fim

1. UNIT :3 & 4 PROF. PARVEEN SULTANA

2. EXPOSURE
Foreign exchange exposure refers to the
sensitivity of a firms cash flows to changes in
exchange rates
foreign exchange exposure is the risk associated
with activities that involve a global firm in
currencies other than its home currency.
firms must assess and Manage their foreign
exchange exposures.

3. What are the specific risks to a global firm from foreign exchange exposure?
Cash inflows and outflows, as measured in home
currency equivalents, associated with foreign operations
can be adversely affected.
• Revenues (profits) and Costs
Settlement value of foreign currency denominated
contracts, in home currency equivalents, can be adversely
affected.
• For Example: Loans in foreign currencies.
The global competitive position of the firm can be
affected by adverse changes in exchange rates.
• Influence on required return.
End Result: The value (market price) of the firm can be
adversely affected.

4. TYPES OF FOREIGN EXCHANGE
EXPOSURE
There are three distinct types of foreign exchange exposures that global
firms may face as a result of their international activities.
These foreign exchange exposures are:
Transaction exposure
• Any MNC engaged in current transactions involving foreign
currencies.
Economic exposure (operating exposure)
• Results for future and unknown transactions in foreign currencies
resulting from a MNC long term involvement in a particular market.
Translation exposure (sometimes called “accounting”
exposure).
• Important for MNCs with a physical presence in a foreign country.

5. Translation Exposure
• Results from the need of a global firm to consolidated its financial
statements to include results from foreign operations.
– Consolidation involves “translating” subsidiary financial
statements from local currencies (in the foreign markets where
the firm is located) to the home currency of the firm (i.e., the
parent).
– Consolidation can result in either translation gains or translation
losses.

6. Translation exposure – the potential that the firm’s consolidated
financial statements can be affected by changes in exchange rates.
Headquarters’
Consolidated
Financials
Subsidiary Financials Subsidiary Financials
Subsidiary Financials
JAPAN
YEN
GERMAN
Y €
USA $
₤
TRANSLATION RISK

7. Why do we Care about Translation?
managers, analysts and investors need some idea about
the importance of the foreign business a translated
accounting data give an approximate idea of this.
performance measurement for bonus plans, hiring,
firing, and promotion decisions.
accounting value serves as a benchmark to evaluate
valuation.
for income tax purposes.
legal requirement to consolidate financial statements.

8. MANAGING TRANSLATION EXPOSURE
Choices faced by the MNC:
1. Adjusting fund flows
altering either the amounts or the currencies of the planned cash flows of the
parent or its subsidiaries to reduce the firm’s local currency accounting
exposure.
2. Forward contracts
reducing a firm’s translation exposure by creating an offsetting asset or liability
in the foreign currency.
Exposure netting
a. Offsetting exposures in one currency with exposures in the
same or another currency
b. Gains and losses on the two currency positions will offset each
other.

9. Methods of Translation exposure
Current/Noncurrent Method
Monetary/Nonmonetary Method
Temporal Method
Current Rate Method
Accounting exposure = exposed assets – exposed
liabilities (excluding the capital/networth)

10. The Mechanics of FAS52: (FINANCIAL ACCOUNTING
STANDARDS BOARD STATEMENT)
FUNCTION CURRENCY
The currency that the business is conducted
in.
REPORTING CURRENCY
The currency in which the MNC prepares its
consolidated financial statements.

11. Exchange rates in various methods
1.Current/non current exchange rate methods
2.Monetary/non monetary exchange rate
methods
3.temporal exchange rate methods
4.Current rate exchange rate methods

12. 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.
generally accepted in the US from the 1930s -1975, at
which time FAS8 became effective.
Short-term gains/losses will be recognized long term
will not be.

