An overview of FX Exposure Risk: Assessment and Management

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1 An overview of FX Exposure Risk: Assessment and Management

2 June 2015

3 1. Introduction This report presents an overview of various types of foreign currency exposure, their impact on the financial statements, and management. Foreign currency exposure is a financial risk posed by an exposure to unanticipated changes in the exchange rate between two currencies. Foreign Exchange risk arises when a company holds assets or liabilities in foreign currencies and affects the earnings and capital of the entity due to the undesired and unanticipated fluctuations in the exchange rates. Foreign currency exposure is equal to the variance between the functional (or measurement or domestic) currency and the foreign currency. Types of FX Exposure: The term exposure refers to the extent to which a firm is affected by exchange rate changes. Exposure determines the potential magnitude of the risks that accompany currency fluctuations. A distinction is commonly drawn between accounting exposure, which refers to the changes in financial statements that occur due to currency changes, and economic exposure, which refers to real economic changes. Accounting exposure may or may not have economic consequences. Economic exposure, in turn, is commonly divided into two categories: Operating exposure is the economic exposure created when the operations of a firm generate foreigncurrency-denominated cash flows. Transaction exposure is the economic exposure created when contractual obligations are denominated in foreign currencies. The primary difference between operating and transaction exposure is that with transaction exposure the amount of the currency flows is known in advance. For this reason, the methods firms may use to manage each type of exposure will differ. The table below illustrates in a snapshot the different types of exposures across time and their implications: Transaction or Contractual Exposure Outstanding obligations Translation or Accounting Exposure Economic or Operating Exposure Accounting statements Future cash flows Time e Point in time when Exchange Rate incident occurs

4 2. Translation Exposure Translation or Accounting Exposure is the sensitivity of the real domestic currency value of Net Assets (Assets minus Liabilities) appearing in the financial statements to unanticipated changes in exchange rates. Thus, translation exposure affects the balance sheet and the income statement. According to IAS 21, the results and financial position of an entity 1 are translated into a different presentation currency using the following procedures: i. Assets and liabilities for each balance sheet presented (including comparatives) are translated at the closing rate at the date of that balance sheet. 2 ii. Income and expenses for each income statement (including comparatives) are translated at exchange rates at the dates of the transactions; and iii. All resulting exchange differences are recognized in other comprehensive income 3. Item Rate How to present Differences Assets (including goodwill) and liabilities Income and expenses Share capital Closing rate Historical rate (average) Not specified in IAS In Other Comprehensive income (OCI) as a separate component of Equity Example 1.1 An entity commenced business on January 1, 2013, with an opening share capital of $2 million. The income statement and closing balance sheet follow: Income Statement for the year ended December 31, 2013 (in million USD) Revenue 32 Cost of sales (10) Gross profit 22 Distribution costs (8) Administrative expenses (2) Profit before tax 12 Tax expense (4) Profit for period 8 1 Under the condition that the functional currency is not the currency of a hyperinflationary economy. 2 This would include any goodwill arising on the acquisition of a foreign operation and any fair value adjustments to the carrying amounts of assets and liabilities arising on the acquisition of that foreign operation are treated as part of the assets and liabilities of the foreign operation. 3 According to IAS 1, Other comprehensive income comprises items of income and expense (including reclassification adjustments) that are not recognized in profit or loss as required or permitted by other IFRSs. The components of other comprehensive income include: a) changes in revaluation surplus (see IAS 16 Property, Plant and Equipment and IAS 38 Intangible Assets); b) actuarial gains and losses on defined benefit plans recognized in accordance with paragraph 93A of IAS 19 Employee Benefits; c) gains and losses arising from translating the financial statements of a foreign operation (see IAS 21 The Effects of Changes in Foreign Exchange Rates); d) gains and losses on re-measuring available-for-sale financial assets (see IAS 39 Financial Instruments: Recognition and Measurement); e) the effective portion of gains and losses on hedging instruments in a cash flow hedge (see IAS 39).

5 Balance Sheet as of December 31, 2013 (in million USD) Share capital 2 Retained earnings 8 Equity Trade payables Total equity and liabilities 14 Land (non-depreciable) acquired Dec 31, Inventories 4 Trade receivables 2 Total assets The functional currency is the dollar, but the entity wishes to present its financial statements using the euro as its presentation currency. The entity translates the opening share capital at the closing rate. The exchange rates in the examined period were: $1 = January 1, December 31, Average rate 1.5 In order to translate the financial statements from the functional currency to the presentation one, according to the procedures indicated earlier, we have: Income Statement for the year ended December 31, 2013 (in million EUR) Calculations Revenue 48 =32 x 1.5 Cost of sales (15) =(10) x 1.5 Gross profit 33 Distribution costs (12) =(8) x 1.5 Administrative expenses (3) =(2) x 1.5 Profit before tax 18 Tax expense (6) =(4) x 1.5 Profit for period 12 Balance Sheet as of December 31, 2013 (in million EUR) Calculations Share capital 4 =2 x 2 Retained earnings 12 from income statement above Translation gain (loss) 4 =16 12 (see also below) Equity 20 Trade payables 8 =4 x 2 Total equity and liabilities 28 Land (non-depreciable) acquired Dec 31, =8 x 2 Inventories 8 =4x 2 Trade receivables 4 =2 x2 Total assets 28

