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Foreign Exchange

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Table of Contents
INTRODUCTION .....................................................................................................................................2
Foreign exchange Risk ................................................................................................................................... 2 Foreign exchange exposure ......................................................................................................................... 2

MEANING OF TRANSACTION EXPOSURE .......................................................................................3
The Life Span of Transaction Exposure ................................................................................................... 4 Types of Transactions resulting in Transaction Exposure ............................................................... 4

MEANING OF TRANSLATION EXPOSURE .......................................................................................5
MEASURING TRANSLATION EXPOSURE................................................................................................... 5 METHODS OF TRANSLATION EXPOSURE ................................................................................................ 6 Current/Non-current method ................................................................................................................................ 6 Monetary/Non-monetary method ....................................................................................................................... 6 Current rate method .................................................................................................................................................. 7 Temporal method ........................................................................................................................................................ 8

ECONOMIC/OPERATING EXPOSURE ............................................................................................ 10
Attributes of Operating Exposure........................................................................................................... 10 Measuring Economic Exposure ............................................................................................................... 11

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INTRODUCTION
Foreign exchange Risk
Foreign Exchange risk is defined as the variability of domestic currency value of assets, liabilities or operating incomes due to uncertain changes in the rate of exchange.

Foreign exchange exposure
Foreign exchange exposure is a measure of a potential for a firm‟s profitability, net cash flow, and market value to change because of a change in exchange rates. An important task of a financial manager is to measure foreign exchange exposure and to manage it so as to maximize the profitability, net cash flow, and market value of the firm. According to Michael Adler and Bernard Dumas defines EXPOURE as the sensitivity of changes in the real domestic currency of assets, liabilities or operating incomes due to unanticipated change in exchange rates. Foreign exchange exposure means the risk of loss stemming from exposure to adverse foreign exchange rate movements. “A measure of the potential change in a firm’s profitability, net cash flow, and market value because of a change in exchange rates”  These three components (profits, cash flow and market value) are the key financial elements of how we view the relative success or failure of a firm  While finance theories tell us that cash flows matter and accounting does not, we know that currency-related gains and losses can have destructive impacts on reported earnings – which are fundamental to the markets opinion of that company There are three types of foreign exchange exposure:  Transaction Exposure

Transaction exposure measures changes in the value of outstanding financial obligation incurred prior to a change in exchange rates but not due to be settled until after the exchange rate change. Thus, it deals with cash flows that result from existing contractual obligations. Page | 2



Operating or Economic Exposure

Operating exposure or economic exposure measures the change in the present value of the firm resulting from any change in expected future operating cash flows of the firm caused by an unexpected change in exchange rates. The change in value depends on the effect of the exchange rate change on future sales volume, prices and costs. 

Translation Exposure

Translation exposure or accounting exposure is the potential for accounting-derived changes in owner‟s equity because of the need to “translate” foreign currency financial statements of foreign subsidiaries into a single reporting currency to prepare worldwide consolidated financial statements.

MEANING OF TRANSACTION EXPOSURE
Transaction exposure is a risk to a firm with known future cash flows in a foreign currency that arises from possible changes in the exchange rate. Transaction exposure is the degree to which cash and transactions denominated in a foreign currency and already entered into for settlement at a future date are affected by exchange rate changes. Transaction exposure measures net cash and known cash inflows against known cash outflows. It measures changes in the value of outstanding financial obligations incurred prior to a change in exchange rates but not due to be settled until after the exchange rate changes Transaction exposure measures gains or losses that arise from the settlement of existing financial obligations, namely  Purchasing or selling on credit goods or services when prices are stated in foreign currencies  Borrowing or lending funds when repayment is to be made in a foreign currency  Being a party to an unperformed forward contract and  Otherwise acquiring assets or incurring liabilities denominated in foreign currencies Page | 3

The Life Span of Transaction Exposure

Types of Transactions resulting in Transaction Exposure
Various types of transactions that contributes to transaction exposure are as follows :1. Accounts payable in foreign currencies . 2. Accounts receivables in foreign currencies 3. Non-recorded commitments to pay in foreign currency. 4. Non-recorded commitments to accept payments in foreign currency. 5. Debt payments to be made in foreign currency. 6. Commitments to accept loan re-payments in foreign currency. 7. Anticipated payments from foreign subsidiaries. 8. Un-performed forward exchange contracts.

