Tài chính doanh nghiệp - Topic 7: Measuring and managing translation and transaction exposure

Topic 7: Measuring and managing translation and Transaction exposureL. Gattis1Financial Risk ManagementLearning Objectives2Students 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 and transaction exposure and gain/lossStudents can calculate EaR and CaR given balance sheet account information and exchange rate volatilityForex Exposure3I. 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)4Translation 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 Netting5Translation 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 Example6Zapata 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!71. Current Rate Method: All assets and liabilities translated at current exchange rate each reporting period. 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. 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) Zapata Exposure: 1,000 + 50,000 -12,000 - 47,000 = -8,000M peso4. Temporal Method: Same as monetary method except inventory is included Zapata Exposure: 1,000 + 50,000 -12,000 - 47,000 +32,000 = 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 STANDARDS8I. 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 MethodIncome Statement(More volatile earnings)If Parent Designates Foreign Currency* as the functional currency(e.g., Euro)Current Rate MethodBalance Sheet “Cumulative Translation Adjustment Account”9* 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 method9Translation Exposure10a. At the beginning of the year, what is Zapata’s exposure if the USD or peso is the functional currency? if USD Functional: 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: 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 Exposure11c. 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.1212Bloomberg WVOL(Annualized Implied Volatilities for World Currencies)13The 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 1.95σ change or a 1% chance of a 2.33σ change.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)14XZFinding Z given X conf. levelDaysUsually assume about 22 business days/month, or 260 per yearFinding σUsually calculated using the standard deviation of previous year(s) daily exchange rate changes or Implied Vols14Earnings 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?15You could also compute EAR using the USD value (V=$100), but be sure to use the €/$ volatility15MANAGING TRANSLATION EXPOSURE16Designate of Functional Currency Natural Balance Sheet Netting Example: get liabilities to offset assets by issuing foreign denominated debt.Translation and Transaction Risk17Translation gains and losses may or may not lead to actual cash losses (Transaction Losses)Example 1: Book value of Mexico City Storage Facility fluctuates with the exchange rate causing translation gains and losses, but the gains and losses are never realized because property is never sold.Example 2: Book value of peso inventory fluctuates with the exchange rate causing translation gain and losses, and is realized as inventory is sold.Translation losses become transaction losses when the account is sold (inventory, property, cash) or comes due (receivables, payables, loans). Transaction exposure is the net position (assets – liabilities) in foreign a denominated accounts that are expected to come dueTransaction gains and losses are the difference between the expected domestic currency value (book value in some cases) and the actual domestic currency value of the position Transaction ExposurePractice ProblemRolls-Royce, the British jet engine manufacturer, sells engines to U.S. airlines and buys parts from U.S. companies. Suppose it has accounts receivable of $1.5 billion and accounts payable of $740 million. It also borrowed $600 million. The current spot rate is $1.5128/£. What is Rolls-Royce's dollar transaction exposure in dollar terms? Suppose the pound appreciates to $1.7642/£. What is Rolls-Royce's gain or loss, in pound terms, on its dollar transaction exposure? 1818Cashflow at Risk (CaR)“Measuring Transaction Exposure”CaR measures the risk that actual cashflows are different than what is expected (or planned)More technically, CaR is the level of cashflow loss that has a x% probability of being exceeded over the next n periods. Example: Manager may have a 1-year €80 receivable and asks how much can the cashflows be different from the expected value with 95% confidence?Expected € CF: Receivable is €80, and the euro is expected to be $1.25 in one year (forward exchange rate). The annualized volatility of the exchange rate estimate is $.225.Expected $ CF: €80 x $1.25/€ = $1001919Cashflow at Risk (CaR) The CaR formula is the same as EaR But V is the expected foreign cashflow (not necessarily balance sheet items that are subject to translation)Example: €80M, 1-year, 95%, σ(annual)=$.225 CaR = 80*1.65*.225=$29.7 I could have divided .225 by the sqrt(260) to get daily, then multiplied by sqrt(260) to get annual, but why bother.The manager could say that he expects $100, but $29.70 is at risk (with 95% certainty)He could also state that there is a 95% probability that the cash flow will be at least $70.30 (i.e., 5% chance less than $70.30)2020Cashflow at Risk (CaR)Example: XYZ Corp has a 1-month, €80 net receivable, the forward exchange rate is 1.25$/€, and ask how much can the cashflows be different from the expected value with 99% confidence? Daily exchange rate standard deviation was $.014 for the past year.What is the expected US$ value of the receivable? What is the 99%, 1-month CaR? (assume 22 days/mo) What is the 99%, one month, minimum US$ proceeds? How would the answers change if it were a net payable? 2121MANAGING TRANSLATION AND TRANSACTION EXPOSURE22Exposure Netting: Example 1: offset fx assets with liabilities by issuing foreign denominated debt.Example 2: offset fx liabilities with assets by holding fx cash or cash equivalentsIncrease hard currency assetsIncrease soft currency liabilitiesPrice Adjustment Clauses (Foreign customers pay more or less based on exchange rates)Use Derivatives (Forwards, Futures, Swaps, Options)Choosing EaR or CaR as the corporation’s primary risk measure23Depends on what triggers financial distress in your business--- Cashflows or Earnings disruptionsAccess to contingent funding (like a line of credit) or liquid assets reduce the need for cashflow management.Adoption of FASB 52 allows firms to have exchange rate adjustments bypass the income statement effectively eliminating earnings exposureAdvantages of CaR and EaR as a Risk Measure24Can summarize the total risk of a corporation’s exposure to currency revaluationsUse exposure nettingAccounts for expected variability of exchange ratesMore volatile exchange rates create larger exposure measuresCan be used to make probabilistic statementsCan be scaled across time by using the sqrt(t)Assigned Problems251.Assigned Problems26Suppose Google expects that in 20 days the following yen accounts will come due: ¥175 million in receivable, ¥50 million in payable, and a debt coupon payment of ¥25 million. What is Google’s 20-day, 95% probability (Hint: 1.65 Standard deviation) CaR if the daily standard deviation of the Yen is .005? Microsoft has a net position of 100M Swedish Kronor and it expects the exchange rate to be SKr8.5/$. What is the transaction gain or loss if the final rate is SKr7.5? IBM has a net position of -100M (net payable) Norwegian Krone and it expects the exchange rate to be NKr7.5/$. What is the transaction gain or loss if the final rate is NKr6.5? Assigned Problems275. 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?    b. What XYZ’s baht translation exposure using the temporal method?   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)  What 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) What is the annual volatility of the Swiss franc if the daily volatility is $.005? (assume 260 business days/year) Textbook28Shapiro and Sarin’s Foundation of Multinational Finance 6th Ed. Chapter 8 covers translation and transaction exposure