Management of Economic ExposureChapter NineCopyright © 2021

Management of Economic Exposure
Chapter Nine
Copyright © 2021 by the McGraw-Hill Companies, Inc. All
rights reserved.
This chapter provides a way to measure economic exposure,
discusses its determinants, and presents methods for managing
and hedging economic exposure.
1
Chapter Outline
How to Measure Economic Exposure
Operating Exposure: Definition
Illustration of Operating Exposure
Determinants of Operating Exposure
Managing Operating Exposure
Summary
9-2
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Economic Exposure
Changes in exchange rates can affect not only firms that are
directly engaged in international trade but also purely domestic

firms.
Furthermore, changes in exchange rates may affect not only the
operating cash flows of a firm by altering its competitive
position but also dollar (home currency) values of the firm’s
assets and liabilities
Exchange rate changes can systematically affect the value of the
firm by influencing its operating cash flows as well as the
domestic currency values of its assets and liabilities
9-3
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Exchange Rate Exposure of U.S. Industry Portfolios
9-4
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This exhibit provides an estimate of the U.S. industries’ market
betas as well as the “forex” betas during the period of 2000-
2018.
4
How to Measure Economic Exposure
Currency risk (or uncertainty) represents random changes in
exchange rates, while currency exposure measures “what is at

risk”
Exposure to currency risk can be properly measured by the
following:
Sensitivity of the future home currency values of the firm’s
assets and liabilities to random changes in exchange rates
Sensitivity of the firm’s operating cash flows to random
changes in exchange rates
9-5
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Channels of Economic Exposure
9-6
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Measuring Asset Exposure
From the perspective of a U.S. firm that owns an asset in
Britain, the exposure can be measured by the coefficient (b) in
regressing the dollar value (P) of the British asset on the
dollar/pound exchange rate (S)
P = a + b×S + e
Where
a is the regression constant

e is the random error term with mean zero
the regression coefficient b measures the sensitivity of the
dollar value of the asset (P) to the exchange rate (S)
9-7
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Measuring Asset Exposure (Continued)
The exposure coefficient, b, is defined as follows:
Where
Cov(P,S) is the covariance between the dollar value of the asset
and the exchange rate
Var(S) is the variance of the exchange rate
Cov(P,S)
Var(S)
b =
9-8
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Example
Suppose a U.S. firm has an asset in Britain whose local
currency price is random.
For simplicity, suppose there are only three states of the world
and each state is equally likely to occur.
The future local currency price of this British asset (P*) as well
as the future exchange rate (S) will be determined, depending

on the realized state of the world.
9-9
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Measurement of Currency Exposure
9-10
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First, consider Case 1, described in Panel A. Case 1 indicates
that the local currency price of the asset (P*) and the dollar
price of the pound (S) are positively correlated, so that
depreciation (appreciation) of the pound against the dollar is
associated with a declining (rising) local currency price of the
asset. The dollar price of the asset on the future (liquidation)
date can be $1,372, or $1,500 or $1,712, depending on the
realized state of the world. (For illustration, the computations
of the parameter values for Case 1 are shown in the next slide.)
Next, consider Case 2. This case indicates that the local
currency value of the asset is clearly negatively correlated with
the dollar price of the British pound. In fact, the effect of
exchange rate changes is exactly offset by movements of the
local currency price of the asset, rendering the dollar price of
the asset totally insensitive to exchange rate changes. The
future dollar price of the asset will be uniformly $1,400 across

the three states of the world. One thus can say that the British
asset is effectively denominated in terms of the dollar. Although
this case may be unrealistic, it shows that uncertain exchange
rates or exchange risk does not necessarily constitute exchange
exposure.
We now turn to Case 3, where the local currency price of the
asset is fixed at £1,000. In this case, the U.S. firm faces a
“contractual” cash flow that is denominated in pounds. This
case, in fact, represents an example of the special case of
economic exposure, transaction exposure. Intuitively, what is at
risk is £1,000, that is, the exposure coefficient, b, is £1,000.
10
Computations of Regression Parameters: Case 1
9-11
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Hedging Asset Exposure
Once the magnitude of the exposure is known, the firm can
hedge the exposure by simply selling the exposure forward
We can decompose the variability of the dollar value of the
asset, Var(P), into two separate components: exchange rate-
related and residual
Consequences of hedging the exposure by forward contracts are
illustrated in the next slide

