Module 3.

Management of Transaction
and Translation Exposure

Chapter 8 and 10

Massey University | massey.ac.nz | 0800 MASSEY

Outline
▪ Definition of transaction exposure
✓ Financial hedging

o Money market hedge

o Forward / futures hedge

o Options hedge

✓ Operational hedging

▪ Exposure netting
▪ Definition of translation exposure
▪ Translation methods
Transaction Exposure Defined
Transaction exposure is the sensitivity that the
domestic-currency value of a firm’s contractual
transactions in foreign currencies has to exchange rate
movements.

To manage transaction exposure:

⚫ Hedge using financial contracts - take opposite
positions in money market and derivatives market.
⚫ Use operational techniques - choice of invoice
currency, lead/lag strategy, exposure netting.
1. Money Market Hedge
Involves the pre-emptive conversion of currencies.
⚫ To hedge a foreign payable:
1. At T=0: borrow in home currency, and convert to
foreign currency to get PV(payable);
2. Invest that amount to earn interest;
3. At T=1: use the future value to meet payment.
⚫ To hedge a foreign receivable: borrow PV(rec.) in
foreign currency today, convert to home currency,
repay the loan plus interest using receivable at T=1.
Money Market Hedge: Example
A U.S.–based company imports from Italy, it owes
€1,000,000 to an Italian supplier due in one year.
The spot exchange rate is $1.50/€, one-year interest rates
are i€ = 4% and i$ = 3%.

To hedge,
1. Buy today PV(payable)= €1,000,000/1.04= €961,538.5,
dollar cost today = €961,538.5×$1.50/€ = $1,442,307.7.

2. Invest this amount at 4% in Italy for one year.

3. At maturity, use FV = €1,000,000 to make the payment.
Total cost at T=1: $1,442,307.7×(1+3%)=$1,485,576.9
2. Forward Hedge
⚫ Hedge for a foreign payable: take a long position
in a forward contract to buy the foreign currency at
maturity.
⚫ Hedge for a foreign receivable: take a short
position in a forward contract to sell the foreign
currency at maturity.

Example:
A US importer has just ordered next year’s inventory
from Italy. Payment of €1,000,000 is due in one year.
Example (cont.)
Forward rate = $1.50/€.
T=0 T=1
Order Inventory; agree to Step 2
pay €1,000,000 in one year. Pay $1,500,000 to buy
€1,000,000 from the
counterparty of the forward
Step 1: contract.
Take a Long position in
a forward contract on Step 3
€1,000,000. Pay €1,000,000 to supplier.
Forward hedge: payoffs

Spot Rate Spot Position on Forward Position Combined Payoff

at Maturity Product Market (1) Payoff (2)
ST ST × size (ST – F) × size (1) + (2)
$1.20 -$1.2 million -$0.3 million -$1.5 million

$1.50 -$1.5 million 0 -$1.5 million

$1.80 -$1.8 million $0.3 million -$1.5 million

✓ A sure amount of payable in US$

 Forward Hedge: Payoff Diagram

Payoff Long forward

1.50
Gains on one -$0
Spot $/€ in
position are one year
offset by losses
on the other
position.

–$1.5 m
Hedged payable

Unhedged payable
3. Futures Hedge
Similar to forward hedge.

⚫ Hedge for a foreign payable: take a long position in

foreign currency futures.
⚫ Hedge for a foreign receivable: take a short position
in foreign currency futures.

Disadvantages:
⚫ Standard contract sizes – may have residual exposure.

⚫ Marking-to-market – has interim cash flow effect.

 4. Hedge with Options
To hedge a foreign payable, buy a call option.
⚫ If the foreign currency appreciates, long call locks in
an upper limit on the home-currency cost of payable.
⚫ If the foreign currency depreciates, has the flexibility
of buying the currency at a lower price (ST).
✓ Provides a flexible hedge against the downside risk.
✓ Also preserves the upside potential.

To hedge a foreign receivable, buy a put option.

Example: Payoffs to hedge with option
Suppose the US importer bought a call option on €1,000,000
with an exercise price (E) of $1.50/€.

