Transaction And Translation Exposure In International Finance – Essay

Foreign exchange exposure is a measure of the potential for a firm’s profitability, net cash flow, and market value to change because of a change in exchange rates.

Types of Foreign Exchange Exposure

Transaction exposure measures changes in the value of outstanding financial obligations due to a change in exchange rates.

Translation exposure deals with changes in cash flows that result from existing contractual obligations.

Operating (economic, competitive, or strategic) exposure measures the change in the present value of the firm resulting from any changes in future operating cash flows of the firm caused by an unexpected change in exchange rates [via changes in sales volume, prices and costs.]

Impact of Hedging

MNEs possess a multitude of cash flows that are sensitive to changes in exchange rates, interest rates, and commodity prices. These three financial price risks are the subject of the growing field of financial risk management. Many firms attempt to manage their currency exposures through hedging.

Hedging is the taking of a position that will rise (fall) in value and offset a fall (rise) in the value of an existing position. While hedging can protect the owner of an asset from a loss, it also eliminates any gain from an increase in the value of the asset hedged against.

The value of a firm, according to financial theory, is the net present value of all expected future cash flows. Currency risk is defined roughly as the variance in expected cash flows arising from unexpected exchange rate changes. A firm that hedges these exposures reduces some of the variance in the value of its future expected cash flows.

However, is a reduction in the variability of cash flows sufficient reason for currency risk management?

Opponents of hedging state (among other things):

• Shareholders are much more capable of diversifying currency risk than the management of the firm.
• Currency risk management reduces the variance of the cash flows of the firm, but also uses valuable resources.
• Management often conducts hedging activities that benefit management at the expense of the shareholders (agency conflict), i.e., large FX loss are more embarrassing than the large cost of hedging.

Proponents of hedging cite:

• Reduction in risk in future cash flows improves the planning capability of the firm.
• Reduction of risk in future cash flows reduces the likelihood that the firm’s cash flows will fall below a necessary minimum (the point of financial distress)
• Management has a comparative advantage over the individual shareholder in knowing the actual currency risk of the firm
• Management is in better position to take advantage of disequilibrium conditions in the market.

Transaction Exposure

Transaction exposure arises when a firm faces contractual cash flows that are fixed in a foreign currency.

Whenever a firm has foreign-currency-denominated receivables or payables, it is subject to transaction exposure, and the eventual settlements have the potential to affect the firm’s cash flow position. Since modern firms are often involved in commercial and financial contracts denominated in foreign currencies, management of transaction exposure has become an important function of international financial management.

Measurement of Transaction Exposure

Transaction exposure is simply the amount of foreign currency that is receivable or payable.

Since MNCs commonly have foreign subsidiaries spread around the world, they need an information system around the world, they need an information system that can track their currency positions .

Identifying Net Transaction Exposure

Before an MNC makes any decisions related to hedging, it should identify the individual net transaction exposure on a currency-by-currency basis. The term ‘net’ here refers to the consolidation of all expected inflows and outflows for a particular time and currency.

The management at each subsidiary plays a vital role in reporting its expected inflows and outflows. Then a centralised group consolidates the subsidiary reports to identify, for the MNC as a whole, the expected net positions in each foreign currency during several upcoming periods.

The MNC can identify its exposure by reviewing this consolidation of subsidiary positions.

One subsidiary may have net receivables in Mexican Pesos three months from now, while a different subsidiary has net payables in Pesos. If the Peso appreciates, this will be favourable to the first subsidiary and unfavourable to the second. However, the impact on the MNC as a whole is at least partially offset. Each subsidiary may desire to hedge its net currency position in order to avoid the possible adverse impacts on its performance due to fluctuations in the currency’s value. The overall performance of the MNC, however, may already be insulated by the offsetting positions between subsidiaries. Therefore, hedging the position of each individual subsidiary may not be necessary.

Although it is difficult to predict future currency value with much accuracy, MNCs can evaluate historical data to at least assess the potential degree of movement for each currency

Standard Deviation

The standard deviation statistic is one such possible way to measure the degree of movement for each currency. Notice that within each period, some currencies clearly fluctuate much more than others.

