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Finance Topics of Translation, Transaction and Operating Exposures

Paper type: Essay
Pages: 12 (2927 words)
Categories: Finance Topics, Taking Risks
Downloads: 32
Views: 358

Introduction

In the world of corporate business Multi national companies (MNC’s) play a pivotal role. Owing to the limitation of the system, these companies are exposed to the volatility of the exchange rate changes. Myth of MNC’s possessing huge profit margins, cheap labor, and access to economical raw materials although some what true, but there is also a huge financial risk these companies have to bear.

MNCs generally deal in two or more than two currencies.

If there are changes in the value of those currencies, companies are liable to gain profit if the change is positive. On the other hand, if the change is negative companies would get exposed. This is an example of companies getting exposed to currency changes, but there are also variables like interest rates, commodity prices and equity prices.

Companies, which dwell in such an environment, have always been managing these risks. Initially these efforts were uncoordinated and ad hoc.

Nowadays, financial risk management is a complete science and is taken very seriously by corporations.

Foreign Exchange exposures

Vulnerabilities which corporations face in the world of finance, due to exchange rates constitute foreign exchange exposures. They are also termed as “currency exposures”. Our deliberation would be on three currency exposures namely Translation, Transaction, and Operational exposures.

Transaction Exposure

 It measures the change in the value of a deal from the time it was signed to the time transactions actually take place due to change in exchange rates. Companies which deal in international trade face the risk of currency exchange rates changing after a legal binding has been achieved. This variation will cause a lot of loss to the effected firm. This form of exposure is of short term in duration because the effects stay there till the transaction of the binding happens. Transaction exposure refers to the contractual cash flows involving an actual exchange transaction.

Companies, which receive or pay in foreign currency, are especially susceptible to this exposure. These companies have different reporting currencies. If there is a change in the foreign and the reporting currency it will affect the amount of reporting currency in the transaction. A company with net receivables in a foreign currency is prone to losses in transaction if the foreign currency weakens in the exchange rate. Conversely, a company with net liabilities in a foreign currency will gain in the same situation.

Operating Exposure: (Competitive Exposure, Strategic Exposure, Economic Exposure)

This exposure deals with the estimation of change in the value of a firm, due to an expected cash flow change, incurred due to an un expected change in exchange rates (Change in prices, increase/decrease in sales volume etc).

The extent to which the future trading of a corporation or its assets and liabilities may be affected by an unexpected change in its operating environment is known as Operating Exposure. Operating exposure relies heavily on the relative pricing. If there is a change in the relative pricing because of any change in the exchange rate, the operating change in the cash flow is referred to as economic exposure (operating exposure). The definition of operating exposure caters for the value of assets as well as flow of cash that is expected.

Translation Exposure (Accounting Exposure)

It is the change in the owner’s capital due to translation of foreign currencies to a single one. Whenever a company’s assets, debts, loans and income will change in its amount because of change in the exchange rate is known as Translation Exposure. This is a particular phenomenon for corporations, which have their denomination in foreign currency. Responsibility lies heavily with the accountants, which save the firm from this exposure by giving a consolidated statement in the financial sheet. They also utilize cost accounting procedures. In many cases this exposure is recorded in the statements of the company as gain or a loss after an exchange rate.

Translation exposure exists when the financial statements of a foreign branch must be translated into the currency in which the parent firm is operating, so they can be incorporated into the parent company’s financial sheets by consolidation, equity or the combination method. Translation exposure is also referred as accounting exposure. The root of this exposure is the difference in exchange rates between the time of consolidation and there effect in the value of the company’s assets and liabilities which are abroad.

An exposed item is the one that is law bided by accounting rules to be translated according to the current exchange rates or the rate of the consolidation date. An unexposed item is bided by the exchange rate at which that item was acquired. A company with assets that are exposed surplus then the liabilities in a foreign land is vulnerable to translation losses from decrease in the value of the foreign currency between two financial years. The situation would be the same if the liabilities were more and there is an appreciation in the foreign currency.

Distinction between the foreign exchange exposures

Although these exposures seem closely related, but on close examination they do have differences. Differences maybe in the definition as well as the their area of effect. Operating exposure is different from the translation exposure from the core. It involves giving a predetermined value to all the future cash flows, and then it measures fluctuations in the exchange rate on all operational cash flows, whether a transaction has taken place or not.

Translation exposure has their profits and losses either directly on the cash flow or indirectly on the stockholders equity, financial assets, whereas transaction exposure has direct bearing on the cash flow.  

In terms of effect Transaction exposure is of short term whereas Translation and Operating exposure have long-term effects. There is also a significant difference in the area that these exposures encompass. Transaction exposure is limited to the particular deal, which has taken place. On the other hand, translation exposure focuses on a wider spectrum like Stockholders equity, liabilities, and assets which ever have to be converted in to a single currency. Operating exposures encompass the widest of the spectrum, assets, all future cash flows, liabilities and there effect is the longest. Understandably there are a variety of factors, which can influence the operating exposures, like cost of raw material, pricing, and the volume of sales.