Spot Rate Spot Position Options Position Combined Payoff

at Maturity Payoff (1) Payoff (2)
ST ST × size Max(ST -E, 0)×size (1) + (2)
$1.20 -$1.2 million 0 -$1.2 million

$1.50 -$1.5 million 0 -$1.5 million

$1.80 -$1.8 million $0.3 million -$1.5 million

Payoffs to the long position in call option
E = $1.50/€, suppose ce = $0.05/€.

Long call on €1m

Profit

- c × size (ST – E –c) × size

–$0.05m Value of €1 in $
$1.55/€ in one year
$1.50/€

loss
Hedge with option: Total payoff diagram
E = $1.50/€, suppose ce = $0.05/€.
Payof
f Long call on €1,000,000

E = $1.50/€
$0 ST
–$0.05m $1.55/€

Unhedged payable
(-ST × size) Hedged €1,000,000
–$1.55m

Hedge against
Potential of savings
unfavorable increases in
if ST goes down.
the exchange rate.
 Hedging Contingent Exposure

If only certain contingencies give rise to exposure, then

options can be effective insurance.

Example: A US company is bidding on a hydroelectric

dam project in Canada, it will need to hedge the
Canadian-US dollar exchange rate only if the bid wins
the contract.
➢ The firm can hedge this contingent risk with options.
Hedging Recurrent Exposures
Companies that have recurrent exposure may hedge
exchange risk at a lower cost with swaps than with a
program of hedging each exposure as it comes along.

⚫ Recall that swap contracts can be viewed as a

portfolio of forward contracts.
⚫ Also swaps are available in longer-terms than
futures and forwards.
Hedging Exposure to Minor Currencies
It is difficult, expensive, or impossible to use financial
contracts to hedge exposure to minor currencies.
⚫ Cross-hedging: hedging a position in one asset by
taking a position in another asset.
➢ The effectiveness of cross-hedging depends upon
how well the assets are correlated.
Name Bid Ask
USDSEK 1Y FWD 1113.6400 1173.6400
EURUSD 1Y FWD 156.0300 158.0300
Spread: 5.25% vs. 0.30%
Correlation coefficient = 0.9772
Cross-hedging a minor currency: Example
A US importer has liabilities in Swedish krona (SEK).
He could cross-hedge with a long or a short forward
contract on the euro.
This can be a good hedge if the two currencies co-vary
in a predictable way:
⚫ the krona is expensive when the euro is expensive,
⚫ or the krona is cheap when the euro is expensive.
Limitations of Financial Hedging
⚫ If an international transaction involves an uncertain
amount of foreign currency, there is under-hedging
or over-hedging.
⚫ For repeated short-term transactions, the continual
short-term hedging of repeated transactions may
have limited effectiveness.

▪ Operational hedging can be useful.

Hedging through Invoice Currency
A firm can shift, share, or diversify exchange risk by:
⚫ Invoicing foreign sales in home currency.
⚫ Pro-rating the currency of the invoice between
foreign and home currencies.
⚫ Using a currency basket units such as SDRs.

➢ Useful when no forward, futures or option

contracts are available.
Hedging via Lead and Lag
If a currency is appreciating:
⚫ pay bills denominated in that currency early;
⚫ let customers in that country pay late.

If a currency is depreciating:
⚫ give incentives to customers who owe you in that
currency to pay early;
⚫ pay your obligations denominated in that currency
as late as your contracts allow.
Exposure Netting
Many MNCs use a reinvoice center, a financial
subsidiary that nets out the intrafirm transactions.
➢ Determine and hedge the residual exposure.

Example: Suppose £1.00 = $2.00

€1.00 = $1.50
SFr 1.00 = $0.90
A U.S. MNC has subsidiaries in Switzerland, Italy
and the U.K.; Intrafirm transactions are shown on
the next slide.
Exposure Netting
SFr150
$150

£150
€150

SFr150
$150

€150
£150
 $2.00 $0.90 $1.50
Exposure
£150× £1 =Netting
$300 SFr150×
StepSFr1 €150×
= $135
1: convert €1 = $225
to the US$.
SFr150
$135
$150

$300
£150
$225
€150
$225

SFr150
$150

$135
€150
$225
£150
$300
$300
 Step 2: use bilateral netting to reduce the number of
transactions by half.