Correlation

The correlations among currency movement can be measured by their correlation coefficients, which indicate the degree to which two currencies move in relation to each other. Thus MNCs can use such information when determining their degree of transaction exposure

Value at risk

A related method for assessing exposure is the value at risk (VAR) method, which incorporates volatility and currency correlations to determine the potential maximum one day loss on the value of positions of an MNC that is exposed to exchange rate movements.

In summary, the first step when assessing transaction exposure is to determine the size of the position in each currency .The second step is to determine how each individual currency position could affect the firm by assessing the standard deviation and correlations of each currencies. Even if a particular currency is perceived as risky, its impact on the firm’s overall exposure will not be severe if the firm has taken only a minor position in that currency. For this reason, both of these steps must be considered when developing an overall assessment of the firm’s transaction exposure.

Managing/Hedging Transaction Exposure

If transaction exposure exists, the firm faces three major tasks. First, it must identify its degree of transaction exposure. Second, it must decide whether to hedge this exposure. Finally, if it decides to hedge part or all of the exposure, it must choose among the various hedging techniques available.

There are alternative ways of hedging transaction exposure using various financial contracts and operational techniques:

Financial contracts:

• Forward market hedge
• Money market hedge
• Option market hedge
• Swap market hedge
• Operational techniques:
• Choice of the invoice currency
• Lead/lag strategy
• Exposure netting

Futures Hedge

A firm that buys a currency futures contract is entitled to receive a specified amount in a specified currency for a stated price on a specified date.

To hedge a payment on future payables in a foreign currency, the firm may purchase a currency futures contract for the currency it will need in the near future. By holding this contract, it locks in the amount of its home currency needed to make the payment.

To hedge the home currency value of future receivables in a foreign currency, the firm may sell a currency futures contract for the currency it will receive after converting the foreign currency receivables into its home currency.

The firm insulates the value of its future receivables from the fluctuations in the foreign currency’s spot rate over time.

Forward Hedge

A forward contract hedge is very similar to a futures contract hedge, except that forward contracts are commonly use for large transactions, whereas futures contracts tend to be used for smaller amounts. Also, MNC’s can request forward contracts that specify the exact number of units that they desire, whereas futures contracts represent a standardised number of units for each currency.

Although forward contracts are easy to use for hedging, that does not mean that every exposure to exchange rate movements should be hedged. In some cases, an MNC may prefer not to hedge its exposure to exchange rate movements.

A forward hedge is probably more costly than no hedge. Probability is determined by Real Cost of Hedging Payables (RCHp). This measures the additional expenses beyond those incurred without hedging. RCHp= NCHp- NCp

Where,

NCHp=nominal cost of hedging payables,

NCp= nominal cost of payables without hedging.

The hedge-versus-non-hedge decision is based on the firm’s degree of risk aversion. Firms with a greater desire to avoid risk will hedge their positions in foreign currencies more often than firms that are less concerned with risk.

If the forward rate is an accurate predictor of the future spot rate, the RCHp will be zero. Because the forward rate often underestimates or overestimates the future spot rate, RCHp differs from zero. If, however, the forward rate is an unbiased predictor of the future spot rate, RCHp will be zero on an average, as the differences between the forward rate and future spot rate is an unbiased predictor of the future spot rate will offset each other over time.

If a firm believes that the forward rate is an unbiased predictor of the future spot rate, it will consider hedging its payables, since the forecasted RCHp is zero, and the transaction exposure can be eliminated.

Money Market Hedge

If a firm has excess cash, it can create a short-term deposit in foreign currency that it will need in the future.

In many cases, MNC’s prefer to hedge payables without using their cash balances. A money market hedge can still be used in this situation, but it requires two money market positions:

Borrowed funds in the home currency and

A short term investment in the foreign currency.

If a firm expects receivables in a foreign currency, it can hedge this position by borrowing the currency now and converting it to dollars. The receivables will be used to pay off the loan.

The forward hedge and the money market hedge are directly comparable. Since the results of both hedges are known beforehand, the firm can implement the one that is more feasible.

If interest rate parity (IRP) exists, and transaction costs do not exist, the money market hedge will yield the same results as the forward hedge. This is so because the forward premium on the forward rate reflects the interest rate differential between the two currencies. The hedging of future payables with a forward purchase will be similar to borrowing at the home interest rate and investing at the foreign interest rate.

