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  • Pages: 8 (4154 words)
  • Published: October 18, 2018
  • Type: Research Paper
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1. Measuring and Managing Foreign Exchange Risk.

The degree to which a company is affected by currency fluctuations is referred to as foreign exchange exposure. (Shapiro, 2003). Foreign Exchange exposure can be divided into two main types-Accounting exposure and Economic exposure. Transaction reflects the firm’s risk to exchange rate movements regarding its balance sheet assets and liabilities... The terms of these transactions are established and settled at a given time period and their exposure can easily be measured by accounting systems (Mullem & Verschoor, 2005). The implicit or explicit contractual agreements have to be taken into account as well as when measuring the overall exchange rate exposure. (Mullem & Verschoor, 2005). The last component of a company’s exposure to currency fluctuations is called competitive or economic exposure. As exchange rate variations affect the relative prices of goods sold in different countries, they affect a firm’s competitive position and indirectly influence its economic environment and future growth possibilities (Mullem & Verschoor, 2005). Although a firm may hedge its foreign exchange contracts, limiting its transaction exposure, economic exposure is difficult to estimate and further, hedge. Economic exposure arises because future profits from operating as importer or exporter depend on exchange rates, and due to its nature, this type of exposure is difficult to mute. (Faff & Iorio 2001, Mullem & Verschoor).

(Mullem & Verschoor, 2005). However, there is greater complexity between the relationship between exchange rate fluctuations and competitiveness and this leads to difficulty in correctly estimating economic exposure and he


nce hedging it efficiently (Mullem & Verschoor, 2005).

Firms that do business abroad must be ready to account for changes in exchange rates that lead to variability in their cash flows. (Solt & Lee, 2001). Transaction exposure reflects the risk that exchange rates change between the time a transaction is recorded and the time actual receipt of cash or payment of cash is made. (Solt & Lee, 2001). Due to its short-term nature futures and forwards can be used to hedge transaction exposure and thereby eliminate its influence on the value of a firm. (Solt & Lee, 2001). Economic exposure on the other hand is the long-term effect of exchange rate changes on the future cash flows and thereby on stock returns. (Solt & Lee, 2001).

The table below summarises the different types of exchange rate risk faced by firms:

Comparison of translation, transaction and operating Exposure

Translation exposure Operating exposure

Fluctuations in income statements items and book values of balance sheet assets and liabilities that are caused by exchange rate fluctuations. Subsequent exchange rate gains and losses are determined by accounting rules and reflect nominal gains and losses only. The measurement of accounting exposure is retrospective that is it is applied to prior period accounts. Its only impact is on liability and assets that already exist. Movements in the amount of future operating cash flows occurring as a result of fluctuations in exchange rates. Subsequent exchange translation gains and losses are determined by changes in the firm’s future competitive position and are real. The measurement of operating exposure is prospective That is it is based on future periods unlik

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the retrospective measurement applied to translation exposure. The impacts of operating exposure are more serious than those of translation exposure as it affects revenues and costs associated with future sales.

Taken from Shapiro (2003).

N.B: Transaction exposure is common to both translation and operating exposure. That is why I have not mentioned it in the table.

Measuring Foreign Exchange Exposure

Shapiro identifies four methods of measuring currency translation gains and losses or translation exposure. They include: the current/concurrent method, the monetary/nonmonetary method the temporal method and the current rate method.

The current/non-current Method

The current method translates all the foreign subsidiary’s assets and liabilities in the home country currency at the current exchange rate. Non-current assets and liabilities are translated at their historical exchange rates, that is, the rates prevailing at the period the assets were purchased or the period the liabilities were incurred. The translation in the income statement is done by applying the average exchange rate of the period except for those revenue and expense items associated with non current assets and liabilities. (Shapiro, 2003)

Depreciation expenses are translated at the at the historical exchange rate of the corresponding asset in the balance sheet, thereby making it possible for different income statement items with same expiration dates to be translated at varying exchange rates (Shapiro, 2003).

The Non-Monetary/Monetary Method

Under this method, monetary assets and liabilities are separated from non-monetary assets and liabilities. Monetary assets include assets such as cash and accounts receivable whereas monetary liabilities include accounts payable and long-term debt. (Shapiro, 2003). Non-monetary items include trading stock, long-term investments and fixed assets such as land property, plant and equipment (PPE). After separating the assets and liabilities into monetary and non-monetary assets, the current rate is then applied to translate the monetary assets whereas the non-monetary assets are translated by applying the historical rates.

The translation of income statement items is done by applying the average exchange rate except for revenue and expense items related to monetary assets and liabilities. The monetary items are translated using the current rate as earlier stated above. (Shapiro, 2003).

The Temporal Method

Under this method, the same procedures applied for the translation of the balance sheet and income statement items using the monetary/non-monetary method apply. However, the only difference is that inventory which is normally translated at the historical cost can be translated at the current rate if the inventory is shown on the balance sheet at the market values. (Shapiro, 2003).

Current Rate Method

The current rate method translates all income statement and balance sheet items using the current rate and if the firm’s foreign-currency-denominated assets exceed its foreign-currency-denominated liabilities, then depreciation in the home currency value will result in a loss while an appreciation in the home currency value will result in a gain.

Managing transaction and Economic Exposure.

Transaction exposure can be managed through well-structured hedging strategies. Hedging refers to the process of establishing an offsetting currency position so as to lock in a home currency value for the currency exposure thus, eliminating risk associated with movements in the currency. Locking in a home

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