9-12
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The first term in the right-hand side of the equation, b2Var(S),
represents the part of the variability of the dollar value of the
asset that is related to random changes in the exchange rate,
whereas the second term, Var(e), captures the residual part of
the dollar value variability that is independent of exchange rate
movements.
12
Consequences of Hedging Currency Exposure
9-13
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13
Operating Exposure: Definition
Many managers do not fully understand the effect of volatile
exchange rates on operating cash flows
Operating exposure is the extent to which the firm’s operating
cash flows will be affected by random changes in the exchange
rates

In many cases, operating exposure may account for a larger
portion of the firm’s total exposure than contractual exposure
9-14
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14
Illustration of Operating Exposure
“Suppose a U.S. computer company has a wholly owned British
subsidiary, Albion Computers PLC, that manufactures and sells
PCs in the U.K. market. Albion Computers imports
microprocessors from Intel, which sells them for $512 per unit.
At the current exchange rate of $1.60 per pound, each Intel
microprocessor costs £320. Albion Computers hires British
workers and sources all the other inputs locally. Albion faces a
50 percent income tax rate in the U.K.”
9-15
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Projected Operations for Albion Computers PLC: Benchmark
Case ($1.60/)
9-16
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16
Illustration of Operating Exposure (Continued)
Consider the possible effect of a depreciation of the pound on
the projected dollar operating cash flow of Albion Computers.
Assume the pound may depreciate from $1.60 to $1.40 per
pound
The dollar operating cash flow may change following a pound
depreciation due to:
Competitive effect
Conversion effect
9-17
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Illustration of Operating Exposure (Concluded)
Consider the following cases with varying degree of realism:
Case 1: No variables change, except the price of the imported
input.
Case 2: The selling price as well as the price of the imported
input changes, with no other changes.
Case 3: All the variables change.
9-18
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Projected Operations for Albion Computers PLC: Case 1
($1.40/£)
9-19
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19
($1.40/£)
9-20
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20
($1.40/£)
9-21

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21
Summary of Operating Exposure Effect of Pound Depreciation
on Albion Computers
9-22
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Determinants of Operating Exposure
Operating exposure cannot be readily determined from the
firm’s accounting statements, unlike transaction exposure
A firm’s operating exposure is determined by:
The structure of the markets in which the firm sources its
inputs, such as labor and materials, and selling its products
The firm’s ability to mitigate the effect of exchange rate
changes by adjusting its markets, product mix, and sourcing
9-23
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Determinants of Operating Exposure (Continued)
A firm is usually subject to high degrees of operating exposure
when either its cost or its price is sensitive to exchange rate
changes
When both the cost and the price are sensitive or insensitive to
exchange rate changes, the firm has no major operating
exposure
The extent to which a firm is subject to operating exposure
depends on the firm’s ability to stabilize cash flows in the face
of exchange rate changes
9-24
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Managing Operating Exposure
Objective of managing operating exposure is to stabilize cash
flows in the fact of fluctuating exchange rates
Firms may use the following strategies for managing operating
exposure:
Selecting low-cost production sites
Flexible sourcing policy
Diversification of the market
Product differentiation and R&D efforts
Financial hedging
9-25
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Selecting Low Cost Production Sites
When the domestic currency is strong or expected to become
strong, a firm may choose to locate production facilities in a
foreign country where costs are low
Low costs may be due to either the undervalued currency or
underpriced factors of production
The firm may choose to establish and maintain production
facilities in multiple countries to deal with the effect of
exchange rate changes
Example: Nissan has manufacturing facilities in the U.S., U.K.,
and Mexico, as well as Japan
9-26
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Flexible Sourcing Policy
Even if a firm has manufacturing facilities only in the domestic
country, it can substantially lessen the effect of exchange rate
changes by sourcing from where input costs are low
Example: In the early 1980s when the dollar was very strong
against most major currencies, U.S. multinational firms often
purchased materials and components from low-cost foreign
suppliers
Flexible sourcing policy is a strategy for managing operating
exposure that involves sourcing from areas where input costs
are low

