Internationally, the accounting profession has been concerned about the position on translation of foreign-currency-accounting statements. Indeed, the accounting professions in the United States and the United Kingdom now have almost ident- ical rules for accounting for foreign currencies in published accounts. Generally speaking, translation of foreign balance sheets uses the current rate method. Transaction gains, whether realized or not, are accounted for through the profit and loss account. But there is a major exception. Where a transaction profit or loss arises from taking on a foreign currency borrowing in a situation in which the bor- rowing can be designated as a hedge for a net investment denominated in the same foreign currency as the borrowing, then the gain or loss on the borrowing, if it is less than the net investment hedged, would be accounted for by movements in reserves rather than through the income statement. If this kind of transaction gain or loss exceeds the amount of the loss or gain respectively on the net investment hedged, the excess gain or loss is to be reported in the profit and loss account. Non-transaction gains and losses are to be dealt with by reserve accounting direct to the balance sheet rather than through the profit and loss account.
According to the US standard FAS 52, translation of foreign currency revenues and costs (the essence of the income statement) is to be made at the average exchange rate during the accounting period. The British standard SSAP 20 allows the use of either the current rate or the average rate for this purpose. However, it is fair to say that opinion in the United States has moved towards the average rate method.
While translation methods affect group balance sheet values, the key point is that they have nothing to do with economic value. The value of the Australian sub- sidiary in the example should not be affected by adopting a different method of accounting. Its worth will be the same whether the all-current, current/non-current or monetary/non-monetary method is used. In all probability its discounted net present value will have changed as a result of the strengthened guilder. But this changed present value is hardly what we pick up by using different methods of translating balance sheets. Clearly, changes in value resulting from changed exchange rates show in terms of different present values. If we are concerned with how true value has changed because of exchange rate movements, we should be looking at economic value and how it changes in sympathy with moving exchange rates. This is what true exposure to exchange rate movements is all about.
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Economic exposure
Economic exposure is concerned with the present value of future operating cash flows to be generated by a company’s activities and how this present value, expressed in parent currency, changes following exchange rate movement. The concept of economic exposure is most frequently applied to a company’s expected future oper- ating cash flows (unhedged) from sales in foreign currency and from foreign opera- tions. But it can equally well be applied to a firm’s home territory operations and the extent to which the present value of those operations alters resultant upon changed exchange rates. For the purpose of convenience, the exposition that follows is based on a firm’s foreign operations, although an uncovered foreign-currency- denominated receivable or payable will vary as exchange rates vary.
The value of an overseas operation can be expressed as the present value of expected future operating cash flows which are incremental to that overseas activity discounted at the appropriate discount rate. Expressing this present value in terms of the parent currency can be achieved via equation (8.1) – but remember that incre- mental cash flows to the whole group of companies include management fees, royalt- ies and similar kinds of flow as well as direct cash flows from trading operations. The present value of the foreign subsidiary may be expressed as:
(8.1)
where PV is the parent currency present value of the foreign business, CI represents estimated future incremental net cash inflows associated with the foreign business expressed in foreign currency, CO is the estimated future incremental net cash outflows associated with the foreign business expressed in foreign currency, e is the expected future exchange rate (expressed in terms of the direct quote in the home ter- ritory), r is the appropriate discount rate, namely the rate of return that the parent requires from an investment in the risk class of the overseas business, t is the period for which cash flows are expected and n is the final period for which all flows are expected. Equation (8.1) assumes that all net incremental cash flows accruing to the overseas operation are distributable to the parent company in the home country.
At first sight the reader might conclude that quantifying economic exposure and the impact of changing exchange rates is fairly straightforward. For example, assume that a UK company has a wholly owned Danish subsidiary with a net present value of DKK120m. If the exchange rate is £1= DKK8 and subsequently moves to £1 = DKK10, presumably the value of the subsidiary has moved from £15m to £12m. Such a conclusion would, in all probability, be incorrect. It is necessary to be far more analytical to reach a worthwhile conclusion on valuation.
Devaluation will affect cash inflows and cash outflows as well as the exchange rate. Consider a company competing in export markets. While devaluation will not affect the total market size, it should have a favourable market share effect. The com- pany in the devaluing country should increase sales or profit margins – in short, it should benefit. Similarly, companies competing with imports in the domestic market should also gain since a devaluation will tend to make imported products more
PV= CI −CO + =
∑
( t( ) t)t t t n e r 1 0142 Chapter 8. Definitions of foreign exchange risk
expensive in local currency terms. However, this benefit may be offset to some extent by domestic deflation which frequently accompanies devaluation. So, in the import competing sector of the domestic market there will be beneficial and negative impacts. Next, in the purely domestic market, devaluation may lead to reduced com- pany performance in the short term as a result of deflationary measures at home which so often accompany currency depreciation.
All of the above factors affect cash inflows. Devaluations also affect cash outflows. Imported inputs become more expensive. If devaluation is accompanied by domestic deflation it will probably be the case that suppliers’ prices will rise as their financing costs move up. An inverse line of reasoning applies with respect to revaluation of a currency.