Even if the forward premium generally reflects the interest rate differential between countries, the existence of transaction costs may cause the results from a forward hedge to differ from those of the money market hedge.

Currency Option Hedge

Firms recognise that hedging techniques such as the forward hedge and money market hedge can backfire when a payables currency depreciates or a receivables currency appreciates over the hedged period. In these situations, an unhedged strategy would likely outperform the forward hedge or money market hedge. The ideal type of hedge would insulate the firm from favourable exchange rate movements. Currency options exhibit these attributes.

A firm must assess whether the advantages of a currency option hedge are worth the price (premium) paid for it.

A currency call option provides the right to buy a specified amount of a particular currency at a specified price (the exercise price) within a given period of time. Yet, unlike a futures or forward contract, the currency call option does not obligate its owner to buy the currency at that price. If the spot rat of the currency remains lower than the exercise price throughout the life of the option, the firm can let the option expire and simply purchase the currency at the existing spot rate. On the other hand, if the spot rate of the currency appreciates over time, the call option allows the firm to purchase the currency at the exercise price. That is, the firm owning a call option has locked in a maximum price (the exercise price) to pay for the currency. It also has the flexibility, though, to let the option expire and obtain the currency at the existing spot rate when the currency is to be sent for payment.

Hedging Policies of MNC’s

In general, hedging policies vary with the MNC management’s degree of risk aversion. An MNC may choose to hedge most of its exposure, to hedge none of its exposure or to selectively hedge.

Advantages of Hedging Most of the Exposure

The value of the firm is not highly influenced by exchange rates.

MNCs may even use some hedges that will likely result in slightly worse outcomes than no hedges at all just to avoid the possibility of a major adverse movement in exchange rates.

MNCs prefer to know what their future cash inflows or outflows in terms of their home currency will be in each period because this improves corporate planning.

Hedging None of the Exposure: MNC that are well diversified across many countries may consider not hedging their exposure. This strategy may be driven by the view that a diversified set of exposures will limit the actual impact that exchange rates will have on the MNC during any period.

Selective Hedging: Many MNCs choose to hedge only when they expect the currency to move in a direction that will make hedging feasible. In addition, these MNCs may hedge future receivables if they foresee depreciation in the currency denominating the receivables.

Selective hedging implies that the MNC prefers to exercise some control over its exposure and makes decisions based on conditions that may affect the currency’s future value.

Hedging Long Term Transaction Exposure

Firms that can accurately estimate foreign currency payables or receivables that will occur several years from now commonly use three techniques to hedge such long-term transaction exposure:

Long-term forward contract

Currency swap

Parallel loan

Currency Swaps/Credit Swaps

Swaps are like packages of forward contracts. Currency swaps can be used to avoid the credit risk associated with a parallel loan. In broad terms, a currency swap is an agreement by two companies to exchange specified amounts of currency now and to reverse the exchange at some point in the future. The lack of credit risk arises from the nature of a currency swap. Default on a currency swap means that the currencies are not exchanged in the future, while default on a parallel loan means that the loan is not repaid. Unlike a parallel loan, default on a currency swap entails no loss of investment or earnings. The only risk in a currency swap is that the companies must exchange the foreign currency in the foreign exchange market at the new exchange rate.

Frequently, multinational banks act as brokers to match partners in parallel loans and currency swaps. However, finding companies whose needs mutually offset one another is difficult, imperfect and only partially reduces currency exposure risk. If a company cannot find a match, a credit swap may be used. Credit swaps involve a deposit in one currency and a loan in another. The deposit is returned after the loan is repaid. For example, a U.S. business could deposit dollars in the San Francisco branch of an Asian bank, which would, in turn, lend the depositor yen for an investment in Japan. After the Asian bank loan is repaid in yen, the dollar deposit would be returned.

Alternative Hedging Techniques

When a perfect hedge is not available (or is too expensive) to eliminate transaction exposure, the firm should consider methods to at least reduce exposure. Such methods include the following:

Leading and Lagging

Another operational technique the firm can use to reduce transaction exposure is leading and lagging foreign currency receipts and payments. To “lead” means to pay or collect early, and to “lag” means to pay or collect late. The firm would like to lead soft currency receivables and lag hard currency receivables to avoid the loss from depreciation of the soft currency and benefit from the appreciation of the hard currency. For the same reason, the firm will attempt to lead the hard currency payables and lag soft currency payables. To the extent that the firm can effectively implement the lead/lag strategy, the transaction exposure the firm faces can be reduced.