13. Balance Sheet Local
Currency
Current/
Noncurrent
Cash € 2,100 $1,050
Inventory € 1,500 $750
Net fixed assets € 3,000 $1,000
Total Assets € 6,600 $2,800
Current liabilities € 1,200 $600
Long-Term debt € 1,800 $600
Common stock € 2,700 $900
Retained earnings € 900 $700
CTA -------- --------
Total Liabilities and
Equity
€ 6,600 $2,800
Current/Noncurrent Method
Current assets /liabilities translated
at the spot rate.
i.e. €2=$1
Noncurrent assets /liabilities
translated at the historical rate in
effect when the item was first
recorded on the books. i.e. €3=$

14. Monetary/Nonmonetary Method
The underlying principle 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.

15. Balance Sheet Local
Currency
Monetary/
Nonmonetary
Cash € 2,100 $1,050
Inventory € 1,500 $500
Net fixed assets € 3,000 $1,000
Total Assets € 6,600 $2,550
Current liabilities € 1,200 $600
Long-Term debt € 1,800 $900
Common stock € 2,700 $900
Retained earnings € 900 $0
CTA -------- --------
Total Liabilities and
Equity
€ 6,600 $2,400
Monetary/Nonmonetary
Method
All monetary balance sheet accounts are
translated at the current exchange rate. i.e.
€2=$1
All other balance sheet accounts are translated
at the historical exchange rate in effect when
the account was first recorded. i.e.€3=$1

16. Temporal Method
Same as monetary and non monetary method
FAS no.8
Monetary assets into current exchange rates
Non monetary assets into historical rates
Inventory at market value is on current ER
Most income statements are translated at average ER
Depreciation and cogs are non monetary at historical
rates.

17. Balance Sheet Local
Currency
Temporal
Cash € 2,100 $1,050
Inventory € 1,500 $900
Net fixed assets € 3,000 $1,000
Total Assets € 6,600 $2,950
Current liabilities € 1,200 $600
Long-Term debt € 1,800 $900
Common stock € 2,700 $900
Retained earnings € 900 $0
CTA -------- --------
Total Liabilities and
Equity
€ 6,600 $2,400
Temporal Method
Items carried on the books at their current
value are translated at the spot exchange
rate. i.e. €2=$1
Items that are carried on the books at
historical costs are translated at the historical
exchange rates.
i.e. €3=$1

18. 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.

19. Balance Sheet Local
Currency
Current
Rate
Cash €2,100.00 $1,050
Inventory €1,500.00 $750
Net fixed assets €3,000.00 $1,500
Total Assets €6,600.00 $3,300
Current liabilities €1,200.00 $600
Long-Term debt €1,800.00 $900
Common stock €2,700.00 $900
Retained earnings €900.00 $360
CTA -------- $540
Total Liabilities
and Equity
€6,600.00 $3,300
Current Rate Method
All balance sheet items (except for
stockholder’s equity) are translated at
the current exchange rate. i.e. €2=$1
A “plug” equity account named
cumulative translation adjustment is
used to make the balance sheet balance

20. How Various Translation Methods Deal with a Change
from €3 to €2 = $1
Balance Sheet Local
Currency
Current/
Noncurrent
Spot rate
Monetary/
Nonmonetary
Temporal Current
Rate
Cash €2,100 $1,050 $1,050 $1,050 $1,050
Inventory €1,500 $750 $500 $900 $750
Net fixed assets €3,000 $1,000 $1,000 $1,000 $1,500
Total Assets €6,600 $2,800 $2,550 $2,950 $3,300
Current liabilities €1,200 $600 $600 $600 $600
Long-Term debt €1,800 $600 $900 $900 $900
Common stock €2,700 $900 $900 $900 $900
Retained earnings €900 $700 $150 $550 $360
CTA -------- -------- -------- -------- $540
Total Liabilities
and Equity
€6,600 $2,800 $2,550 $2,950 $3,300
Book value of inventory
at spot exchange rate
Current
value of
inventory at
spot
exchange
rate
Historica
l data
Spot
rate
Income statement
Under the current rate method,
a “plug” equity account named
cumulative translation
adjustment makes the balance
sheet balance.

21. Translation
A US company establishes a subsidiary in the year 2006 in
Europe. The below balance sheet is translated at the
prevailing exchange rate of $1.00/Euro If the dollar were to
depreciate 25%, prepare the balance sheet under the 4
translation methods.