Getting to grips with economic exposure involves us in analysing the effects of changing exchange rates on the following items:
n Export sales, where margins and cash flows should change because devaluation should make exports more competitive.
n Domestic sales, where margins and cash flows should alter substantially in the import competing sector.
n Pure domestic sales, where margins and cash flows should change in response to deflationary measures which frequently accompany devaluations.
n Costs of imported inputs, which should rise in response to a devaluation. n Cost of domestic inputs, which may vary with exchange rate changes.
The analysis is clearly complex, but it is necessary in order to assess fully how the home currency present value of overseas operations is likely to alter in response to movements in foreign exchange rates.
So far it has been assumed that the parent’s present value of its foreign subsidiary is a function of that subsidiary’s estimated future net cash flows. In other words, there is an assumption that all cash flows are distributable to the parent. In fact, host governments frequently restrict distribution to foreign parents by exchange controls. Suffice here to say that where distribution of cash flows to the parent is limited, the present value formula needs to be adjusted a little:
(8.2)
The notation is as before except that Div represents the expected net dividend inflow in a particular year, OPF represents other parent flows such as royalties and man- agement fees in a particular period, and TV represents the terminal value remittable over the foreign exchanges at the end of the project’s life.
The reader should always bear in mind that economic exposure is equally applic- able to the home operations of a firm inasmuch as a change in exchange rates is likely to affect the present value of its home operations; this may arise for all of the reasons which would impinge upon foreign businesses.
There is another, related dimension to economic exposure. A UK firm exporting goods to the United States, denominated in dollars, in competition with a German
PV= Div +OPF TV + + + =
∑
( t( ) t) t ( ) t n n t n e r e r 1 1 0manufacturer will be facing a transaction exposure against the dollar and an eco- nomic exposure against the euro. Clearly, as the exchange rate between the pound and the euro changes, so the UK manufacturer is in a stronger or weaker position and this will filter through to sales levels, profit and cash generation. As such, the present value of the UK company’s export business will alter as exchange rates change. Just like the previous kind of economic exposure, this subset is difficult to quantify for reasons similar to those mentioned before.
It can be seen that assessing economic exposure necessarily involves us in a sub- stantial amount of work on elasticities of demand and behaviour of costs in response to changes in exchange rates. But the critical question that we would ask is whether economic exposure (or transaction exposure or translation exposure for that matter) is of any relevance to the financial manager of an international company. This ques- tion is addressed in Chapter 10.
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Summary
n Foreign exchange risk concerns risks created by changes in foreign currency levels.
n An asset, liability or profit or cash flow stream, whether certain or not, is said to be exposed to exchange risk when a currency movement would change, for better or worse, its parent, or home, currency value.
n Exposure arises because currency movements may alter home currency values. n Categorizations of foreign currency exposure vary from text to text. This chap-
ter distinguishes three forms of currency risk. These are transaction exposure, translation exposure and economic exposure. Later, in Chapter 11, a further classification, macroeconomic exposure, is highlighted. But we shall leave this to one side for the moment. In any case it is really more than foreign exchange exposure.
n Transaction exposure arises because a payable or receivable is denominated in a foreign currency.
n Translation exposure (sometimes also called accounting exposure) arises on the consolidation of foreign-currency-denominated assets, liabilities and profits in the process of preparing accounts.
n Economic exposure arises because the present value of a stream of expected future operating cash flows denominated in the home currency or in a foreign currency may vary because of changed exchange rates.
n Note that transaction and economic exposure are both cash flow exposures. Pure translation exposure is not cash flow based.
n A particular item may be classified under more than one heading. For example, a long-term foreign-denominated borrowing is both a transaction exposure
(because the home currency equivalent to repay the loan varies as exchange rates change) and a translation exposure.
n The magnitude of a translation exposure varies according to the accounting con- vention used for translation of foreign-denominated items. There are four basic translation methods. These are the current/non-current method, the all-current (sometimes called closing rate) method, the monetary/non-monetary method, and the temporal method. The exact mechanisms by which each method works are summarized in the main text.
n It is worth noting that, nowadays, most advanced economies, including the United States and the United Kingdom, consolidate foreign-denominated balance sheet items according to the all-current method. These countries tend to use either the closing rate or the average rate during an accounting period for the purpose of translating foreign-denominated profit and loss accounts.
n The relevance of classifying foreign exchange risk according to its transaction, translation or economic nature is that we would advocate that some categories of exposure should be actively managed by the headquarters treasury while our prescription for other categories is that since some of them do not matter, there is little point in applying treasury time in taking action to avoid the risk con- cerned – more of this later.
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End of chapter questions
Question 1Compare and contrast transaction exposure and economic exposure. Question 2
Why might the cash flows of purely domestic firms be exposed to exchange rate fluctuations?
Question 3
How do most companies deal with economic exposure? 144 Chapter 8. Definitions of foreign exchange risk