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?

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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. Note: In the 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 the value of an existing position. 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. 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 months, “i” is the borrowing interest rate, and “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 transaction exposure?

1.  Remain unhedged
2.  Hedge in the forward market
3.  Hedge in the money market
4.  Hedge in the options market
5.  Remain unhedged, collect? 1,000,000 in three months at the new spot rate.
6.  Hedge in the forward market, collect? 1,000,000 in three months at $1. 7540/?

Hedge in the money market, borrow? 975,610 today, and exchange for dollars at the current spot rate ($1. 7640/? ).

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, the 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.  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 operating exposure?

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?

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).
2. 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 remain the same.

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