Transaction, Operating Accounting Exposures
Transaction, Operating, & Accounting (Translation) Exposures
Foreign Exchange Exposure – measures the potential for a firm’s profitability, net cash flow, and market value to alter because of a change in exchange rates. Q: What are the three main foreign exchange exposures?
- Transaction Exposure
- Operating Exposure
- Accounting Exposure Transaction Exposure – measures changes in the value of outstanding financial obligations incurred prior to a change in exchange rates.
Operating Exposure (Economic Exposure, Competitive Exposure, Strategic Exposure) – measures a change in the present value of a firm resulting from any change in future expected operating cash flows caused by unexpected changes in exchange rates. Accounting Exposure (Translation Exposure) – measures accounting-derived changes in owner’s equity as a result of translating foreign currency financial statements into a single reporting currency.
Exhibit 8. 1. Note: In the fourth quarter of 2001 Amazon. om reported a net income of $5 million, due in part to a one-time foreign currency gain of $16 million. Hedging – To take a position that will rise (or fall) in value to offset a change in the value of an existing position. Transaction Exposure Transaction Exposure – measures changes in the value of outstanding financial obligations incurred prior to a change in exchange rates.
Transaction exposure can arise from the following activities: Purchasing or selling foreign goods and services on credit. Borrowing or lending in another currency. Foreign exchange contracts. Exhibit 8. 3 The Life Span of Transaction Exposure. Example Expect to collect? 1,000,000 in three months on a sale, minimum acceptable value $1,700,000. Q: What type of transaction exposure has occurred
A: Billing Exposure S0 = $1. 7640/? ES90= $1. 76/? F90= $1. 7540/? iU. K. = 10% per year (2. 5% per quarter) kU. K. = 8% per year (2% per quarter) iU. S. = 8% per year (2% per quarter) kU. S. = 6% per year (1. 5% per quarter) P90ATM = $1. 75 (1. 5% premium) P90OTM = $1. 71 (1% premium)
Note: ES90 is the estimated spot rate in three months, “i” is the borrowing interest rate, and “k” is the investment interest rate, P90ATM is an at-the-money three-month put option, and P90OTM is an out-of-the-money three-month put option.
Q: Is the pound expected to appreciate or depreciate?
A: Depreciate Q: What is the forward premium/discount on the pound?
A: [pic]
Q: What are the four alternatives to hedge transaction exposure?
- Remain unhedged
- Hedge in the forward market
- Hedge in the money market
- Hedge in the options market
- Remain unhedged, collect? 1,000,000 in three months at the new spot rate.
- Hedge in the forward market, collect? 1,000,000 in three months at $1. 7540/?
Hedge in the money market, borrow? 975,610 today, and exchange for dollars at the current spot rate ($1. 7640/? ).
An at-the-money[1] (ATM) put option is selling for a 1. 5% premium. The cost of the option is (size of the option) x (premium) x (spot rate) = cost, in this case ? 1,000,000 x 0. 015 x $1. 7640 = $26,460. This is the maximum loss, while the maximum gain is the spot price – the cost of the option. [pic] To compare the alternatives, the first estimate what you expect spot rates to be, then estimate a range of possible prices, and consider your ability to accept the downside. Then select the best strategy. Operating Exposure Operating Exposure (Economic Exposure, Competitive Exposure, Strategic Exposure) – measures a change in the present value of a firm resulting from any change in future expected operating cash flows caused by unexpected changes in exchange rates.
Q: Operating Exposure depends on whether an unexpected change in exchange rates causes unanticipated changes in what?
A: Sales volume, sales prices, or operating costs Figure 9. 1 Financial and Operating Cash Flows Between Parent and Subsidiary [pic] Q: What are four proactive ways to manage operating exposure?
All assets and liabilities are translated at the current exchange rate. Temporal method – assumes that a number of individual line item assets such as inventory and net plant and equipment are restated regularly to reflect market value.
Q: Which method is the most common worldwide?
A: The current rate method
Q: What are the advantages of the current rate method?
- The variability of reported earnings due to translation gains or losses is eliminated, because the gain or loss on translation goes directly to a reserve account (rather than passing through the income statement).
- Does not distort balance sheet ratios such as the current ratio or debt-to-equity ratio (because the relative proportions of the individual balance sheet accounts remain the same.
