opportunity for uncovered interest rate
The basic strategy was based on the ability to get extended terms from the seller, Crosswell
International, and get paid for the goods quickly from the local Brazilian distributor. If the
distributor could obtain 180-day credit terms, or a standard 180-day letter of credit from
Crosswell, the firm could sell the goods into the local market for cash within 30 days of receiving
the diapers at port. The cash proceeds from the resale could then be invested in the relatively
“high-yielding” Real-denominated deposit rates. At the end of the following four to five months
when the payment on the goods to Crosswell was due, the deposits could be closed and the profits
taken to offset the cost of financing the purchase. This would reduce the R$6.86 per case
financing cost of the distributor as described in the baseline analysis in this case. Of course, this
was only true if the Real/dollar exchange rate was stable over the period.
What were the potential benefits and risks of this strategy to Crosswell.
The potential benefits and risks of this strategy to Crosswell are:
Benefit: Using UIA to offsetting the distributor’s cost in order to lower diapers’ price could
effectively made Crosswell enter in the Brazil’s diaper market and gain profit for the long-run.
Risk: a.) The Real/dollar exchange rate couldn’t be stable forever. If the Real are depreciate
significantly against the dollar, there will be less or even no profit for the distributor to offset its
cost. b.) The collection of the cash proceeds from the resale could be late, if the sales of diaper are
not good. c.) The interest rate differentials couldn’t persist over the long-run.
Suggest business approaches which might modify the strategy to reduce risk elements.
For the unstable exchange rate, I suggest The Mathiuex brothers should take on more
exchange rate risk themselves by selling the diapers at a fixed price in Brazilian Real. This
will reduce the risk to the Brazilian distributor. With less risk, the distributor cannot require
such a large margin. To assure the diaper sales for generating cash proceeds, Mathiuex
brothers should find a distributor who has more experience about grocery store instead of the
one who involved in hospital and disposable hygiene markets. To avoid long-run interest rate
decreasing, Crosswell could export goods into Uruguay and truck goods into Brazil for
paying the lower import tariffs in order to reduce prices.