The major distinction of the operating exposure is that, whereas Translation and Transactional exposures are limited to the individual corporation, but economic exposure has to cater for the effects of the exchange rate on its competitors.

Another major difference once comparing accounting and operating exposure is that the former represents an exposure, which has happened, and latter caters for future exposure.

Measurement of Foreign Exchange exposures

Foreign exchange exposures measure the profit margin, net cash flow, and the market value of a firm to vary according to the change in the exchange rates.

Measurement of Transaction exposure

Measurement of transaction exposure is fairly easy. It is measured from currency to currency.  The amount of the contractually fixed list is calculated. The final payment according to the latest exchange rate for the currency in which the amount has to be paid is calculated. The exposure is the difference between the two.

Measurement of Operating Exposure

Measuring of the operating exposure is a tedious task and requires a lot of planning. Measurement of the operating exposure requires that we analyze and forecast corporations future transaction exposures together with the future exposures that the corporations competitors and to be competitors will face. Let us assume that a company A has X number of transactions from its present and future dealings abroad. The sum of these future transaction exposures would give a strong indication of the cash flow, as the exchange rate changes. Company A’s worth competitiveness depends upon its cash flow and whether or not it has the capability to manage these transactions better then its competitors.

Operating exposures takes into account the long term goal of the firm. It measures two types of cash flows:

Operating cash flows

Operating cash flow constitutes payments for services, goods, and rent. It also includes payments of royalties, license fees, and management fees.

Financial cash flows         

These are payments for the inter company loans and liabilities. They also include payment of stockholder equity.

Measurement of Translation exposure

Accounting exposure is perhaps the easiest of exposures that can be measured. For measuring the current exchange rate should be known, then the difference between the local and the reporting currency is calculated.

Hedging

Corporations possessing individual investor’s money are viable to exposure by fluctuations in all kinds of financial retailing, as a natural by-product of their financial activities. Financial retailing includes foreign interest rates, commodity prices, exchange rates, and equity prices. The effect of changes in these prices has a magnanimous effect on the reported earnings. Its common knowledge companies reporting reduced or enhanced financial statements owing to fluctuating commodity prices or gain due to favorable exchange rates.

Hedging in the general sense is a company entering or creating a transaction, whose sensitivity to fluctuation in financial retailing offsets their vulnerability in their core business. Hedging involves a lot of planning and by no means is an easy exercise. Another major reason for hedging the exposure of the firm to its financial risk is to increase or sustain the competitiveness of the corporation.

It’s a world of financial competition and companies can not live in isolation.. they compete with other corporations domestically as well as internationally, especially between companies that produce similar products in the global market. Take the example of a pharmaceutical company that has its competition with domestic firms and also competes with other international pharmaceutical companies.

Simple hedging techniques can render a company to effectively close in a deal or transaction at a predetermined exchange rate and minimize the risk of transaction profits and losses between the signing of transaction and the settlement date.

To elaborate a US company was due for payment of 10 million pounds on May 1. Constant fluctuation of exchange rate was a problem which company was likely to face. Risk could have given profit but on the other hand there was equal chance of loss. To alleviate this problem the company decided to hedge a forward contract with the bank for the conversion of 10 Million pounds at a fixed rate of 1.7$/pound. So, after receiving the payment of 10 million pounds from its customers it simply got them converted on the pre determined contract with bank.

Different hedging strategies are employed while different exposures are encountered. Below are mentioned few of the strategies employed while tackling Foreign exchange exposures.

Hedging of Transaction exposure

There are various ways of protecting against a transaction exposure including clauses in the contract, which keep prices fixed, forward contracts, various currency options etc.

  • Forward market hedge: The above-mentioned example is of a forward contract where company had to receive payments in a foreign currency. So, in the hindsight they make a deal with the bank on the conversion of the same amount, at a fixed rate.
  • Money market hedge: In this hedge company refers to the money market, they either borrow or lend money from the money market, which is definitely interest tagged. Convert that amount according to the existing spot rate. Then invest that money for a specific time period, which generally coincides with receivables of the foreign currency. Then give that loan + interest back. Thee are several variables attached with this transaction like the spot rate at which loan was converted, secondly the investment has to be sound otherwise this method will backfire.
  • Risk shifting: As the name suggests this method shifts the risk equally between the companies in which transaction has to take place. Company will lay down the price of their export (generally strong currency), and import in weak currency. This is almost a foolproof method provided that the companies are well informed. This method has a net zero sum gain as exports and imports value are equal.
  •  Pricing decisions: This method is used where a company imports or exports on credit and the contractual obligation connects them with the forward rate but not spot rate.
  • Exposure netting: In this process MNC’s choose to transact in currencies where there are minimum chances of exposure. Choice of currencies is determined by the amount of fluctuation they go through. In this case more stable currencies are preferred. Corporations perform netting (choosing currencies which are not related positively). Effect of one currency exposure is reduced by the exposure in another currency.
  • Currency risk sharing: customizing a hedge contract that has a Price Adjustment clause evolves this type of sharing. Contractual partners draw a base price, which is decided in consensus. Base price caters for most of the exchange fluctuations. Partners decide to share any exposure risk beyond a neutral zone. If the exchange rate fluctuation is less and stays within the neutral zone then what ever profit or loss it would not be shared.
  • Cross hedging: This method is useful where a forward contract is not available in a desired currency. Solution to the problem is that a cross hedge is created in a currency which is related. Critical factor of this solution is that a correlation has to exist between the two currencies.