6 Calculation of translation gain (loss): If translated into euros, the retained earnings would be 16 million ($8 million x 2 ). As the income statement has been translated using the average rate, the profit is 12 million, creating a difference of 4 million. Note that this exchange difference is shown as component of equity and is not recognized in profit or loss. 3. Transaction Exposure Transaction exposure reflects the impact of settling outstanding obligations entered before into a change in the exchange rate, but settled after the change. Exposure would include all payables and receivables which appear on the balance sheet, as well as off-balance sheet items which represent commitments already entered into, which will create future receivables and payables. Unlike translation gains (losses) which require only a bookkeeping adjustment, transaction gains (losses) are realized as soon as the exchange rate changes. There are four main types of transactions from which contractual exposure arises: Borrowing or lending funds when repayment is to be made in a foreign currency. Purchasing or selling on credit goods or services when prices are stated in foreign currencies. Being a party to an unperformed foreign exchange forward contract. Otherwise acquiring assets or incurring liabilities denominated in foreign currencies. According to IAS 21, a foreign currency transaction should be recorded initially at the rate of exchange at the date of the transaction (use of averages is permitted if they are a reasonable approximation of actual). At each subsequent balance sheet date: Foreign currency monetary 4 amounts should be reported using the closing rate. Non-monetary 5 items carried at historical cost should be reported using the exchange rate at the date of the transaction. Non-monetary items carried at fair value should be reported at the rate that existed when the fair values were determined. Exchange differences arising when monetary items are settled or when monetary items are translated at rates different from those at which were translated when initially recognized or in previous financial statements, are reported in profit or loss in the period. However, exchange differences arising on a monetary item that forms part of a reporting entity s net investment in a foreign operation shall be recognized in profit or loss in the separate financial statements of the reporting entity or the individual financial statements of the foreign operation, as appropriate. In the financial statements that include the foreign operation and the reporting entity (e.g. consolidated financial statements when the foreign operation is a subsidiary), such exchange differences shall be recognized initially in other comprehensive income and reclassified from equity to profit or loss on disposal of the net investment. When a gain or loss on a non-monetary item is recognized in other comprehensive income, any exchange component of that gain or loss shall be recognized in other comprehensive income. Conversely, when a gain or loss on a non-monetary item is recognized in profit or loss, any exchange component of that gain or loss shall be recognized in profit or loss. Other Standards require some gains and losses to be recognized in other comprehensive income. For example, IAS 16 requires some gains and losses arising on a revaluation of property, plant and equipment 4 Monetary items are units of currency held and assets and liabilities to be received or paid in a fixed or determinable number of units of currency. Examples of monetary items are: Trade receivables and payables; Cash dividends recognized as a liability; Investments in debt securities; Deferred taxes; Pension and other employee benefits to be paid in cash; Provisions that are to be settled in cash. 5 Non-monetary items are all items that are not monetary items, i.e. non-monetary items do not have the right to receive or an obligation to deliver a fixed or determinable amount of units of currency. Examples of nonmonetary items are: Prepaid amounts for goods or services; Deferred income; Investments in equity instruments; Inventories and other fixed assets; Goodwill, patents, trademarks and other intangible assets.