Cross-hedging

Thus far, a market for forward rates, futures contracts, credit or options in the foreign currency being hedged has been presumed to exist. But this may not be true in all cases, especially for small developing countries. In such cases, cross hedging may be the only hedging alternative available. Cross hedging is a form of a hedge developed in a currency whose value is highly correlated with the value of the currency in which the receivable or payable is denominated. In some cases, it is relatively easy to find highly correlated currencies, because many smaller countries try to peg the exchange rate between their currency and some major currency such as the dollar, the franc or euro. However, these currencies may not be perfectly correlated because efforts to peg values frequently fail. As an example, a company has a payable or a receivable denominated in the currency for a small nation for which there are no developed currency or credit markets. The company would explore the possibility that the currency is pegged to the value of a major currency. If not, the company would look at past changes in the value of the currency to see if they are correlated with changes in the value of any major currency. The company would then undertake a forward market, futures market, money market, or options market hedge in the major currency that is most closely related to the small nation’s currency. Cross-hedging success depends upon the extent to which the major currency changes in value along with the minor currency. Although cross hedging is certainly imperfect, it may be the only means available for reducing transaction exposure.

Translation Exposure

An MNC creates its financial statements by consolidating all of its individual subsidiaries financial statements. A subsidiary’s financial statement is normally measured in its local currency. To be consolidated, each subsidiary’s financial statement must be translated into the currency of the MNC’s parent .Since exchange rates change over time, the translation of the subsidiary’s financial statement into a different currency is affected by exchange rate movements. The exposure of the MNC’s consolidated financial statements to exchange rate fluctuations is known as translation exposure. In particular, subsidiary earnings translated into the reporting currency on the consolidated income statement are subject to changing exchange rates.

Translation exposure, thus is the potential for an increase or decrease in the parent’s net worth and reported income caused by a change in exchange rates since the last transaction

Translation methods differ by country along two dimensions

One is a difference in the way a foreign subsidiary is characterized depending on its independence

The other is the definition of which currency is most important for the subsidiary

Does Translation Exposure matter?

The relevance of translation exposure can be argued based on a cash flow perspective or a stock price perspective.

Cash Flow perspective: Translation of financial statements for consolidated reporting purpose does not by itself affect an MNC’s Cash flows. For this reason some analysts suggest that translation exposure is relevant. MNC’s could argue that the subsidiary earnings do not actually have to be converted into the parents earnings. Therefore, if a subsidiary’s local currency is currently weak, the earnings could be reinstated rather than converted and sent to the parent. The earnings could be reinvested in the subsidiary’s country if feasible opportunities exist.

If an MNC’s subsidiary remits a portion of the earnings to the parent, however a weak foreign currency adversely affects cash flows. Even if the subsidiary does not plan to remit any earnings today, it will remit earnings at some point in the future. To the extent that today’s spot rate serves as a forecast of the spot rate that will exist at the time when the earnings are remitted .In this case, the expected future cash flows are affected by the prevailing weakness of the foreign currency.

Stock Price Perspective: Many investors tend to use earnings when valuing firms, either by deriving estimates of expected cash flows from previous earnings or by applying a price-earnings ratio to expected annual earnings to derive a value per share of the stock. Since a MNC’s translation exposure affects its consolidated earnings, it can affect the firm’s valuation.

Conclusion about the relevance of translation exposure:

Translation exposure is relevant for three reasons

Some MNC subsidiaries may want to remit a portion of their earnings to their respective parents now

The prevailing exchange rates may be used as to forecast the expected cash flows that will result from future remittances by subsidiaries

Many investors use consolidated earnings to value MNC’s

Determinants of Translation exposure

Some MNC’s are subject to a greater degree of translation exposure than others. An MNC’s degree of translation exposure is dependent on the following

The proportion of its business conducted by its business subsidiaries: The greater percentage of an MNC’s business conducted by its foreign subsidiaries, the larger the percentage of a given financial statement item that is susceptible to translation exposure.

The location of foreign subsidiaries: The location of the subsidiaries can also influence the degree of translation exposure because the financial statement items off each subsidiary are typically measured by the home currency of the subsidiary’s country.

