Managing Translation Exposure
Firms have three available methods for managing their translation exposure: (1) adjusting fund flows, (2) entering into forward contracts, and (3) exposure netting. The basic hedging strategy for reducing translation exposure shown in Exhibit 10.5 uses these methods. Essentially, the strategy involves increasing hard currency (likely to appreciate) assets and decreasing soft currency (likely to depreciate) assets, while simultaneously decreasing hard currency liabilities and increasing soft currency liabilities. For example, if a devaluation appears likely, the basic hedging strategy will be executed as follows: Reduce the level of cash, tighten credit terms to decrease accounts receivable, increase LC borrowing, delay accounts payable, and sell the weak currency forward. An expected currency appreciation would trigger the opposite tactics.
Despite their prevalence among firms, these hedging activities are not automatically valuable. As discussed in the previous section, if the market already recognizes the likelihood of currency appreciation or depreciation, this recognition will be reflected in the costs of the various hedging techniques. Only if the firm’s anticipations differ from the markets and are also superior to the markets can hedging lead to reduced costs. Otherwise, the principal value of hedging would be to protect a firm from unforeseen currency fluctuations.
Funds Adjustment
Most techniques for hedging an impending LC devaluation reduce LC assets or increase LC liabilities, thereby generating LC cash. If accounting exposure is to be reduced, these funds must be converted into hard currency assets. For example, a company will reduce its translation loss if, before an LC devaluation, it converts some of its LC cash holdings to the home currency. This conversion can be accomplished, either directly or indirectly, by means of funds adjustment techniques.
Firms have three available methods for managing their translation exposure: (1) adjusting fund flows, (2) entering into forward contracts, and (3) exposure netting. The basic hedging strategy for reducing translation exposure shown in Exhibit 10.5 uses these methods. Essentially, the strategy involves increasing hard currency (likely to appreciate) assets and decreasing soft currency (likely to depreciate) assets, while simultaneously decreasing hard currency liabilities and increasing soft currency liabilities. For example, if a devaluation appears likely, the basic hedging strategy will be executed as follows: Reduce the level of cash, tighten credit terms to decrease accounts receivable, increase LC borrowing, delay accounts payable, and sell the weak currency forward. An expected currency appreciation would trigger the opposite tactics.
Despite their prevalence among firms, these hedging activities are not automatically valuable. As discussed in the previous section, if the market already recognizes the likelihood of currency appreciation or depreciation, this recognition will be reflected in the costs of the various hedging techniques. Only if the firm’s anticipations differ from the markets and are also superior to the markets can hedging lead to reduced costs. Otherwise, the principal value of hedging would be to protect a firm from unforeseen currency fluctuations.
Funds Adjustment
Most techniques for hedging an impending LC devaluation reduce LC assets or increase LC liabilities, thereby generating LC cash. If accounting exposure is to be reduced, these funds must be converted into hard currency assets. For example, a company will reduce its translation loss if, before an LC devaluation, it converts some of its LC cash holdings to the home currency. This conversion can be accomplished, either directly or indirectly, by means of funds adjustment techniques
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