7 to be recognized in other comprehensive income. When such an asset is measured in a foreign currency, IAS 21 requires the revalued amount to be translated using the rate at the date the value is determined, resulting in an exchange difference that is also recognized in other comprehensive income. Item Rate How to present Differences Monetary items Closing rate In profit or loss Non-monetary items with the exception of: Historical rate at historical cost Net investment in the foreign operation Non-monetary items Rate at the date when fair value at fair value was measured P&L OCI Example 2.1 ABC Corp. has its headquarters in USA and has a 100%-owned subsidiary in EU; ABC Europe. The functional currency of the subsidiary is the euro and the currency of the parent is US dollars. In Y-E 2013, the subsidiary s balance sheet was: Balance Sheet as of December 31, 2013 (in ) Cash 1,600,000 Accounts payable 800,000 Accounts receivable 3,200,000 S-T bank loan 1,600,000 Inventories 2,400,000 L-T debt 1,600,000 Net plant and equipment 4,800,000 Common stock 1,600,000 Retained earnings 6,200,000 Total 12,000,000 Total 12,000,000 Moreover, we have the following info: Inventories on hand were purchased during the immediately prior quarter when the average exchange rate was 1= $ Net plant and equipment were acquired at a past rate of 1= $ The exchange rate was 1= $1.2 on December 31, If the exchange rate drops by 16.67% to 1= $1, the gains (losses) will be: Assets In Euros Item Exchange rate ($/ ) In US Dollars Cash $1,600,000 Monetary $1,920,000 Accounts receivable 3,200,000 Monetary ,840,000 Inventories 2,400,000 Nonmonetary Not Exposed Net plant and equipment 4,800,000 Nonmonetary Not Exposed Total exposed assets (A) $5,760,000 Liabilities Accounts payable $800,000 Monetary $960,000 S-T bank loan 1,600,000 Monetary ,920,000 L-T debt 1,600,000 Monetary ,920,000 Total exposed liabilities (L) $4,800,000 Net exposed assets (A) - (L) $960,000 (x) Amount of currency depreciation (from 1.2 $/ to 1.0 $/ ) % Exchange gains (losses) -$160,000

8 The loss of $160,000 will be presented in the income statement affecting the net income. Example 2.2: Currency transaction that is settled during the same accounting period XYZ Limited, whose functional currency is, buys raw materials invoiced at $10,000 on January 1, This is a credit transaction. Exchange rate is: 1= $1.47. XYZ Limited records this transaction as follows: Dr. Purchases 6,803 Cr. Creditors 6,803 To record transaction for US $10,000 at exchange rate of 1 = $1.47. Now suppose that the entity pays to the creditors $10,000 on March 1, Exchange rate is: 1= $1.52. Dr. Creditors 6,803 Cr. Bank 6,579 Cr. Exchange gain 224 To record payment of US $10,000 at exchange rate 1 = $1.52. Exchange gain/loss is credited/charged to profit or loss. Example 2.3: Mark to market valuation of outstanding monetary item on the reporting date XYZ Limited, whose functional currency is, buys raw materials invoiced at $10,000 on April 1, This is a credit transaction. Exchange rate is: 1= $1.58. XYZ Limited records this transaction as follows: Dr. Purchases 6,329 Cr. Creditors 6,329 To record transaction for US $10,000 at exchange rate of 1 = $1.58. Now suppose that the entity did not settle the creditors of $10,000 on June 30, 2013, which is the second quarter reporting date. At June 30, 2013, the exchange rate is 1= $1.52. XYZ Limited has to value the amount due to the creditors, which is a monetary item, by applying the closing exchange rate of the reporting date. Dr. Exchange fluctuation loss 250 (= 6,579-6,329) Cr. Creditors 250 We derive the creditor new exposure at $10,000/1.52 = 6,579. To record exchange rate fluctuation on June 30, 2013: ($10,000/1.58) = 6,329 Exchange fluctuation gain/loss is credited/charged to profit or loss.

9 Management of economic- transaction exposure Transaction exposure is an economic exposure due to contractual obligations denominated in a foreign currency. When the contract produces foreign currency inflow, the company is said to be long in the currency. When the contract requires a foreign currency outflow, the company is said to be short in the currency. Managing transaction exposure is the process of generating currency inflows and outflows that moderate the long or short position a company faces in foreign currency. The term hedging in this context typically refers to actions that eliminate the exposure entirely. The simplest tools for hedging involve the use of forward markets and money markets. There are a number of other mechanisms that vary in cost and effectiveness. One important point is that large multinational firms may be in better positions to hedge against exposure and do so at a lower cost since they have control over many cash flows denominated in many currencies. 4. Economic Exposure Economic or Operating Exposure is the sensitivity of a company s future cash flows, foreign investments, and earnings to unanticipated changes in exchange rates and is long-term in nature. Economic exposure encompasses the immediate and potential impact of unexpected exchange rates changes on the cash flow generated and consequently, on the earning power of the company as a whole beyond the accounting period when these changes occurred. Operating exposure occurs as a result of foreign-currency-denominated operations. These operations can take many forms and the consequences of such exposure are dramatic. A foreign operation that is a complete subsidiary (manufacturing, purchasing, and selling in the foreign country) will create exposure only for the amount of future profits. For a company that manufactures domestically but sells overseas, the whole revenue stream is exposed. Conversely, for a company with foreign production but domestic sales, the whole cost stream is exposed. Interestingly, even a firm whose operations are entirely domestic will have operating exposure to the extent that its domestic competitors have foreign-currency-denominated operations. Economic Exposure Strategic Exposure Competitive Exposure In theory, economic exposure can arise only from unexpected changes in exchange rates. Expected changes would be factored in by the financial markets and would be reflected in inflation and interest rate differentials between the country of the parent company and the country of the affiliates in accordance with the Purchasing Power Parity (PPP) and the International Fisher Effect. If financial markets are not efficient to permit these adjustments to be made, the impact of expected exchange rate changes would have been already reflected in the expected cash flows generated by the affiliates and on the market value of the parent company. Example 3.1 ABC Corp. has its headquarters in USA and has a 100%-owned subsidiary in EU; ABC Europe. Economic risk arises from the unexpected change in the value of euro, which is the currency of economic consequence for the European subsidiary. An unexpected depreciation or appreciation in the value of the euro alters both the competitiveness of the subsidiary and the financial results which are consolidated with the parent company. For ABC Europe we have the following information: It uses European material and labor; All sales are invoiced in euros and the average collection period is 90 days;