9-27
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Diversification of the Market
Diversifying the market for the firm’s products is another way
to managing exchange exposure
Example: If GE is selling power generators in Mexico and
Germany, reduced sales in Mexico (due to the dollar
appreciation against the peso) could be compensated by
increased sales in Germany (due to the dollar depreciation
against the euro)
Note that expansion into a new business should be justified on
is own right, not solely as a solution to currency exposure
9-28
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R&D Efforts and Product Differentiation
Investment in research and development (R&D) can allow the
firm to maintain and strengthen its competitive position in the
face of adverse exchange rate movements
Successful R&D allows the firm to do the following:
Cut costs and enhance productivity
Introduce new and unique products for which competitors offer
no close substitutes
9-29

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Financial Hedging
Financial hedging can be used to stabilize the firm’s cash flows
Financial hedging refers to hedging exchange risk exposure
using financial contracts such as currency forward and options
contracts
If operational hedges, which involve redeployment of resources,
are costly or impractical, financial contracts can provide the
firm with a flexible and economical way of dealing with
exchange exposure
9-30
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Management of Transaction Exposure
Chapter Eight
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1
Chapter Outline
Three Types of Exposure
Should the Firm Hedge?
Hedging Foreign Currency Receivables
Hedging Foreign Currency Payables
Cross-Hedging Minor Currency Exposure
Hedging Contingent Exposure
Hedging Recurrent Exposure with Swap Contracts
Hedging through Invoice Currency
Hedging via Lead and Lag
Exposure Netting
What Risk Management Products Do Firms Use?
Summary
8-2
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8-‹#›

Three Types of Exposure
It is conventional to classify foreign currency exposures into
three types:
Transaction exposure is the potential change in the value of
financial positions due to changes in the exchange rate between
the inception of a contract and the settlement of the contract
Economic exposure is the possibility that cash flows and the
value of the firm may be affected by unanticipated changes in
the exchange rates
Translation exposure is the effect of an unanticipated change in
the exchange rates on the consolidated financial reports of an
MNC
8-3
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Three Types of Exposure (Continued)
Firm is subject to transaction exposure when it faces contractual
cash flows that are fixed in foreign currencies
Example
Suppose a U.S. firm sold its product to a German client on
three-month credit terms and invoiced €1 million
When the U.S. firm received €1m in three months, it will have
to convert (unless it hedges) the euros into dollars at the spot
exchange rate prevailing on the maturity date, which cannot be
known in advance
8-4
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8-‹#›
When a firm has foreign-currency-denominated receivables or
payables, it is subject to transaction exposure, and those
settlements are likely to affect the firm’s cash flow position.
4
Hedging Transaction Exposure
This chapter focuses on alternative ways of hedging transaction
exposure using various financial contracts and operational
techniques
Financial contracts
Forward contracts, money market instruments, options
contracts, and swap contracts
Operational techniques
Choice of the invoice currency, lead/lag strategy, and exposure
netting
8-5
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Should the Firm Hedge?
No consensus on the question of whether a firm should hedge;
Most arguments suggesting corporate exposure management will
not add value to the firm hold in the case of a “perfect” capital
market
One can make a case for corporate risk management based on