Each of this transaction requires that the firm either accepts or to deliver certain amount of foreign exchange at future point in time i.e. the transaction is required to be denominated in foreign currency for transaction exposure to occur.

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MEANING OF TRANSLATION EXPOSURE
Translation (accounting) exposure arises from the need to, for purposes of reporting and consolidation, to convert the financial statements of foreign operations from the local currency (LC) involved to the home currency (HC). If exchange rates have changed since the previous reporting period, this translation, or restatement, of those assets, liabilities, revenues, expenses, gains and losses that are denominated in foreign currencies will result in foreign exchange gains or losses. The most common means of protecting against translation exposure is balance sheet hedging. This involves attempting equalize exposed assets and liabilities. For example, a company may try to reduce its foreign currency denominated assets if it fears a devaluation of the overseas currency, by running down cash balances, chasing debtors and reducing stock levels. At the same time it might increase its liabilities by borrowing in the local currency and slowing down payment to creditors. If it can equate its foreign currency assets and liabilities then it will have no net exposure to changes in exchange rates. Translation exposure is the potential for an increase or decrease in the parent‟s net worth and reported net income caused by a change in exchange rates since the last translation.

MEASURING TRANSLATION EXPOSURE
The translation of subsidiaries‟ financial statements from their functional currencies into reporting currency give rise to translation gain or loss if there has been exchange rate changes within the period covered by the translated financial statements. Such a gain or loss is the quantity of risk/ exposure to which such a group is/ was exposed.

How ever, home-country and the entire financial community are interested in homecurrency values, the foreign currency balance-sheet accounts and income statement must be assigned home currency values. In particular, the financial statements of an MNC‟s overseas subsidiaries must be translated from local currency to home currency prior to consolidation with the parent‟s financial statements.

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Translation exposure is simply the difference between exposed assets and exposed assets. The controversies to among accountants center on which assets and liabilities are exposed and on when accounting –driven foreign exchange gains and losses should be recognized (reported on income statement). The crucial point to realize in putting these controversies in perspective is that such gains or losses are of an accounting nature-that is, no cash flows are necessarily involved.

METHODS OF TRANSLATION EXPOSURE
Current/Non-current method With this, all the foreign subsidiary‟s current assets and liabilities are translated into home currency at the current exchange rate. Each non-current asset or liability is translated at its historical exchange rate, that is, at the rate in effect at the time the asset was acquired or liability incurred. Hence, a foreign subsidiary with positive localcurrency working capital will give rise to a translation loss (gain) from devaluation (revaluation) with the current/non-current method, and vice versa if working capital is negative. The income statement is translated at the average exchange rate of the period, except for those revenues and expense items associated with non-current assets or liabilities. The latter items, such as depreciation expense, are translated at the same rates as the corresponding balance-sheet items. Thus, it is possible to see different revenue and expense items with similar maturities being translated at different rates. Monetary/Non-monetary method The monetary/non-monetary method differentiates between monetary assets and liabilities-that is, those items that represent a claim to receive, or an obligation to pay, a fixed amount of foreign currency units-and non-monetary, or physical, assets and liabilities. Monetary items (for example, cash, accounts payable and receivable, and long-term debt) are translated at the current rate; non-monetary items (for example,. Inventory, fixed assets, and long-term investments) are translated at historical rates. Page | 6

Income statement items are translated at the average exchange rate during the period, except for revenue and expense items related to non-monetary assets and liabilities. The latter items, primarily depreciation expense and cost of goods sold, are translated at the same rate as the corresponding balance-sheet items. As a result, the cost of goods sold may be translated at a rate different from that used to translate sales. Current rate method The current rate method is the most prevalent in the world today. Under this method, all financial statement line items are translated at the “current” exchange rate with few exceptions. Line items include the following:  Assets and liabilities. All assets and liabilities are translated at the current rate of exchange, that is at the rate of exchange in effect on the balance sheet date.  Income statement items. All items, including depreciation and cost of goods sold are translated at either the actual exchange rate on the dates the various revenues, expenses, gains and losses were incurred or at an appropriately weighted average exchange rate for the period.  Distributions. Dividends paid are translated at the exchange rate in effect on the date of payment.  Equity items. Common stock and paid-in capital accounts are translated at historical rates.  Year-end retained earnings consist of the original year-beginning retained earnings plus or minus any income or loss for the year. Gains or losses caused by translation adjustments are NOT included in the calculation of consolidated net income. They are reported separately and accumulated in a separate equity reserve account with a title such as cumulative translation adjustment (CTA). The biggest advantage of current rate method is that the gain or loss on translation does not pass through the income statement but goes directly to a reserve account. This eliminates the variability of reported earnings due to foreign exchange translation gains or losses. Second advantage is that the relative proportions of individual balance sheet accounts remain the same. The process does not distort balance sheet ratios such as current ratio or the debt-to-equity ratio. Page | 7