Hedging of Translation exposure

Following are the methods by which translation exposure can be effectively curtailed.

  • Adjusting fund flows: We already know that translation exposure encompasses cash flow, assets, liabilities which have to be converted to another currency for the purpose of reporting. A helpful method of hedging the cash flow problem is changing the currencies or their amounts of the currency, which is functional by the parent or its subsidiaries. This method would reduce reporting currencies cash flow.
  • Forward contracts: This method is similar to the one, which was employed while catering for transaction exposure. The main difference is that instead of a transaction, an offsetting asset or liability is created for the loss or profit of translation respectively.
  • Exposure netting: The method is similar to the one employed early for transactions. Another currency is employed to create an offsetting effect. The effect has to be opposite to the one created by translation.

Hedging of operating exposure

Hedging of operating exposure is far more important for a firm’s long health then transaction and translation exposure combined.

  • Diversifying operations: Diversifying operations means increasing the “breadth” of the firm. It will give an early and comprehensive indication of changes in the world market, and thus giving better reaction time to the managers.
  • Diversifying financing: Its synonymous to the previous point. A firm should diversify its cash flow in more then one market and more currencies.
  • Pro-active Management: Operating exposure demands that a paradigm shift in the policies should be done to remove any chances of currency exposures.
  • Matching currency cash flows: If there is a continuous long exposure to a particular currency, then it can be solved by taking a loan in that currency.
  • Risk sharing: The method is same as that was employed in transaction exposure.
  • Back to back loans: This method is also known as credit swap. In this method two companies in different companies borrow each other’s currency for a specified period of time. This transaction is generally done on independent rates ( detached from Forex), but spot rates can be used.
  • Currency Swaps: The major difference between this method and back-to-back loans is the documentation. This method is not reflected in the balance sheet. Process is similar to credit swapping
  • Leads and Lags: This method caters for operating exposure by re-timing its payments of foreign currency. By lead it means that payment is made early and vice versa for lag.
  • Re invoicing Centers: The method involves a “middle-man” (separate subsidiary), creating a link between the parent or related unit and its subsidiaries in close geographic region. It gives freedom to all subsidiaries to function in their currency and the transaction exposure is with the center.

Conclusion

It is the era of “globalization” and international products are available at our doorsteps. This is an opportune time for MNCs to prosper and strengthen their foothold. Consumers are also benefiting equally from this competitive environment, in terms of better quality of products and cheap prices.

Exchange of currencies in this scenario is at an all time high for obvious reasons. Effect of these currency transactions is creating anomalies in the form of exposures. In places, where there are dealings in millions these exposures gain enormous importance. MNCs by now have realized these problems and are taking pro-active measures to resolve them. Those companies which have not given exposures there due importance will suffer and lag behind in this financial world.

References

  1. Choi, J.J. 1986. A model of firm valuation with exchange rate exposure. Journal of International Business Studies.
  2. Shapiro, A.C. 1975. Exchange rate changes, inflation, and the value of the multinational corporation. Journal of Finance
  3. Allen, Linda & Christos Pantzalis. 1996. Valuation of the Operating Flexibility of Multinational Corporations. Journal of International Business Studies.
  4. Buckley, Peter & Mark C. Casson. 1998. Models of the Multinational Enterprise. Journal of International Business Studies
  5. Greene, William H. 2000. Econometric Analysis. 4th Edition, New Jersey: Prentice Hall
  6. He, Jia & Lilian Ng. 1998. The Foreign Exchange Exposure of Japanese Multinational Corporations. The Journal of Finance
  7. http://business.fullerton.edu/finance/jgreco/fin370/CHAPTER10.ppt
  8. Jesswein, Kurt, Chuck C. Y. Kwok, and William Folks, Jr. “Corporate Use of Innovative Foreign Exchange Risk Management Products.” Columbia Journal of World Business Fall 1995
  9. Stulz, Rene, and Clifford Smith. “The Determinants of Firms’ Hedging Policies.” Journal of Financial and Quantitative Analysis (December 1985)

Cite this essay

Finance Topics of Translation, Transaction and Operating Exposures. (2017, Mar 04). Retrieved from https://studymoose.com/finance-topics-of-translation-transaction-and-operating-exposures-essay

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