Tài chính doanh nghiệp - Finance 407: Multinational financial management - Topic 11: Measuring and managing translation exposure

Topic #11: Measuring and managing translation exposureL. GattisThe Pennsylvania State University1Finance 407: Multinational Financial ManagementReview Poll2Dell records a 500,000 Danish kroner accounts payable when the spot rate of the kroner is Kr5.5/USD. One month later, the Kroner appreciates to Kr5.0 and the payable is still outstanding. What gain or loss will Dell report in its USD financials if they revise the exchange rate? A. -$250,000 B. -$9,091 C. $0 D.$9,091 E.$250,000Learning Objectives3Students understand and can recalltype of foreign exchange exposuretranslation methods and FASB-52methods for managing translation exposurethe definitions, implementation, and use of EaR to measure exchange rate riskStudents can calculatetranslation exposure and gain/lossStudents can calculate EaR given balance sheet account information and exchange rate volatilityForex Exposure4I. Translation “Accounting” Exposure arises when reporting and consolidating financial statements require conversion from foreign currency to home currency. It is a possible accounting gain/loss on foreign assets and liabilities which are reported as losses in income or adjustments to equity (Translation exposures often lead to cashflow losses when account are liquidated)II. Cashflow ExposuresTransaction Exposure: potential gains or losses on foreign transactions such as bond payments and receivables paid in the foreign currency. (Up until a payment is made, these are only translation exposures)Competitive Exposure: long-term exposure to currency change on future business.Types of Foreign Exchange ExposureExamples (U.S. MNC Perspective)5Translation ExposureForeign subsidiary records ¥10,000 receivable at $.008/¥ spot exchange rate at time of sale ($80 book value), but yen devalues to $.007/¥ US$ value of receivable falls $10 to $70 which is reflected in parent company income statement or balance sheet It affects cashflows when the receivable is receivedTransaction ExposureEuro appreciates from $1.20 to $1.40 at the maturity of euro denominated bond that has a face value of €1,000 It costs $200 more to repay the bond after the appreciation.Competitive ExposureYour manufacturing facility is China is expected to become more costly in the future (in USD terms) due to the appreciation of the yuan.Translation Exposure Netting6Translation Exposure is the net position (Assets-Liabilities) in a foreign currency that must be revalued using new exchange ratesU.S. MNC Example 1: Receivables and Payables must be revalued€100M Account Receivable€70M Accounts PayableExposure: €30M (“Exposed to Depreciation of the Euro”)“Long the euro” (Net Asset Position)U.S. MNC Example 2: Receivables and Payables must be revalued€50M Account Receivable€70M Accounts PayableExposure: -€20M (“Exposed to Appreciation of the Euro”)“Short the euro” (Net Liability Position)The accounts that must be revalued depend on the accounting method for translation. Translation Example7Zapata Auto Parts, the Mexican affiliate of American Diversified, Inc., had the following balance sheet on January 1, 2010: Assets (peso, millions) Liabilities & EquityCash 1,000 Accts Payable 47,000Accts Rec. 50,000 Long Term Debt 12,000Inventory 32,000 Total Liabilities: 59,000Net Fixed Asset 111,000 Equity 135,000 Total Assets 194,000 Liab. & Equity 194,000 Exchange Rate: 1/1/10: 12 Peso per USD At the beginning of the year, what is Zapata’s translation exposure to the peso? --- It depends on the translation method which determines which account are revalued at the new rate and which are not!81. Current Rate Method: All assets and liabilities translated at current exchange rate each reporting period. Exposure is net equity. Zapata Exposure: 194,000 – 59,000= 135,000M peso2. Current/Noncurrent Method: Only current accounts are translated at current exchange rates. Noncurrent accounts remain at the historical exchange rate used to record the account. Exposure is CA – CL. Zapata Exposure: 1,000 + 50,000 + 32,000 -47,000 = 36,000M peso3. Monetary/Nonmonetary Method: Only monetary accounts are translated at current exchange rates. Non-monetary accounts remain at the historical exchange rate used to record the account. (Monetary accounts include cash, receivables, payables, debt). Exposure is MA – ML. Zapata Exposure: 1,000 + 50,000 -12,000 - 47,000 = -8,000M peso4. Temporal Method: Same as monetary method except inventory is included. Exposure is MA – ML + Inventory Zapata Exposure: -8,000M + 32,000M = 24,000M pesoTranslation MethodsAssets (Peso, millions) Liabilities & EquityCash 1,000 Accts Payable 47,000Accounts Rec. 50,000 Long Term Debt 12,000Inventory 32,000 Total Liabilities 59,000Net Fixed Asset 111,000 Equity 135,000Total Assets 194,000 L&E 194,000STATEMENT OF FINANCIAL ACCOUNTING STANDARDS9I. FASB NO. 8 in effect until 1981 A. Used Temporal translation method B. Dissatisfaction with FASB No. 8 because “true” profitability often disguised by exchange rate profit volatilityII. FASB NO. 52 adopted in 1981- Most translation gains or losses to bypass income statement.