The current rate method is the simplest; all balance sheet and income items are translated at the current rate. Under this method, if a firm‟s foreign-currency denominated assets exceeds its foreign-currency denominated liabilities, devaluation must result in a loss and a revaluation, in a gain. One variation is to translate all assets and liabilities except net fixed assets at the current rate. The main disadvantage of the current rate method is that it violates the accounting principle of carrying balance sheet accounts at historical cost. Temporal method Under the temporal method, specific assets and liabilities are translated at exchange rate consistent with the timing of the item‟s creation. The temporal method assumes that a number of individual line item assets such as inventory and net plant and equipment are restated regularly to reflect market value. Line items include:  Monetary assets (cash, marketable securities, accounts receivable and long-term receivables). They are translated at current exchange rates.  Monetary liabilities (current liabilities and long-term debt) are translated at current exchange rates.  Nonmonetary assets and liabilities (inventory and fixed assets) are translated at historical rates.  Income statement items are translated at the average exchange rate for the period, except for items such as depreciation and cost of goods sold.  Distributions. Dividends paid are translated at the exchange rate in effect on the date of payment.  Equity items. Common stock and paid-in capital accounts are translated at historical rates. Year end retained earnings consist of the original year-beginning retained earnings plus or minus any income or loss for the year, plus or minus any imbalance from translation. Under the temporal method, gains or losses resulting from measurement are carried directly to current consolidated income and not to equity reserves. Hence, foreign

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exchange gains and losses arising from the translation process do introduce volatility to consolidated earnings. This appears to be a modified version of the monetary/non-monetary method. The only difference is that under the monetary/non-monetary method, inventory is always translated at the historical rate. Under the temporal method, inventory is normally translated at the historical rate, but it can be translated at the current rate if the inventory is shown on the balance sheet at market values. Despite the similarities, however, the theoretical basis of each method is different. The choice of exchange rate for translation is based on the type of asset or liability in the monetary/non-monetary method; in the temporal method, it is based on the underlying approach to evaluating cost (historical versus market). Income statement items are normally translated at an average rate for the reporting period. However, cost of goods sold and depreciation and amortization charges related to balance sheet items carried at past prices are translated at historical rates. Basic advantage of the method is that foreign nonmonetary assets are carried at their original cost in the parent‟s consolidated statement.

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ECONOMIC/OPERATING EXPOSURE
Economic Exposure relates to the possibility that the value of the company (the Present Value of all future cash flows) will change due to unexpected changes in future exchange rates. Its magnitude is difficult to measure as it considers unexpected changes in exchange rates. Even purely domestic firms may be affected by economic exposure if there is foreign competition within the local markets.

Economic exposure is also known as operating, competitive and strategic exposure. The reason is because operating exposure reflects the economic consequences that changes in exchange rate may have on the operating income of the firm and must deal with both strategic and competitive responses to these unexpected changes. Operating exposure, also called economic exposure, competitive exposure, and even strategic exposure on occasion, 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.

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. The cash flows of the MNE can be divided into operating cash flows and financing cash flows.  Operating cash flows arise from intercompany (between unrelated companies) and intra-company (between units of the same company) receivables and

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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 of an inter and intra-company nature. 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 production.

Measuring Economic Exposure
Consider the example of a British firm, which operates a subsidiary in country, which unexpectedly devalues its currency. This could be „bad news‟ in that every local currency unit of profit earned would now be worth less when repatriated to the UK. On the other hand, it could be „good news‟ as the subsidiary might now find it far easier to Page | 11

export to the rest of the world and hence significantly increase its contribution to parent company cash flow. The news could, alternatively, be neutral if the subsidiary intended to ration its profits to re-invest in the same country abroad.

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