Exposure of Foreign Exchange Risk

Foreign Exchange Exposure is the sensitivity of the real domestic currency value of assets, liabilities, or operating incomes to unanticipated changes in exchange rates EXPOSURE OF FOREIGN EXCHANGE RISK Foreign Exchange Risk is measured by the variance of the domestic - currency value of assets, liabilities, or operating income that is attributable to unanticipated changes in exchange rates EXPOSURE OF FOREIGN EXCHANGE RISK EXPOSURE OF FOREIGN EXCHANGE RISK • Three important Facts: -Changes in the nominal exchange rate are not offset by corresponding changes in prices at home and abroad: there is real exchange rate risk - Neither the forward rate is successful in forecasting the exchange rate nor are other fundamental variables - Given the various market imperfections in

the real world, hedging exchange rate risk can lead to an increase in the value of the firm • Three types of Exposure: - Translation or Accounting Exposure - Transaction or Contractual Exposure - Operating or Economic Exposure EXPOSURE OF FOREIGN EXCHANGE RISK EXPOSURE OF FOREIGN EXCHANGE RISK Exchange Rate Shock 1. Translation or Accounting Exposure ∆in FE rate ∆in Accounting statements 3. Operating Exposure ∆in FE rate ∆in future cash flows 2. Transaction Exposure ∆in FE rate ∆in outstanding obligations • Three types of Exposure: • Translation or Accounting Exposure: Is the sensitivity of the real domestic currency value of Assets and Liabilities, appearing in the financial statementsto unanticipated changes in exchange rates EXPOSURE OF FOREIGN EXCHANGE RISK • Transaction or Contractual Exposure: Is the sensitivity of the real domestic currency value of Assets and Liabilities, when assets and liabilities are liquidatedwith respect to unanticipated changes in exchange rates for exporting, importing, or import- substituting firms EXPOSURE OF FOREIGN EXCHANGE RISK • Economic or Operating Exposure: Is the sensitivity of the real domestic currency value of Assets and Liabilities, or future operating incomes to unanticipated changes in exchange rates EXPOSURE OF FOREIGN EXCHANGE RISK • Why Accounting Exposure?: - Managers, analysts and investors need some idea about the importance of the foreign business. Translated accounting data give an approximate idea of this. - Performance measurement for bonus plans, hiring, firing, and promotion decisions. - Accounting value serves as a benchmark to evaluate a discounted-cash flow valuation. - For income tax purposes. - Legal requirement to consolidate financial statements. TRANSLATION OR ACCOUNTING EXPOSURE • Four Methods to translate foreign currency to home currency: 1. Current/Non-Current Method: All current assets and current liabilities are translated at current exchange rate 2. Monetary/ Non-Monetary Method: All monetary assets and liabilities are translated at current exchange rate 3. Temporal Method: Same as Monetary/Non-Monetary method BUT inventory may be translated at current exchange rate IF it is shown at market value 4. Current Rate Method: All balance sheet and income statement items are translated at current exchange rate TRANSLATION OR ACCOUNTING EXPOSURE 1. FASB 8 Temporal Method: Similar to Monetary/Non-Monetary Method except treatment of inventory. 2. FASB 52 Current Rate Method: Similar to Current Rate Method. It allows cumulative translation adjustment account, functional currency and reporting currency. TRANSLATION OR ACCOUNTING EXPOSURE • Methods used in the US: TRANSLATION OR ACCOUNTING EXPOSURE Unlike the Economic and...

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