INTERNATIONAL FINANCE – PART 3
OPPERATING EXPOSURE MANAGEMENT
INTRODUCTION
A Δ in foreign exchange affects individual transactions, competitiveness, firm value as a
whole and the survival of the firm.
Transaction exposure & operating exposure
- due to unexpected Δs in future cfs due to an unexpected exchange rate Δ
- called economic exposure
- transaction exposure → a contractual obligation
- operating exposure → focuses on foreign currency cfs generated from operation
that may change because of a Δ in exchange rates
TRANSLATIONAL EXPOSURE
- aka translation risk
“The risk that a co's equities, assets, liabilities, or income will change in value as a result of
exchange rate Δs.”
Occurs when a firm denominates a portion of its E,A,L, or income in a foreign currency.
Managed by employing a balance sheet hedge strategy
- balance sheet hedge → where a co matches its A in foreign currency with = amounts
of L in the same foreign currency such that its net exposure in each currency is 0
,Managing translation exposure
Definition:
- effect that unexpected changes in currency will have on consolidated financial
reports of the MNC
- the exposure is recorded as a net exposure
Example:
- Usave a sub of Shoprite Checkers in Zambia records a Z100M receivable in its books:
▪ At ZK1000/ZAR, SC will record R100K as a receivable
▪ At ZK2000/ZAR, SC will record R50K as a receivable
- there is no cash flow impact, this R50K “loss” is merely a paper loss
- this “paper loss” is referred to as a translation exposure → could also be positive
1. Monetary/non-monetary method of translation
- all monetary balance sheet items of foreign sub are translated at current exchange
rate
- items incl balances such as cash, marketable securities, acc receivable & acc payable
- all other items (non-monetary items) of balance sheet are translated at their
historical exchange rate
▪ rate at which they were first recorded
- most income statement items are translated at the average exchange rate for the
period
▪ BUT non-monetary items such as COS & dep are translated at historical cost.
2. Balance sheet hedge
- eliminates the mismatch btw net assets & net liabilities denominates in the same
currency
3. Derivatives hedge
- E.g. the use of forward contracts with a maturity of the reporting period to attempt
to manage the accounting numbers
- High risk speculation
TRANSACTION EXPOSURE
“The risk that currency exchange rates will fluctuate after a firm has already undertaken a
financial obligation.”
- value of contract may change before being settled
, E.g. a domestic company signs a contract with a foreign company. The domestic company,
the one that is going to receive payment in a foreign currency, now has transaction
exposure. The value of the contract is exposed to the risk of exchange rate fluctuations.
OPERATING EXPOSURE
- impact of Δ in foreign exchange rate on firm value
- difficult to measure
- affects firm’s present & future cfs
▪ affects the value of the firm (may make firm uncompetitive)
Measures the Δ in expected firm value resulting from an unexpected Δ in exchange rates
- expected changes in exchange rates can be calculated through parity conditions
▪ the rest is unexpected
- firm value unaffected by expected changes (should be incorporated in financial plan)
Difficult to manage
- management involves management of company’s marketing, production & sourcing
▪ allows co to change these activities to take advantage of favourable exchange
rate movement
▪ reduces the negative impact of adverse exchange rate movement
- management requires concerted effort at an operational & strategic level
Attributes
- operating exposure management is NB for the long-term sustainability of a business
- operating exposure is subjective → it depends on estimates of future cf changes
over an arbitrary time horizon
- management’s responsibility to plan for operating exposure because it relates to the
interaction of strategies in finance, marketing, purchasing and production.
OPPERATING EXPOSURE MANAGEMENT
INTRODUCTION
A Δ in foreign exchange affects individual transactions, competitiveness, firm value as a
whole and the survival of the firm.
Transaction exposure & operating exposure
- due to unexpected Δs in future cfs due to an unexpected exchange rate Δ
- called economic exposure
- transaction exposure → a contractual obligation
- operating exposure → focuses on foreign currency cfs generated from operation
that may change because of a Δ in exchange rates
TRANSLATIONAL EXPOSURE
- aka translation risk
“The risk that a co's equities, assets, liabilities, or income will change in value as a result of
exchange rate Δs.”
Occurs when a firm denominates a portion of its E,A,L, or income in a foreign currency.
Managed by employing a balance sheet hedge strategy
- balance sheet hedge → where a co matches its A in foreign currency with = amounts
of L in the same foreign currency such that its net exposure in each currency is 0
,Managing translation exposure
Definition:
- effect that unexpected changes in currency will have on consolidated financial
reports of the MNC
- the exposure is recorded as a net exposure
Example:
- Usave a sub of Shoprite Checkers in Zambia records a Z100M receivable in its books:
▪ At ZK1000/ZAR, SC will record R100K as a receivable
▪ At ZK2000/ZAR, SC will record R50K as a receivable
- there is no cash flow impact, this R50K “loss” is merely a paper loss
- this “paper loss” is referred to as a translation exposure → could also be positive
1. Monetary/non-monetary method of translation
- all monetary balance sheet items of foreign sub are translated at current exchange
rate
- items incl balances such as cash, marketable securities, acc receivable & acc payable
- all other items (non-monetary items) of balance sheet are translated at their
historical exchange rate
▪ rate at which they were first recorded
- most income statement items are translated at the average exchange rate for the
period
▪ BUT non-monetary items such as COS & dep are translated at historical cost.
2. Balance sheet hedge
- eliminates the mismatch btw net assets & net liabilities denominates in the same
currency
3. Derivatives hedge
- E.g. the use of forward contracts with a maturity of the reporting period to attempt
to manage the accounting numbers
- High risk speculation
TRANSACTION EXPOSURE
“The risk that currency exchange rates will fluctuate after a firm has already undertaken a
financial obligation.”
- value of contract may change before being settled
, E.g. a domestic company signs a contract with a foreign company. The domestic company,
the one that is going to receive payment in a foreign currency, now has transaction
exposure. The value of the contract is exposed to the risk of exchange rate fluctuations.
OPERATING EXPOSURE
- impact of Δ in foreign exchange rate on firm value
- difficult to measure
- affects firm’s present & future cfs
▪ affects the value of the firm (may make firm uncompetitive)
Measures the Δ in expected firm value resulting from an unexpected Δ in exchange rates
- expected changes in exchange rates can be calculated through parity conditions
▪ the rest is unexpected
- firm value unaffected by expected changes (should be incorporated in financial plan)
Difficult to manage
- management involves management of company’s marketing, production & sourcing
▪ allows co to change these activities to take advantage of favourable exchange
rate movement
▪ reduces the negative impact of adverse exchange rate movement
- management requires concerted effort at an operational & strategic level
Attributes
- operating exposure management is NB for the long-term sustainability of a business
- operating exposure is subjective → it depends on estimates of future cf changes
over an arbitrary time horizon
- management’s responsibility to plan for operating exposure because it relates to the
interaction of strategies in finance, marketing, purchasing and production.