$15

$165
$75

$75

8-25
Step 3: simplify with multilateral netting.

$180
$210 +$90
$270

$180
–$180
–$90 –$210
–$390
Exposure Netting with Central Depository
Some firms use a central depository as a cash pool to
facilitate funds mobilization and reduce the chance
of misallocated funds.

Central
depository
Functional vs. Reporting Currency
Functional currency is the currency that the business
is conducted in. It may not necessarily be the currency
of its geographic location.
For example, the functional currency of a U.S. MNC’s
subsidiary located in Singapore could be
▪ The U.S. dollar, if it is an integrated subsidiary.
▪ Singapore dollar, if it is a self-sustaining subsidiary.

Reporting currency is the currency in which the MNC

prepares its consolidated financial statements.
Translation Exposure
Also known as the accounting exposure - the potential
that a firm’s consolidated financial statements can be
affected by exchange rate movements when

⚫ The firm has an integrated foreign entity operating

as an extension of the parent company.
⚫ The firm has a self-sustaining foreign entity
operating locally independent of the parent company.
➢ Translation exposure arises when the functional
currency is different from the reporting currency.
Translation Methods
⚫ Current / Noncurrent method
⚫ Monetary / Nonmonetary method
⚫ Temporal method
⚫ Current rate method

They are different in terms of:

❖ The exchange rate at which individual balance
sheet and income statement items are re-measured.
❖ Where any imbalances are to be recorded.
Current/Noncurrent Method
Underlying principal: assets and liabilities should be
translated based on their maturity.
⚫ Current assets/liabilities: translated at the spot rate.
⚫ Noncurrent assets/liabilities: translated at the
historical rate in effect when the item was first
recorded on the books.
⚫ Retained earnings is the balancing item.
❖ Income statement, use average exchange rate for the
accounting period for most items but historical rates
for items associated with noncurrent assets/liabilities.
 Current/Noncurrent Method: Example
⚫ Current spot rate: Balance Sheet Local Current/
€2 = $1. Currency Noncurrent
Cash € 2,100 $1,050
⚫ Historical rate in Inventory € 1,500 $750
effect when the Net fixed assets € 3,000 $1,000
non-current A&Ls Total Assets € 6,600 $2,800
were first
recorded on the Current liabilities € 1,200 $600
Long-Term debt € 1,800 $600
books: €3 = $1.
Common stock € 2,700 $900
⚫ Balancing item: Retained earnings € 900 $700
retained earnings. CTA -------- --------
Total Liabilities and € 6,600 $2,800
Equity
Summary: Current/Noncurrent Method
⚫ Retained Earnings is not translated, but is a plug
value used in balancing the balance sheet to make
sure that Assets = (Liabilities + Shareholder equity).
⚫ Does not need to use Cumulative Translation
Adjustment (CTA).

⚫ A major problem: items like long-term debts are

assumed of having no exposure to foreign exchange
risk, this does not make sense.
Monetary/Nonmonetary Method
Underlying principle: monetary accounts have the
attribute of change in values when FX rate changes.
⚫ Monetary balance sheet accounts: cash, accounts
receivable etc. are translated at the current FX rate.
⚫ Nonmonetary balance sheet accounts: inventory,
land, equity etc. are translated at the historical FX
rate in effect when the account was first recorded.
❖ Income statement items: use the average exchange
rate for the accounting period for monetary items and
historical rates for nonmonetary items.
Monetary/Nonmonetary Method
Retained earnings is the balancing item.

A monetary item has a value fixed in terms of the

number of units of the currency denomination.

