Transaction, Operating Accounting Exposures

Transaction, Operating, & Accounting (Translation) Exposures Foreign Exchange Exposure – measures the potential for a firm’s profitability, net cash flow, and market value to alter because of a change in exchange rates. Q: What are the three main foreign exchange exposures? A: 1) Transaction Exposure 2) Operating Exposure 3) Accounting Exposure Transaction Exposure – measures changes in the value of outstanding financial obligations incurred prior to a change in exchange rates.Operating Exposure (Economic Exposure, Competitive Exposure, Strategic Exposure) – measures a change in the present value of a firm resulting from any change in future expected operating cash flows caused by unexpected changes in exchange rates. Accounting Exposure (Translation Exposure) – measures accounting-derived changes in owner’s equity as a result of translating foreign currency financial statements into a single reporting currency. Exhibit 8. 1 [pic] Note: In th e fourth quarter of 2001 Amazon. om reported a net income of $5 million, due in part to a one-time foreign currency gain of $16 million. Hedging – To take a position that will rise (or fall) in value to offset a change in value of an existing position. |Benefits of Hedging |Costs of Hedging | |Improved the planning capability of the firm. |Risk-averse strategy that benefits management more than | |Reduced the likelihood of financial distress. i. e. the risk that cash|shareholders. (i. e. shareholders can diversify currency risk on an| |flows will fall below what is required for debt payments and continued|â€Å"as needed† basis) | |operations) |Consumes the firm’s resources and expected cash flows to the firm | |Management has a comparative advantage over shareholders. (i. e. |are not increased. (i. e. gency theory, NPV of hedging is zero, | |understanding the currency risk of the firm and take advantage of a |and FX losses appear on the I/S while hedging are b uried in | |disequilibrium through selective hedging) |operating and interest expenses) | Transaction Exposure Transaction Exposure – measures changes in the value of outstanding financial obligations incurred prior to a change in exchange rates. Transaction exposure can arise from the following activities: ? Purchasing or selling foreign goods and services on credit. Borrowing or lending in another currency. ? Foreign exchange contracts. Exhibit 8. 3 The Life Span of Transaction Exposure [pic] Example Expect to collect ? 1,000,000 in three months on a sale, minimum acceptable value $1,700,000. Q: What type of transaction exposure has occurred? A: Billing Exposure S0 = $1. 7640/? ES90= $1. 76/? F90= $1. 7540/? iU. K. = 10% per year (2. 5% per quarter) kU. K. = 8% per year (2% per quarter) iU. S. = 8% per year (2% per quarter) kU. S. = 6% per year (1. 5% per quarter) P90ATM = $1. 75 (1. 5% premium) P90OTM = $1. 71 (1% premium)Note: ES90 is the estimated spot rate in three mont hs, â€Å"i† is the borrowing interest rate, and â€Å"k† is the investment interest rate, P90ATM is an at-the-money three-month put option, and P90OTM is an out-of-the-money three month put option. Q: Is the pound expected to appreciate or depreciate? A: Depreciate Q: What is the forward premium/discount on the pound? A: [pic] Q: What are the four alternatives to hedge a transaction exposure? A:1) Remain unhedged 2) Hedge in the forward market 3) Hedge in the money market 4) Hedge in the options market 1) Remain unhedged, collect ? 1,000,000 in three months at the new spot rate. pic] 2) Hedge in the forward market, collect ? 1,000,000 in three months at $1. 7540/?. [pic] 3) Hedge in the money market, borrow ? 975,610 today, and exchange for dollars at the current spot rate ($1. 7640/? ). Invest the $1,720,976 for 90 days, and in 90 days pay back the loan + interest with the ? 1,000,000. Q: To construct a money market hedge, how much should the investor borrow today if the annual interest rate is 10% and the company expects to receive ? 1,000,000 in 90 days? A: [pic] Q: At what investment rate is the money market hedge superior to the forward contract? A: [pic] pic] Note: Either the forward contract or the money market hedge is better than an uncovered position if the spot rate at time 2 is less than the forward rate. But, if the funds can be invested at anything above 7. 68% (or 1. 92% for 90 days) then the money market hedge is a better option than the forward contract. If the spot rate at time 2 is greater than what can be earned by investing the funds in the company (in this case the funds are invested in the company yielding the company’s WACC of 12% or $1,772,605) then the uncovered hedge would be superior. 4) Hedge in the options market.An at-the-money[1] (ATM) put option is selling for a 1. 5% premium. The cost of the option is (size of the option) x (premium) x (spot rate) = cost, in this case ? 1,000,000 x 0. 015 x $1. 