Measuring and Managing Translation and Transaction Exposure
The stream of time sweeps away errors, and leaves the truth for the inheritance of humanity.
George Brandes
LEARNING OBJECTIVES
• To define translation and transaction exposure and distinguish between the two
• To describe the four principal currency translation methods available and to calculate translation exposure using these different methods
• To describe and apply the current (FASB-52) currency translation method prescribed by the Financial Accounting Standards Board
• To identify the basic hedging strategy and techniques used by firms to manage their currency transaction and translation risks
• To explain how a forward market hedge works
• To explain how a money market hedge works
• To describe how foreign currency contract prices should be set to factor in exchange rate change expectations
• To describe how currency risk-sharing arrangements work
• To explain when foreign currency options are the preferred hedging technique
• To describe the costs associated with using the different hedging techniques
• To describe and assess the economic soundness of the various corporate hedging objectives
• To explain the advantages and disadvantages of centralizing foreign exchange risk management
KEY TERMS
accounting exposure
cross-hedge
currency call option
currency collar
currency options
currency put option
currency risk sharing
current exchange rate
current/noncurrent method
current rate method
cylinder
economic exposure
exposure netting
Financial Accounting Standards Board (FASB)
foreign exchange risk
forward market hedge
functional currency
funds adjustment
hard currency
hedging
historical exchange rate
hyperinflationary country
monetary/nonmonetary method
money market hedge
neutral zone
operating exposure
opportunity cost
price adjustment clause
range forward
reporting currency
risk shifting
soft currency
Statement of Financial Accounting Standards No. 52 (FASB 52)
Statement of Financial Accounting Standards No. 133 (FASB 133)
temporal method
transaction exposure
translation exposure
Foreign currency fluctuations are one of the key sources of risk in multinational operations. Consider the case of Dell Inc., which operates assembly plants for its computers within the United States as well as in Ireland, Malaysia, China, and Brazil; runs offices and call centers in several other countries; and markets its products in more than 100 countries. Dells currency problems are evident in the fact that it may manufacture a product in Ireland for sale in, say, Denmark and obtain payments in Danish krone. Dell would like to ensure that its foreign profits are not eroded by currency fluctuations. Also, at the end of the year, when Dell consolidates its financial statements for the year in U.S. dollars, it wants to ensure that exchange rate changes do not adversely impact its financial performance.
The pressure to monitor and manage foreign currency risks has led many companies to develop sophisticated computer-based systems to keep track of their foreign exchange exposure and aid in managing that exposure. The general concept of exposure refers to the degree to which a company is affected by exchange rate changes. This impact can be measured in several ways. As so often happens, economists tend to favor one approach to measuring foreign exchange exposure, whereas accountants favor an alternative approach. This chapter deals with the measurement and management of accounting exposure, including both translation and transaction exposure. Management of accounting exposure centers on the concept of hedging. Hedging a particular currency exposure means establishing an offsetting currency position so that whatever is lost or gained on the original currency exposure is exactly offset by a corresponding foreign exchange gain or loss on the currency hedge. Regardless of what happens to the future exchange rate, therefore, hedging locks in a dollar (home currency) value for the currency exposure. In this way, hedging can protect a firm from foreign exchange risk, which is the risk of valuation changes resulting from unforeseen currency movements.