Analyze the foreign exchange exposures, risks, hedges, financing cash flows, Merits
Course Learning Outcomes for Unit V Upon completion of this unit, students should be able to:
7. Discover the factors that produce transaction, translation, and operating exposure. 7.1 analyze the foreign exchange exposures, risks, hedges, financing cash flows, advantages,
and disadvantages experienced by firms. 7.2 Illustrate both the theoretical and practical differences between the two primary methods of
translating or re-measuring foreign currency-denominated financial statements. 7.3 Examine how operating exposure arises through unexpected changes in both operating
and financing cash flows.
Reading Assignment Chapter 9: Transaction Exposure Chapter 10: Translation Exposure Chapter 11: Operating Exposure
Unit Lesson Foreign exchange exposure (monetary values) measures profitability due to rate changes (Moffett, Stonehill, & Eiteman, 2015). Change for multinational firms involves a risk in using a currency different from the firms’ base currency. Financial managers must seek to determine whether the level of exposure will be more or less detrimental to the firm’s financial performance. For example, Starbucks’ financial analysts conducted extensive studies prior to entering the country of India, a traditional tea-consuming nation (Panchal, 2012; Trefis Team, 2012). Starbucks’ success resulted from slow market entry as well as forming a joint venture approach with a larger force, Tata, which owns hotels and car companies. Establishing a joint venture allowed Starbucks to minimize risk and exposure (Martinez, 2014). There are three types of foreign exposure: transaction, translation, and operating (Moffett et al., 2015). Transaction exposure demonstrates risk that firms encounter after making significant obligations to enter the market in a foreign territory. Multinational firms manage risks with a variety of methods. Hedging, a risk management tool, is an attempt to minimize price fluctuations through investing. For example, as a result of the 2014 Ebola virus outbreak, investors pulled away from travel industry stock (Krantz & Jones, 2014). Likewise, due to uncertainties during the geo-political talks of 2014, investors reduced risky investments and increased cash flows (Bank of America Newsroom, 2014). Advantages of hedging include minimizing uncertainty in cash flow, reducing the odds of cash falling to the point of fiscal distress, and positioning for easy recognition of threats (Moffett et al., 2015). Disadvantages of hedging include reducing shareholders’ value; it is a very expensive process; and depending on the market, hedging may not work. Existing obligations are utilized to determine transaction exposure. Management alternatives take account of unhedged position, forward market hedge, money market hedge, and options market hedge. Hedging appeals to management because it allows the opportunity to limit or offset the impact of risk.
UNIT V STUDY GUIDE
Transaction, Translation,
and Operating Exposure
BBA 4301, International Finance 2
UNIT x STUDY GUIDE
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Translation exposure is experienced if exchange rates change after a firm transfers its assets or currency into the foreign denomination (Moffett et al., 2015). Therefore, translation is the process of multinational firms’ foreign subsidiaries converting financial statements to the base-operational currency. For example, Starbucks-India converts their financial statements from Indian rupee to U.S. dollars. Translated financial statements include the income statement and balance sheet. Methods of translation include current rate and temporal method. Current rate, the most frequently applied method, is interpreted from financial statements at the current rate. The financial assets, liabilities, and revenue are understood or translated to represent the rate at the date it was recorded. Unlike the current rate, the temporal method identifies specific line items on financial statements that coincide with the acquisition date. For example, inventory on financial statements is regularly updated to reflect market value. The process for translation exposure in the United States is accomplished through presenting foreign- subsidiary financial statements that are stated in U.S. dollars. Foreign-stated subsidiary financial items are then translated using the current rate. Next, foreign-subsidiary financial items stated in local currency and U.S. dollars are re-measured by the temporal method. Finally, foreign-subsidiary financial items that are listed and not stated in local or U.S. currency must utilize the temporal method. International translation procedures follow the procedures outlined by the International Accounting Standards Committee (IASC). Operating exposure is facilitated through unexpected fluctuations in cash flow. Accounts receivable reflect cash inflows, while accounts payable represent cash outflows. Analyzing and forecasting comprise critiquing a firm’s future transactions as well as relating them to competitors worldwide. Measuring operating exposure is accomplished first through the utilization of short-run cash flows within a 12-month budget. Second, medium-run equilibrium cash flows within a 24-to-60-month budget are applied. Next, with medium-run disequilibrium, realized cash flows will differ from expected cash flow. In the final stage, long-run cash flows beyond 60 months are appropriately employed. Strategies to manage operating exposure can be achieved through diversification (Moffett et al., 2015). This technique allows management to reduce risk while yielding higher returns through diversifying operating and financing structures. Furthermore, diversification allows firms to react to potential threats. However, proactive strategies to manage operating exposure embrace common approaches such matching currency cash flows and/or acquiring liabilities in the foreign currency (Moffett et al., 2015). Risk-sharing agreements, where buyer and seller share fluctuating risks, are also a viable choice. Other profitable options include back-to-back or parallel loans, resulting in swapping currency between businesses. Management can also use cross-currency swap, which is swapping currencies without reflection on the balance sheet. Also, contractual approaches such as long-term hedging are designed to offset lost earnings. Multinational firms are subject to risks resulting from migrating exchange rates. Limiting the exposure to risk must be addressed strategically. The application of the appropriate risk strategy will increase a firm’s stability.
BBA 4301, International Finance 3
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References Bank of America Newsroom. (2014). BofA Merrill Lynch fund manager survey investors turning to cash as
geopolitics and interest rate rise fears bite. Retrieved from http://newsroom.bankofamerica.com/press-releases/bofa-merrill-lynch-fund-manager-survey- investors-turning-cash-geopolitics-and-interes
Krantz, M., & Jones, C. (2014). Ebola worries spread chill over travel stocks. Retrieved from
http://www.usatoday.com/story/money/business/2014/10/01/ebola-worries-airline-travel-industry- stocks/16561809/
Martinez, C. P. (2014). The success of Starbucks in India. Retrieved from
http://www.borgenmagazine.com/the-success-of-starbucks-in-india/ Moffett, M. H., Stonehill, A. I., & Eiteman, D. K. (2015). Fundamentals of multinational finance (5th ed.).
Boston, MA: Pearson Education. Panchal, S. (2012). Coffee giant Starbucks taps into tea-loving India. Agence France-Presse. Retrieved from
http://business.inquirer.net/79878/coffee-giant-starbucks-taps-into-tea-loving-india Trefis Team. (2012). Starbuck is finally coming to India….cautiously. Retrieved from
http://www.forbes.com/sites/greatspeculations/2012/09/07/starbucks-is-finally-coming-to-india- cautiously/