various market imperfections:
Information asymmetry
Differential transaction costs
Default costs
Progressive corporate taxes
8-6
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Tax Savings from Hedging Exchange Risk Exposure
8-7
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Hedging Foreign Currency Receivables
Suppose Boeing Corporation exported a landing gear of Boeing
737 aircraft to British Airways and billed £10 million payable
in one year, with money market interest rates and foreign
exchange rates given as follows:
U.S. interest rate: 6.10% per annum
U.K. interest rate: 9% per annum
Spot exchange rate: $1.50/£
Forward exchange rate: $1.46/£ (1-year maturity)
When Boeing receives £10m in one year, it will convert the

pounds into dollars at the spot exchange rate prevailing at the
time
8-8
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8-‹#›
Now, we will look at the various techniques for managing this
transaction exposure.
8
Forward Market Hedge
Most direct and popular way of hedging transaction exposure is
by currency forward contracts
Sell (buy) foreign currency receivables (payables) forward to
eliminate exchange risk exposure
Boeing may sell forward its pounds receivables, £10m, for
delivery in one year, in exchange for a given amount of U.S.
dollars
On the maturity date of the contract, Boeing will have to deliver
£10m to the bank, which is the counterparty of the contract,
and, in return, take delivery of $14.6m ($1.46/£ * £10m),
regardless of the spot exchange rate that may prevail on the
maturity date
8-9
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8-‹#›

Refer to example provided in slide 8.
9
Dollar Proceeds from the British Sale: Forward Hedge versus
Unhedged Position
8-10
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10
Forward Market Hedge (Continued)
Suppose that on the maturity date of the forward contract, the
spot rate turns out to be $1.40/£, which is less than the forward
rate, $1.46/£
Boeing would have received $14m instead of $14.6m had it not
entered the forward contract
What if the spot rate had been $1.50/£ at maturity?
Boeing would have received $15m by remaining unhedged
Ex post, forward hedging would have cost Boeing $0.4m
Gains and losses are computed by the following:
8-11
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8-‹#›
11
Gains/Losses from Forward Hedge
8-12
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12
Illustration of Gains and Losses from Forward Hedging
8-13
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Forward Market Hedge (Concluded)
Firm must make decision whether to hedge ex ante

Consider the following scenarios:
T ≈ F
Expected gains or losses are approximately zero, but forward
hedging eliminates exchange exposure
Firm will be inclined to hedge if it is averse to risk
T < F
Firm expects a positive gain from forward hedging and would
be even more includes to hedge than in Scenario 1
T > F
Firm would be less inclined to hedge under this scenario, other
things being equal
8-14
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8-‹#›
T denotes the firm’s expected spot exchange rate for the
maturity date and F represents the forward rate.
14
Currency Futures versus Forwards
A firm could use a currency futures contract, rather than a
forward contract, for hedging purposes
A futures contract is not as suitable as a forward contract for
hedging purposes for two reasons:
Unlike forward contracts that are tailor-made to the firm’s
specific needs, futures contracts are standardized instruments in
terms of contract size, delivery date, etc.
Thus, in most cases, the firm can only hedge approximately
Due to the marking-to-market property, there are interim cash

flows prior to the maturity date of the futures contract that may
have to be invested at uncertain interest rates
Again, this makes exact hedging difficult
8-15
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8-‹#›
15
Money Market Hedge
A firm may borrow (lend) in foreign currency to hedge its
foreign currency receivables (payables), thereby matching its
assets and liabilities in the same currency
Boeing can eliminate the exchange exposure arising from the
British sale by first borrowing in pounds, then converting the
loan proceeds into dollars, which then can be invested at the
dollar interest rate
On the maturity date of the loan, Boeing is going to use the
pound receivable to pay off the pound loan
If Boeing borrows a particular pound amount so that the
maturity value of this loan becomes exactly equal to the pound
receivable from the British sale, Boeing’s net pound exposure is
reduced to zero
8-16
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8-‹#›
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Money Market Hedge (Continued)
What amount of pounds should Boeing borrow?
Amount to borrow may be computer as the discounted present
value of the pound receivable
£10m / (1.09) = £9,174,312
Step-by-step procedure of money market hedging:
Borrow £9,174,312
Convert £9,174,312 into $13,761,468 at the current spot
exchange rate of $1.50/£
Invest $13,761,468 in the U.S.
After one year, collect £10m from British Airways and use it to
repay the pound loan
Receive the maturity value of the dollar investment, that is,
$14,600,918 = ($13,761,468)(1.061)
8-17
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17