- New FASB 52 Distinction: Functional v. Reporting currency designationFunctional currency for foreign subsidiary: The currency used in the primary economic environment in which it operates. (USD or fx for U.S. MNC)Reporting currency: The currency the parent firm uses to prepare its financial statements (USD for U.S. MNCs)STATEMENT OF FINANCIAL ACCOUNTING STANDARDS NO. 52Functional Currency of Foreign SubsidiaryBalance Sheet TranslationParent Financials EffectIf Parent Designates Home Currency as the functional currency(e.g., USD)Temporal MethodExp=MA-ML+InvIncome Statement(More volatile earnings)If Parent Designates Foreign Currency* as the functional currency(e.g., Euro)Current Rate MethodExp=A-L=EquityBalance Sheet “Cumulative Translation Adjustment Account”10* A majority of companies have opted for local (foreign) currency as the function currency to avoid income statement volatility* Caveat, if there is hyperinflation (cumulative 3-yr inflation of 100%), then reverts to temporal method10Translation Exposure11a. At the beginning of the year, what is Zapata’s exposure if the USD or peso is the functional currency? if USD Functional: A. P135,000 B. P24,000 if PESO Functional: b. What is the translation gain/loss if the exchange rate changes from 12 to13 Mex/USD if the USD or peso is the functional currency? if USD Functional: A. -$865M B. +$865M C. -$154M D. $154M if PESO Functional: Assets (Peso, millions) Liabilities & EquityCash 1,000 Accts Payable 47,000Accounts Rec. 50,000 Long Term Debt 12,000Inventory 32,000 Total Liabilities 59,000Net Fixed Asset 111,000 Equity 135,000Total Assets 194,000 L&E 194,000Translation Exposure12c. Zapata borrows 5,000 pesos. What will this do to its translation exposure if it uses the borrowing to pay a dividend to its parent? A. Increase Exposure B. Decrease C. No change 2. If it uses the funds to increase its cash position? A. Increase Exposure B. Decrease C. No change Assets (Peso, millions) Liabilities & EquityCash 1,000 Accts Payable 47,000Accounts Rec. 50,000 Long Term Debt 12,000Inventory 32,000 Total Liabilities 59,000Net Fixed Asset 111,000 Equity 135,000Total Assets 194,000 L&E 194,000FX Stress Tests A Stress Test quantifies the risk that accounting earnings are different than what are expectedExample: foreign asset was purchased at €80 and was booked at $1.30/€Book value is $104.00In 60 business days (about 3 months), the year-end accounting statements will be published and the firm uses the current rate translation method in which all translation gains and losses affect earnings.What are the earnings gain or loss if the euro depreciates or appreciated by 10% (this in an example of a stress test)App 10%: Dep 10%: But we don’t know if 10% is a large change over 3 months.1313Bloomberg WVOL(Annualized Implied Volatilities for World Currencies)14The EURUSD 3-month annualized implied volatility is 12.898% or $.17 (12.898%*$1.30)Daily Volatility (σ)=.17/SQRT(260)=$.0105If we assume that exchange rate changes are normally distributed, there is only a 5% chance of a 1.65σ adverse change or a 1% chance of a 2.33σ adverse change. (One tail statistic)Earnings at Risk (EaR) EaR is a probabilistic measure of potential loss given a time period and confidence intervalGeneral Formula for x probability t business days V is the absolute value of the foreign account exposure (based on method)15XZFinding Z given X conf. levelDaysOften assumes 22 business days/month, or 260 per yearFinding σOften calculated using the standard deviation of previous year(s) daily exchange rate changes or Implied Vols15Earnings at Risk (EaR)In this case, V (€80) is the net position that is subject to currency translation and reported in earningsAssuming daily rate volatility (a.k.a., StdDev) is $.0105/€, what is the 90%, 60-day EaR?EAR= A. $5.08M B. $3.25M C. $12.75M D. $8.32M16You could also compute EAR using the USD value (V=$100), but be sure to use the €/$ volatility16MANAGING TRANSLATION EXPOSURE17Designation of Foreign Currency as Functional Currency (bypassing income statement)Natural Balance Sheet Netting Example: get liabilities to offset assets by issuing foreign denominated debt.iClicker: Class Evaluation18How would you rate today’s class? Highest LowestAssigned Problems191. XYZ corp. has the following financial statement for its Thailand subsidiary: (Currency Values in Thai Baht)Accounts Receivable 115,000Inventory 95,000Fixed Assets 100,000Accounts Payable 75,000Long-term Debt 85,000Equity 150,000  a. What is XYZ’s baht translation exposure using the current rate method?  150,000=Equity=Assets-Liability b. What XYZ’s baht translation exposure using the temporal method? 50,000=115,0000+95,000-75,000-85,000 c. What is XYZ’s 60-day, 99% baht EaR using the temporal method? (assume that the daily standard deviation of the Thai baht is $.05) 50,000*(2.33*sqrt(60)*.05)=45,120.26What is the 20 business day USD volatility of the pound if the annualized implied volatility is 15% and the current spot rate is $1.60? (assume 260 business days/year)=.15*1.6/sqrt(260)*sqrt(20)=$.06656What is the annual volatility of the Swiss franc if the daily volatility is $.005? (assume 260 business days/year).005*sqrt(260)=$.0806Textbook20Shapiro and Sarin’s Foundation of Multinational Finance 6th Ed. Chapter 8 covers translation and transaction exposure