23. Translation
AV Ltd is an Indian subsidiary of a US manufacturer. AV's balance sheet in 1000's
of Rupees is as follows as on March 31:
Calculate accounting gain or loss by the current rate and monetary/non-monetary
methods. Explain the accounting translation via changes in the value of exposed
accounts.

26. Transaction Exposure
Transaction Exposure: Results from a firm taking on
“fixed” cash flow foreign currency denominated
contractual agreements.
Examples of transaction exposure:
• An Account Receivable denominate in a foreign currency.
• A maturing financial asset (e.g., a bond) denominated in a foreign
currency.
• An Account Payable denominate in a foreign currency.
• A maturing financial liability (e.g., a loan) denominated in a foreign
currency.

27. Transaction Exposure
Transaction exposure exists when the future cash
transactions of a firm are affected by exchange rate
fluctuations.
When transaction exposure exists, the firm faces three
major tasks:
 Identify its degree of transaction exposure,
 Decide whether to hedge its exposure, and
 Choose among the available hedging techniques if it decides
on hedging.

28. MANAGING TRANSACTION EXPOSURE
I. METHODS OF HEDGING
Forward market hedge
Money market hedge
Risk shifting
Pricing decision
Exposure netting
Cross-hedging
Foreign currency options

29. A.FORWARD MARKET HEDGE
1. consists of offsetting
a. a receivable or payable in a foreign currency
b. using a forward contract:
- to sell or buy that currency
- at a set delivery date
- which coincides with receipt of the foreign
currency.
B.MONEY MARKET HEDGE
1.Definition: simultaneous borrowing and lending activities in two different currencies to
lock in the dollar value of a future foreign currency cash flow
C.RISK SHIFTING
1. home currency invoicing
2. zero sum game
3. common in global business
4. firm will invoice exports in strong currency, import
in weak currency.
5. Drawback: it is not possible with informed
customers or suppliers.

30. PRICING DECISIONS
1. General rules: on credit sales convert foreign price to home price using
forward rate, but not spot rate.
2. If the home price is high (low) enough the exporter (importer) should
follow through with the sale (sign the contract).
E. EXPOSURE NETTING
1. Protection can be gained by selecting currencies that minimize exposure.
2. Netting: MNC chooses currencies that are not perfectly positively
correlated.
3. Exposure in one currency can be offset by the exposure in another
currency.

31. CURRENCY RISK SHARING
1. Developing a customized hedge contract
2. The contract typically takes the form of a Price Adjustment Clause,
whereby a base price is adjusted to reflect certain exchange rate changes.
G. CROSS-HEDGING
1. Often forward contracts not available in a certain currency.
2. Solution: a cross-hedge - a forward contract in a related currency.
3. Correlation between 2 currencies is critical to success of this hedge.
H. FOREIGN CURRENCY OPTIONS
 When transaction is uncertain, currency options are a good hedging tool in
situations in which the quantity of foreign exchange to be received or paid out
is uncertain.
 A call option : is valuable when a firm has offered to buy a foreign asset at a
fixed foreign currency price but is uncertain whether its bid will be accepted.
 A put option: allows the company to insure its profit margin against adverse
movements in the foreign currency while guaranteeing fixed prices to foreign
customer.

32. TECHNIQUES TO ELIMINATE
TRANSACTION EXPOSURE
Hedging Payables Hedging Receivables
Futures Purchase currency Sell currency
hedge futures contract(s). futures contract(s).
Forward Negotiate forward Negotiate forward
hedge contract to buy contract to sell
foreign currency. foreign currency.
Money Borrow local Borrow foreign
market currency. Convert currency. Convert
hedge to and then invest to and then invest
in foreign currency. in local currency.
Currency Purchase currency Purchase currency
option call option(s). put option(s).

33. ECONOMIC EXPOSURE
Economic Exposure: Results from the “physical” entry (and
on-going presence) of a global firm into a foreign market.
 This is a long term foreign exchange exposure resulting from a
previous FDI location decision.
 Over time, the firm will acquire foreign currency denominated
assets and liabilities in the foreign country.
 The firm will also have operating income and operating costs
in the foreign country.
 Economic exposure impacts the firm through contracts and
transactions which have yet to occur, but will, in the future, because
of the firm’s location.
 These are really “future” transaction exposures which are
unknown today.
 Economic exposure can have profound impacts on a global firm’s
competitive position and on the market value of that firm.