7640 = $26 ,460. This is the maximum loss, while the maximum gain is the spot price – the cost of the option. [pic] To compare the alternatives, first estimate what you expect spot rates to be, then estimate a range of possible prices, and consider your ability to accept the downside. Then select the best strategy. Some Examples: [pic] Q: Transaction exposure arises from what? A: Sales and expenses that are already contracted for.Operating Exposure Operating Exposure (Economic Exposure, Competitive Exposure, Strategic Exposure) – measures a change in the present value of a firm resulting from any change in future expected operating cash flows caused by unexpected changes in exchange rates. Q: Operating Exposure depends on whether an unexpected change in exchange rates causes unanticipated changes in what? A: Sales volume, sales prices, or operating costs Figure 9. 1 Financial and Operating Cash Flows Between Parent and Subsidiary [pic] Q: What are four proactive ways to manage op erating exposure?A: 1) Matching currency cash flows 2) Risk-sharing agreements 3) Back-to-back or parallel loans 4) Currency swaps Note: Planning for operating exposure depends on the interaction of strategies in finance, marketing, purchasing, and production. Accounting (Translation) Exposure Accounting Exposure (Translation Exposure) – measures accounting-derived changes in owner’s equity as a result of translating foreign currency financial statements into a single reporting currency. Q: What are the financial goals of the multinational enterprise? A:1) To maximize consolidated after-tax income ) To minimize the firm’s effective global tax burden 3) To correct the positioning of the firm’s income, cash flows, and available funds. Note: These goals are frequently seen as inconsistent. Functional currency – the dominate currency used by the foreign subsidiary in its day-to-day operations. Q: What are the two basic methods for the translation of fo reign subsidiary financial statements? A: 1) The current rate method 2) The temporal method Current rate method – a method of translating the financial statements of foreign affiliates into the parent’s reporting currency.All assets and liabilities are translated at the current exchange rate. 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. Q: Which method is the most common worldwide? A: The current rate method Q: What are the advantages of the current rate method? A: 1) The variability of reported earnings due to translation gains or losses is eliminated, because the gain or loss on translation goes directly to a reserve account (rather than passing through the income statement). ) Does not distort balance sheet ratios such as the current ratio or debt-to-equity ratio (because the relative proportions of the individual balance sheet accounts rema in the same. Q: What is the disadvantage of the current rate method? A: 1) It violates the accounting principle of carrying balance sheet accounts at historical costs. Q: What is the advantage of the temporal method? A: 1) Foreign nonmonetary assets are carried at their original cost in the parent’s consolidated statement. Homework Problems Chapter 8 1.Imagine one of the companies from your final project is expecting an $80million payment in one year. The company also expects $20million in expenses in one year. Use real figures or the following: Current spot rate 3. 4x/$ (trend shows 3. 8x/$ two months ago) Interest rates are 14% in your country and 4% in the U. S. Forward contracts are too expensive Based on the current spot rate and relative interest rates, please advise your company on its currency exposure. Chapter 9 2. Imagine one of your companies will soon be exporting to China.Use the following (replace the $ equivalent with your currency at the current spot price): C urrent sales of 1,000,000 units per year at a price equivalent to $24 each. Current spot price Rmb8. 2/$, but the H. K. advisory will drop the value next week to Rmb10/$. Direct costs are 75% of the U. S. dollar sales price. Accepting this forecast, advise the company on two options: 1) Maintain the same renminbi price (i. e. no change in price) 2) Raise the price to offset the devaluation and experience a 10% drop in unit volume. A) What would be the short-run (one year) impact of each strategy?B) Which do you recommend? Optional Assignment: (0. 5 participation points) Prepare a write-up on the country you are doing for your final project. (Include GDP, inflation, major exports/imports, major stock exchange, currency, exchange rate, and anything else you find interesting and relevant)†¦ use sources like countryreports. org, cia. gov, etc. And remember to compare your country to something (i. e. the U. S. or another country in the region)†¦ Try to make everything you turn in look â€Å"professional,† imagine you're getting paid for your work.Please cite your sources throughout the report, and if you could e-mail it to me before next Monday, that's even better. Final Project These are two great sites to look at for your final project: globaledge. msu. edu www. world-exchanges. org ———————– [1] An at-the-money put, means that the strike price is equal to the current spot price†¦ Meaning an investor is indifferent between exercising the option or going to the market. In this case the forward rate is $1. 7540/? , and the option is $1. 75/? plus 1. 5% premium.