Cash Flow Analysis of a Money
Market Hedge
8-18
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Options Market Hedge
One possible shortcoming of both forward and money market
hedges is that these methods completely eliminate exchange risk
exposure
Ideally, Boeing would like to protect itself only if the pound
weakens, while retaining the opportunity to benefit if the pound
strengthens
Currency options provide a flexible “optional” hedge against
exchange exposure
Firm may buy a foreign currency call (put) option to hedge its
foreign currency payables (receivables)
8-19
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8-‹#›

19
Options Market Hedge (Continued)
Suppose that in the OTC market, Boeing purchased a put option
on £10m with an exercise price of $1.46/£ and a one-year
expiration, and assume the option premium (price) was $0.02
per pound
Boeing paid $200,000 (= $0.02 * 10 million) for the option
Provides Boeing with the right, but not the obligation, to sell up
to £10m for $1.46/£, regardless of the future spot rate
Assume the spot exchange rate turns out to be $1.30 on the
expiration date
Upfront cost is equivalent to $212,200 = ($200,000 * 1.061)
Net dollar proceeds are $14,387,800 = $14.6m - $212,200
Boeing is assured of “minimum” dollar receipt of $14,387,800
8-20
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Options Market Hedge (Concluded)
Consider an alternative scenario where the pound appreciates
against the dollar, and assume the spot rate turns out to be $1.60
per pound at expiration
Boeing will have no incentive to exercise the option
Rather, it would let the option expire and convert £10m into

$16m at the spot rate
Subtracting $212,200 for the option cost, the net dollar proceeds
will become $15,787,800 under the option hedge
Options hedge allows the firm to limit downside risk while
preserving the upside potential, but firm must pay for this
flexibility in terms of the option premium
8-21
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21
Comparison of Hedging Strategies
Money market hedge versus forward hedge
Money market hedge dominates since the guaranteed dollar
proceeds from the British sale with the money market hedge
exceeds guaranteed proceeds with forward hedge
Money market hedge versus options hedge
Options hedge dominates money market hedge for future spot
rates greater than $1.4813/£, but money market hedge dominates
options hedge for spot rates lower than $1.4813/£
Options hedge versus forward hedge
Options hedge dominates the forward hedge for future spot rates
greater than $1.48 per pound, whereas the opposite holds for
spot rates lower than $1.48 per pound
8-22
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8-‹#›
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Boeing’s Alternative Hedging Strategies for a Foreign Currency
Receivable
8-23
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23
Hedging Foreign Currency Payables
Suppose Boeing imported a Rolls-Royce jet engine for £5
million payable in one year
Market condition is summarized as follows:
The U.S. interest rate: 6.00% per annum
The U.K. interest rate: 6.50% per annum
The spot exchange rate: $1.80/£
The forward exchange rate: $1.75/£ (1-year maturity)
Boeing is concerned about the future dollar cost of this
purchase, and they will try to minimize the dollar cost of paying
off the payable
8-24