In New Zealand FRS-21, Financial Reporting

Standards, monetary item is defined as “money held
and items to be received or paid in fixed or
determinable amounts of money.”
 Monetary/Nonmonetary Method: Example

⚫ Current exchange Balance Sheet Local Monetary/

Currency Nonmonetary
rate: €2 = $1.
Cash € 2,100 $1,050
⚫ Historical rate in Inventory € 1,500 $500
effect when non- Net fixed assets € 3,000 $1,000
Total Assets € 6,600 $2,550
monetary
accounts were
Current liabilities € 1,200 $600
first recorded: Long-Term debt € 1,800 $900
€3 = $1. Common stock € 2,700 $900
Retained earnings € 900 $150
⚫ Balancing item:
CTA -------- --------
retained earnings. Total Liabilities and € 6,600 $2,550
Equity
Temporal Method
Underlying principal: assets and liabilities should be
translated based on how they are recorded on the books.
⚫ Accounts are translated at the current spot FX rate if
they are carried on the books at current values.
⚫ Items that are carried on the books at historical costs are
translated at the historical FX rates in effect at the time
they were placed on the books.
❖ Income statement items: most use the average exchange
rate for the accounting period except for items
recorded at historical rates.
 Temporal Method: Example
⚫ Suppose Balance Sheet Local Temporal
Inventory & L-T Currency
debt are recorded Cash € 2,100 $1,050
at their current Inventory € 1,800 $900
values. Net fixed assets € 3,000 $1,000
Total Assets € 6,900 $2,950
⚫ Current spot rate:
€2 = $1. Current liabilities € 1,200 $600
Long-Term debt € 1,800 $900
⚫ Historical rate:
€3 = $1. Common stock € 2,700 $900
Retained earnings € 900 $550
⚫ Balancing item: CTA -------- --------
retained earnings. Total Liabilities and € 6,600 $2,950
Equity
 Temporal Method: Example
Balance Sheet Local Temporal
⚫ If Inventory is Currency
recorded at the Cash € 2,100 $1,050
historical value. Inventory € 1,500 $500
Net fixed assets € 3,000 $1,000
⚫ Current spot rate: Total Assets € 6,600 $2,550
€2 = $1.
⚫ Historical rate: Current liabilities € 1,200 $600
€3 = $1.
Long-Term debt € 1,800 $900
⚫ Balancing item: Common stock € 2,700 $900
Retained earnings € 900 $150
retained earnings.
CTA -------- --------
Total Liabilities and Equity € 6,600 $2,550
Current Rate Method
Underlying principal: all balance sheet items, except
for shareholder equity, are translated at the current FX
rate.
⚫ Use a “plug” equity account, cumulative translation
adjustment (CTA), to make the balance sheet
balance.
❖ Income statement items are translated at either the
exchange rate prevailing when they are recognized
or at an average rate over the reporting period.
 Current Rate Method: Example
Balance Sheet Local Current
⚫ current exchange Currency Rate
rate €2 = $1. Cash €2,100.00 $1,050
Inventory €1,500.00 $750
Net fixed assets €3,000.00 $1,500
⚫ Historical exchange
Total Assets €6,600.00 $3,300
rate: various.
Current liabilities €1,200.00 $600
⚫ Balancing item: Long-Term debt €1,800.00 $900
CTA (a “plug” Common stock €2,700.00 $900
equity account). Retained earnings €900.00 $360
CTA -------- $540
Total Liabilities €6,600.00 $3,300
and Equity
Different Financial Reporting Standards
⚫ The U.S. Financial Accounting Standards Board
Statement 52 (FASB 52) became effective in 1982,
use current rate method and temporal method.

⚫ The European Union: the International Financial

Reporting Standards (IFRS) published by
International Accounting Standards Board (IASB).
⚫ New Zealand adopted its equivalent in 2002 (NZ IAS
21). The Effects of Changes in Foreign Exchange
Rates: resembles the monetary/nonmonetary method.
⚫ Convergence of IASB-FASB.
Homework:
Chapter 8: Questions 4, 5, 7, 10. Problems: 2-8.
Chapter 10: Questions 1, 2, 5.

Next week:
⚫ Management of economic exposure (chapter 9).