34. ECONOMIC EXPOSURE
Economic Exposure
= Transaction Exposure +Operating Exposure
Operating Exposure arises because exchange rate changes alter the
value of future revenues and costs.

35. OPERATING EXPOSURE
DEFINITION:
Operating exposure measures any change in the present value of a firm
resulting from changes in future operating cash flows caused by an
unexpected change in exchange rates.
OE analysis assesses the longer term impact of changing exchange rates on
a firm’s operating and on its competitive position.
The goal of the OE analysis is to identify strategic moves and policies to
deal with effectively unexpected exchange rate changes.

36. OPERATING EXPOSURE
Analyze change in PV of firm resulting from changes
in future operating cash flows & competitive position
caused by any unexpected change in exchange rates.
 Operating cash flows arise from inter-company and intra-company receivables &
payables, rent & lease payments, royalty & licensing fees.
 Financing cash flows are payments for use of inter- and intra- company loans &
stockholder equity.

37. Financial Cash Flows
Dividend paid to parent
Parent invested equity capital
Interest on intrafirm lending
Intrafirm principal payments
Payment for goods & services
Rent and lease payments
Royalties and license fees
Management fees & distributed overhead
Operational Cash Flows
Parent
Subsidiary
Operating & Financing Cash Flows

38. ATTRIBUTES OF OPERATING
EXPOSURE
Measuring the operating exposure of a firm requires forecasting and
analyzing all the firm’s future individual transaction exposures
together with the future exposures of all the firm’s competitors and
potential competitors worldwide.
From a broader perspective, operating exposure is not just the
sensitivity of a firm’s future cash flows to unexpected changes in
foreign exchange rates, but also to its sensitivity to other key
macroeconomic variables.
This factor has been labeled macroeconomic uncertainty.

39. ATTRIBUTES OF OPERATING
EXPOSURE The cash flows of the MNE can be divided into operating cash flows and
financing cash flows.
Operating cash flows arise from receivables and payables, rent and lease
payments, royalty and license fees and assorted management fees.
Financing cash flows are payments for loans (principal and interest), equity
injections and dividends.
Operating exposure is far more important for the long-run
health of a business than changes caused by transaction or
accounting exposure.
Operating exposure is inevitably subjective, because it
depends on estimates of future cash flow changes over an
arbitrary time horizon.
Planning for operating exposure is a total management
responsibility because it depends on the interaction of
strategies in finance, marketing, purchasing, and

40. An expected change in foreign exchange rates is not included in the
definition of operating exposure, because both management and investors
should have factored this information into their evaluation of anticipated
operating results and market value.
From an investor’s perspective, if the foreign exchange market is efficient,
information about expected changes in exchange rates should be reflected
in a firm’s market value.
Only unexpected changes in exchange rates, or an inefficient foreign
exchange market, should cause market value to change.

41. MEASURING THE IMPACT OF OE
An unexpected change in exchange rates impacts a firm’s expected
cash flows at four levels:
 Short run
 Medium run: Equilibrium case
 Medium run: Disequilibrium case
 Long run

42. STRATEGIC MANAGEMENT OF OE
The objective of both operating and transaction exposure
management is to anticipate and influence the effect of unexpected
changes in exchange rates on a firm’s future cash flows, rather than
merely hoping for the best.
To meet this objective, management can diversify the firm’s
operating and financing base.
Management can also change the firm’s operating and financing
policies.
A diversification strategy does not require management to predict
disequilibrium, only to recognize it when it occurs.

43. STRATEGIC MANAGEMENT OF OE
if a firm’s operations are diversified internationally, management is
prepositioned both to recognize disequilibrium when it occurs and to
react competitively.
Recognizing a temporary change in worldwide competitive conditions
permits management to make changes in operating strategies.
Diversification also reduces the variability of the firm’s cash flows.
Domestic firms may be subject to the full impact of foreign exchange
operating exposure (even without any cash flows) and do not have
the option to react in the same manner as an MNE.