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8-‹#›
24
Foreign Currency Payables: Alternatives
Forward market hedge
If Boeing decides to hedge this payable exposure using a
forward contract, it only needs to buy £5m forward in exchange
for the following dollar amount:
$8,750,000 = (£5,000,000) ($1.75/£)
Money market hedge
PV of foreign currency payable: £4,694,836 = £5m / 1.065
Outlay of dollars today: $8,957,747 = ($8,450,705) ($1.80/£)
Future value: $8,957,747 = ($8,450,705) (1.06)
Options market hedge
Purchase a “call” on £5m
8-25
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Boeing’s Alternative Hedging Strategies for a Foreign Currency

Payable
8-26
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Dollar Costs of Securing the Pound Payable: Alternative
Hedging Strategies
8-27
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Cross-Hedging Minor Currency Exposure
If a firm has positions in major currencies (e.g., British pound,
euro, and Japanese yen), it can easily use forward, money
market, or options contracts to manage its exchange risk
exposure
However, if the firm has positions in less liquid currencies
(e.g., Indonesian rupiah, Thai bhat, and Czech koruna), it may

be either very costly or impossible to use financial contracts in
these currencies
In this situation, firms may use cross-hedging, which involves
hedging a position in one asset by taking position in another
asset
8-28
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8-‹#›
28
Hedging Contingent Exposure
Options contract can also provide an effective hedge against
what might be called contingent exposure
Contingent exposure is the risk due to uncertain situations in
which a firm does not know if it will face exchange risk
exposure in the future
Example: Suppose GE is bidding on a hydroelectric project in
Canada. If the bid is accepted, which will be known in three
months, GE is going to receive C$100m to initiate the project.
Since GE may or may not face exchange exposure, it faces a
typical contingent exposure situation
Difficult to manage contingent exposure using traditional
hedging tools like forward contracts, but an alternative is for
GE to buy a put option on C$100m
8-29
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8-‹#›
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Hedging Recurrent Exposure with Swap Contracts
Firms often must deal with a “sequence” of accounts payable or
receivable in terms of a foreign currency, and these recurrent
cash flows can be best hedged using a currency swap contract
Currency swap contracts are agreements to exchange one
currency for another at a predetermined exchange rate, that is,
the swap rate, on a sequence of future dates
Similar to a portfolio of forward contracts with different
maturities
Very flexible in terms of amount and maturity, with maturity
ranging from a few months to 20 years
8-30
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8-‹#›
30
Hedging through Invoice Currency
Hedging through invoice currency is an operational technique
that allows the firm to shift, share, or diversify exchange risk
by appropriately choosing the currency of invoice
Example: If Boeing invoices $150m rather than £100m for the
sale of aircraft, it does not face exchange exposure anymore.

Though the exchange exposure has not disappeared, it has been
shifted to the British importer.
Another option would be for Boeing to invoice half of the bill
in U.S. dollars and the remaining half in British pounds, thereby
sharing the exchange exposure
Finally, the firm can diversify exchange exposure to some
extent by using currency basket units, such as the SDR, as the
invoice currency
8-31
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8-‹#›
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Hedging via Lead and Lag
The lead/lag strategy reduces transaction exposure by paying or
collecting foreign financial obligations early (lead) or late (lag)
depending on whether the currency is hard or soft
Challenges associated with this strategy:
If we assume Boeing would like BA to prepay £100m, we can
also assume BA would have no incentive to do so unless they
received a substantial discount to compensate for prepayment
Pushing BA to prepay may hurt future sales efforts by Boeing
To the extent the original invoice price incorporated the
expected depreciation of the pound, Boeing is already partially
protected against depreciation of the pound
Strategy can be employed more effectively to deal with
intrafirm payables and receivables among subsidiaries
8-32

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8-‹#›
32
Exposure Netting: Lufthansa
“In 1984, Lufthansa, a German airline, signed a contract to buy
$3 billion worth of aircraft from Boeing and entered into a
forward contract to purchase $1.5 billion forward for the
purpose of hedging against the expected appreciation of the
dollar against the German mark. This decision, however,
suffered from a major flaw: A significant portion of Lufthansa’s
cash flows was also dollar-denominated.”
Lufthansa had a so-called “natural hedge”
The following year, the dollar depreciated substantially against
the mark and Lufthansa experienced a major foreign exchange
loss from settling the forward contract
The lesson here is that, when a firm has both receivables and
payables in a given foreign currency, it should consider hedging
only its net exposure
8-33
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33

