Foreign exchange exposure is present when the value of the future cash flows of a firm is dependent on the value of the foreign currency. For example when XYZ Inc, an American company, sells products to a German subsidiary, the cash inflow of XYZ is exposed to the foreign exchange whilst the cash outflow of the German subsidiary is also exposed to the foreign exchange. Exchange rate risk exists for foreign investments and for importing and exporting businesses, risks that are caused by the fact that foreign exchange rates are always fluctuating (White, Sondhi and Fried, 2003).
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Analysis of a firm’s foreign exchange exposure gives an accurate representation of the firm’s financial position, enabling making of informed decisions. The three kinds of foreign exchange exposure are accounting, operating and transaction exposures.
Accounting exposure, also known as translation exposure, arises when books of accounts are translated into the home currency. The translation happens when the books are reported to shareholders (Eun and Resnick, 2014). So while the subsidiaries of XYZ may have closed the books earlier, this will need to be translated to XYZ shareholders in the United States at a later date for the consolidated financial statements.
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Beyond the reporting requirements, the gains or losses in the translated financial statements arising from accounting exposure do not have much impact. Indeed, the effects of the exposure may be reversed in the following financial year if there is a reversal in movement of current exchange rates. Nonetheless for a public company, accounting exposure could impact on the reported earnings and concomitantly the firm’s stock price (Butler, 2012).
Operating exposure has more impact on a firm’s financial statements than accounting and transaction exposures, with the foreign exchange affecting the value of the company. A firm is valued according to its assets and operating cash flows, items that are affected by operating exposure albeit that their effect is hard to identify and measure (Eun and Resnick, 2014). This is because though the company can measure effects on assets as presented in the financial statements, the operating exposure is also linked to the performance of the entire industry including entry barriers and competitiveness; factors that attract subjective interpretation from different experts. Notably operating exposure affects the present value of future cash flows.
One way XYZ, Inc can mitigate operating exposure is by diversifying its market across many countries. In so doing, decrease in cash flow and profitability in one market will be offset by increase in cash flow and profitability in another market.
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Transaction exposure arises due to a firm transacting in foreign currency and refers to the risk of exchange rate change between the time of a transaction and the time it is settled (Eun and Resnick, 2014). For XYZ, Inc, the company’s subsidiaries in other countries will transact in foreign currency over varying periods. XYZ’s profitability will be impacted when the subsidiaries transact in the foreign currencies and the currency market becomes unfavorable. For example, if the subsidiary has bought products from XYZ in dollars on two month’s credit, the subsidiary will pay more on the due date if the value of the dollar increases. This is because the purchase price and the costing of the product increases. This in turn negatively affects the profit margin of the subsidiary. However, if the value of the dollar decreases, XYZ will receive less for the products than it sold them for, with XYZ’s profitability being affected negatively.
One of the most suitable strategies XYZ can use to mitigate transaction exposure is by using foreign exchange derivatives (Hagelin and Ramborg, 2004). Hence the payoff to XYZ will depend on the foreign exchange rate of local currency of the subsidiary to that of the dollar. One derivative is the currency future where XYZ and each subsidiary have a futures contract where the price for currency exchange in the future is fixed during purchase.
Current rate and Temporal Translation Methods
Current rate method of translation is used for currencies that are experiencing normal rate of inflation whereas temporal method is used for currencies experiencing hyperinflation. Current rate is used where the foreign currency is the function currency; but if the reporting currency is the function currency, this would need re-measurement hence temporal method is used (Butler, 2012). Whereas the current rate (balance sheet) and an annual average rate income statement) is used for the current rate method, historical rates and a monthly weighted rate is used for temporal method. For the balance sheet, in the current method, all asset and liability accounts use the current rate but the stakeholder equity and capital stock accounts use historical rates, with the difference being shown in the cumulative translation adjustment (Eun and Resnick, 2014). For temporal method, historical rate is used except for monetary assets and liabilities that use the current rate.