The accounting method that it uses: An MNC’s degree of translation exposure can be greatly affected by the counting procedure it uses to translate when consolidating financial data

Management of Translation Exposure

Translation exposure occurs when an MNC translates each subsidiary’s financial data to its home currency for consolidated financial statements. Because cash flow is not affected, some people are of the opinion that it is not necessary to hedge or even reduce translation exposure. But since it has a potential impact on reported consolidated earnings, some firms do manage their translational exposures.

Balance Sheet Hedge

Some firms attempt to avoid translation exposure by matching foreign liabilities with foreign assets. Balance Sheet Hedge requires an equal amount of exposed foreign currency assets and liabilities on a firm’s consolidated balance sheet.

A change in exchange rates will change the value of exposed assets but offset that with an opposite change in liabilities. This is termed monetary balance. The cost of this method depends on relative borrowing costs in the varying currencies.

A balance sheet hedge justified when:

The foreign subsidiary is about to be liquidated so that the value of its CTA would be realized.

The firm has debt covenants or bank agreements that state the firm’s debt/equity ratios will be maintained within specific limits.

Management is evaluated on the basis of certain income statement and balance sheet measures that are affected by translation losses or gains.

The foreign subsidiary is operating in a hyperinflationary environment

MNCs can also use forward contracts or future contracts to hedge translation exposure. Specifically, they can sell the currency forward that their foreign subsidiaries receive as earnings. In this way they create a cash outflow in the currency to offset the earnings received in that currency.

Limitations of Hedging Translation Exposure

Translation gains and losses can be quite different from operating gains and losses, not only in

Magnitude but in direction; management may need to determine which is of greater significance. There are a few limitations to hedging translation exposures:

Inaccurate earnings forecasts: A subsidiary’s forecasted earnings for the end of the year are not guaranteed. If the actual earnings turn out to be much higher than anticipated and you have entered into a forward contract, then the translation loss would likely exceed the gain generated from the forward contract strategy.

Inadequate forward contracts for some currencies: A second limitation is that forward contracts are not available for all currencies. Thus an MNC with subsidiaries in some smaller countries may not be able to obtain forward contracts for the currencies of concern.

Accounting distortions: A third limitation is that the forward rate gain or loss reflects the difference between the forward rate and the future spot rate, whereas the translation gain or loss reflects the difference between the average exchange rate over the period of concern and the future spot rate. In addition, the translation losses are not tax deductible, whereas gains on forward contracts used to hedge translation exposure are taxed.

Increased transaction exposure: One of the most critical limitations with a hedging strategy (forward or money market hedge) on translation exposure is that the MNC would be increasing its transaction exposure. For example, consider a situation in which the subsidiary’s currency appreciates during the fiscal year, resulting in a translation gain. If the MNC enacts a hedge strategy at the start of the fiscal year, this strategy will generate a transaction loss that will somewhat offset the translation gain.

The translation gain is simply a paper gain that is the reported dollar value of earnings is higher due to the subsidiary’s currency appreciation. If the subsidiary reinvests the earnings, however, the parent does not receive any more income due to this appreciation. The MNC parent’s net cash flow is not affected. Conversely, the loss resulting from a hedge strategy is a real loss, that is, the net cash flow to the parent will be reduced due to this loss. Thus in this situation, the MNC reduces its translation exposure at the expense of increasing its transaction exposure.

Alternative Solution to hedging translation exposure

Perhaps the best way for MNC to deal with translation exposure is to clarify how their consolidated earnings have been affected by exchange rate movements. In this way, shareholders and potential investors will be more aware of the translation effect. An unusually low level of consolidated earnings may not discourage shareholders and potential investors if it is attributed to translation of subsidiary earnings at low exchange rates.

Conclusion

The risk of currency exposure can be mitigated or even eliminated in its entirety by the techniques and instruments described. How much currency risk exposure remains depends on the instrument selected. Many instruments do not hedge transaction exposure perfectly, but are more accessible to the individual and small to medium size companies. Instruments used to more completely hedge currency exposure, such as put and call options, may contain sizeable transaction costs. Nevertheless, most international businesses prefer the certainty of minimizing exposure, despite the increased transaction costs involved, in lieu of unquantifiable and potentially disastrous foreign exchange exposure.