Exposure Netting
Realistically, typical multinational corporations are likely to
have a portfolio of currency positions
In this case, firms should hedge residual exposure rather than
hedge each currency position separately
Exposure netting is hedging only the net exposure by firms that
have both payable and receivables in foreign currencies
For firms that would like to apply this approach aggressively, it
helps to centralize the firm’s exchange exposure management
function in one location
Many MNCs are using a reinvoice center, a financial subsidiary,
as a mechanism for centralizing exposure management functions
8-34
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What Risk Management Products Do Firms Use?
Among U.S. corporations, based on a survey of Fortune 500
firms, the most popular product was the traditional forward
contract
Jesswein, Kwok, and Folks (1995) found 93% of respondents
reported using forward contracts
Kim and Chance (2018) study:
Examined actual currency risk management practices of 101
largest nonfinancial corporations in South Korea
Authors document a great discrepancy between what firms say
they do versus what they actually do, attributing the discord to

attempts by companies to time their hedges
8-35
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Management of Translation Exposure
Chapter Ten
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1
Chapter Outline
Translation Methods
FASB Statement 8
FASB Statement 52
International Accounting Standards
Management of Translation Exposure
Empirical Analysis of the Change from FASB 8 to FASB 52
10-2
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Translation Exposure
Translation exposure, frequently referred to as accounting
exposure, refers to the effect that an unanticipated change in
exchange rates will have on the consolidated financial reports of
a MNC
When exchange rates change, the value of a foreign subsidiary’s
assets and liabilities denominated in a foreign currency change
when they are viewed from the perspective of the parent firm
10-3
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Translation Methods
Four methods of foreign currency translation have been used in
recent years:
Current/noncurrent method
Monetary/nonmonetary method
Temporal method
Current rate method
10-4
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Current/Noncurrent Method
The idea that current assets and liabilities are converted at the
current exchange rate while noncurrent assets and liabilities are
translated at the historical exchange rates is the
current/noncurrent method
Under this method, a foreign subsidiary with current assets in
excess of current liabilities will cause a translation gain (loss)
if the local currency appreciates (depreciates)
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
10-5
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5
Monetary/Nonmonetary Method
The idea that monetary balance sheet accounts (e.g., accounts
receivable) are translated at the current exchange rate while
nonmonetary balance sheet accounts (e.g., stockholder’s equity)
are converted at the historical exchange rate is the
monetary/nonmonetary method
Compared to current/noncurrent method, this approach differs
substantially with respect to accounts like inventory, long-term
receivables, and long-term debt
Classifies accounts based on similarity of attributes rather than
similarly of maturities
10-6
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Temporal Method
The idea that current and noncurrent monetary accounts as well
as accounts that are carried on the books at current value are
converted at the current exchange rate is the temporal method
Accounts carried on the books at historical costs are translated
at the historical exchange rate
Fixed assets and inventory are usually carried at historical
costs, and as a result, the temporal method and the
monetary/nonmonetary method will typically provide the same
translation
10-7
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Current Rate Method
The idea that all balance sheet accounts are translated at the
current exchange rate except stockholder’s equity, which is
translated at the exchange rate on the date of issuance, is the
current rate method
Simplest of all translation methods to apply
A “plug” equity account named cumulative translation
adjustment (CTA) is used to make the balance sheet balance,
since translation gains or losses do not go through the income
statement according to this method
10-8
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FASB Statement 8
FASB 8 became effective on January 1, 1976
Objective was to measure in dollars an enterprise’s assets,
liabilities, revenues, or expenses that are denominated in a
foreign currency according to GAAP
Essentially the temporal method of translation, with few
subtleties
Temporal method requires taking foreign exchange gains or
losses through the income statement.
Therefore reported earnings could (and did) fluctuate
substantially from year to year, irritating executives
10-9
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FASB Statement 52
Due to controversary surrounding FASB 8, FASB 52 was issued
in December 1981
Stated objectives of FASB 52:
Provide information that is generally compatible with the
expected economic effects of a rate change on an enterprise’s
cash flows and equity
Reflect in consolidated statements the financial results and
relationship of the individual consolidated entities as measured
in their functional currencies in conformity with U.S. GAAP
10-10
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10
Functional Currency versus
Reporting Currency
The method of translation prescribed by FASB 52 depends upon
the functional currency used by the foreign subsidiary whose
statements are to be translated
Functional currency is the currency of the primary economic
environment in which the entity operates
Reporting currency is the currency in which the MNC prepares
its consolidated financial statements