44. STRATEGIC MANAGEMENT OF OE
If a firm’s financing sources are diversified, it will be prepositioned to
take advantage of temporary deviations from the international Fisher
effect.
However, to switch financing sources a firm must already be well-known
in the international investment community.
Again, this would not be an option for a domestic firm (if it has
limited its financing to one capital market).

45. MANAGEMENT OF OPERATING
EXPOSURE
Operating and transaction exposures can be partially managed
by adopting operating or financing policies that offset
anticipated foreign exchange exposures.
The six 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

46. MATCHING CURRENCY CASH
FLOWS.
 One way to offset an anticipated continuous long exposure to a particular company
is to acquire debt denominated in that currency (matching).
 A second alternative: the US firm seeks out potential suppliers of raw materials or
components in Canada as a substitute for US or other foreign firms.
 A third alternative: the company could engage in currency switching, in which the
company would pay foreign suppliers with Canadian dollars.

47. RISK-SHARING:
 An alternate method for managing a long-term cash flow
exposure between firms is risk sharing.
 This is a contractual arrangement in which the buyer and
seller agree to “share” or split currency movement
impacts on payments between them.
This agreement is intended to smooth the impact on both
parties of volatile and unpredictable exchange rate
movements.

48. BACK-TO-BACK LOANS:
A back-to-back loan, also referred to as a parallel
loan or credit swap, occurs when two business firms
in separate countries arrange to borrow each other’s
currency for a specific period of time.
At an agreed terminal date they return the borrowed
currencies.
Such a swap creates a covered hedge against
exchange loss, since each company, on its own
books, borrows the same currency it repays.

49. CURRENCY SWAP
A currency swap resembles a back-to-back loan except that it
does not appear on a firm’s balance sheet.
In a currency swap, a firm and a swap dealer or swap bank agree
to exchange an equivalent amount of two different currencies for
a specified amount of time.

50. LEADS AND LAGS
Retiming the transfer of funds
 Firms can reduce both operating and transaction exposure by
accelerating or decelerating the timing of payments that must
be made or received in foreign currencies.
 Intra-company leads and lags is more feasible as related
companies presumably embrace a common set of goals for the
consolidated group.
 Inter-company leads and lags requires the time preference of
one independent firm to be imposed on another.

51. RE-INVOICING CENTERS
There are three basic benefits arising from the creation of a
reinvoicing center:
 Managing foreign exchange exposure
 Guaranteeing the exchange rate for future orders
 Managing intra-subsidiary cash flows
 Disadvantage: cost of setting up, and running the center.

52. ECONOMIC EXPOSURE:
1. A forward looking concept: it focuses on future cash flows.
2. Involves real cash flows, not just accounting figures.
3. Relates to changes in the economic value (or, in an
efficient market, the market value) of the firm.
4. Contractual exposure depends on the firm’s portfolio of
FC engagements undertaken in the past. Operating exposure
depends on the environment (especially the market
structure and the input-output mix) and on the firm's
strategic response (e.g., relocation of production, changes in
the marketing mix or financial structure, etc.).
5. Also exists for firms without foreign subsidiaries, such as
exporting firms, import-competing firms, and notably
potential import-competing firms.
ACCOUNTING EXPOSURE:
1. A backward-looking concept: it reflects past decisions as
reflected in the subsidiary's assets and liabilities.
2. A change in an accounting value due to translation is not a
"realized" gain or loss; no change in the cash situation is involved
—except possibly through taxation effects.
3. Changes the firm's accounting value, but not necessarily its
market value.
4. Depends on the accounting rules chosen. This is because the
subsidiary's own internal rules affect its accounting values (e.g.,
type of depreciation, or inventory valuation methods) and also
because the translation process itself can be done in different ways
(see below).
5. Accounting exposure only exists in the case of foreign direct
investment, since pure exporting or import-substituting firms have
no foreign subsidiaries.

53. THE END