10-11
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The Mechanics of FASB 52 Translation Process
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
Temporal method used to accomplish remeasurement
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
10-12
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FASB 52 Two-Stage Process
10-13
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Highly Inflationary Economies
In highly inflationary economies, FASB 52 requires foreign
entities to remeasure financial statements using the temporal
method “as if the functional currency were the reporting
currency”
Highly inflationary economy is defined as, “one that has
cumulative inflation of approximately 100 percent or more over
a 3-year period”
10-14
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International Accounting Standards
Since January 2005, all companies doing business in the
European Union must use the accounting standards distributed
by the International Accounting Standards Board (IASB)
Similar to the FASB, the IASB publishes its standards in a
series of pronouncements called International Financial
Reporting Standards
It also adopted and maintains the pronouncements of the IASC,
the IASC, called International Accounting Standards (IAS)
10-15
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Translation versus Transaction Exposure
Some items that are a source of transaction exposure are also a
source of translation exposure, while others are not
Generally, it is not possible to eliminate both translation and
transaction exposure
Because transaction exposure involves real cash flows, it would
be prudent to consider it the more important of the two
A recent survey found 83% of MNCs placed a “significant” or
the “most” emphasis on transaction exposure relative to 37% for
translation exposure
10-16
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Hedging Translation Exposure
If one desires to attempt to control accounting changes in the
historical value of net investment, there are two methods for
dealing with residual translation exposure:
Balance sheet hedge
Derivatives hedge
10-17
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Balance Sheet Hedge
Note that translation exposure is currency specific, not entity
specific
Source is a mismatch of net assets and net liabilities
denominated in the same currency
A balance sheet hedge is intended to reduce translation
exposure of an MNC by eliminating the mismatch of exposed
net assets (and exposed net liabilities) denominated in the same
currency
However, it may create transaction exposure
10-18
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Derivatives Hedge
A derivative product, such as a forward contract, can be used to
attempt to hedge
A derivatives hedge to control translation exposure involves
speculation about foreign exchange rates
FASB 133 establishes accounting and reporting standards for
derivative instruments and hedging activities
To quality for hedge accounting under FASB 133, a company
must identify a clear link between an exposure and a derivative
instrument
10-19
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Translation Exposure versus
Operating Exposure
Depreciation of the local currency may, under certain
circumstances, have a favorable operating effect
For example, a currency depreciation may allow the affiliate to
raise its sales price because the prices of imported competitive
goods are now relatively higher
If costs do not rise proportionately and unit demand remains the
same, the affiliate would experience an operating profit as a
result of the currency depreciation
10-20
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Empirical Analysis of the Change from FASB 8 to FASB 52
Garlicki, Fabozzi, and Fonfeder (1987)
Researchers found no significant positive reaction to the change
or perceived change in the foreign currency translation process
Findings suggest market agents do not react to cosmetic
earnings changes that do not affect value
Results underline the futility of attempting to manage
translation gains and losses
10-21
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