10 Inventory is equal to 25% of annual direct costs; Depreciation on plant and equipment is 600,000 per year. Plant and equipment, common stock and long-term debt were acquired at a past rate of 1= $1,276; Corporate income tax is equal to 34%; ABC Europe can expand or contract production volume without any significant change in per-unit direct costs or in overall general and administrative expenses; The cost of capital is 20%. We assume that exchange rate was 1= $1.2 on December 31, 2013 and on January 1, 2014 it drops to 1= $1. Three cases are examined: 1. Case 1: no change in costs, prices, sales volume; 2. Case 2: increase in sales volume only; 3. Case 3: increase in sales price only. Balance Sheet as of December 31, 2013 (in ) Cash 1,600,000 Accounts payable 800,000 Accounts receivable 3,200,000 S-T bank loan 1,600,000 Inventories 2,400,000 L-T debt 1,600,000 Net plant and equipment 4,800,000 Common stock 1,600,000 Retained earnings 6,200,000 Total 12,000,000 Total 12,000,000 Assumptions Base case Case 1 Case 2 Case 3 Exchange rate, $/ Sales volume (units) 1,000,000 1,000,000 2,000,000 1,000,000 Sales price per unit Direct cost per unit Annual cash flows before adjustments Sales revenue 12,800,000 12,800,000 25,600,000 15,360,000 Direct cost of goods sold 9,600,000 9,600,000 19,200,000 9,600,000 Cash operating expenses (fixed) 890, , , ,000 Depreciation 600, , , ,000 Pretax profit 1,710,000 1,710,000 4,910,000 4,270,000 Income tax expense 581, ,400 1,669,400 1,451,800 Profit after tax 1,128,600 1,128,600 3,240,600 2,818,200 + Depreciation 600, , , ,000 Cash flow from operations (in ) 1,728,600 1,728,600 3,840,600 3,418,200 Cash flow from operations (in $) $2,074,320 $1,728,600 $3,840,600 $3,418,200 Adjustments to working capital for 2014 and 2018 caused by changes in conditions Accounts receivable 3,200,000 3,200,000 6,400, ,840,000 7 Inventory 2,400,000 2,400,000 4,800, ,400,000 8 Total 5,600,000 5,600,000 11,200,000 6,240,000 6 Double sales volume requires double investment in accounts receivable and in inventory. 7 The increase in sales price per unit leads to increased investment in accounts receivable. 8 The investment in inventory remains the same since annual direct costs do not change.

11 Change from base conditions in 2014 ( ) 0 5,600, ,000 Change from base conditions in 2014 ($) $0 $5,600,000 $640,000 Year Year-End cash-flows 2014 $2,074,320 $1,728,600 -$1,759,400 9 $2,778, $2,074,320 $1,728,600 $3,840,600 $3,418, $2,074,320 $1,728,600 $3,840,600 $3,418, $2,074,320 $1,728,600 $3,840,600 $3,418, $2,074,320 $1,728,600 $9,440, $4,058, Year Change in Year-End cash-flows from Base conditions $345,720 -$3,833,720 $703, $345,720 $1,766,280 $1,343, $345,720 $1,766,280 $1,343, $345,720 $1,766,280 $1,343, $345,720 $7,366,280 $1,983,880 Present Value of incremental Year-End cash-flows -$1,033, $2,866, $3,742, Management of economic- operating exposure One can use forward markets and money markets to partially hedge operating exposure, but the cost of this may be exorbitant. Most often, a company employs strategic decisions regarding revenues (pricing and marketing) and costs (production and input decisions) to manage operating exposure. No method can be completely effective, but the extent of operating exposure in many countries requires that all possible actions be taken and that every alternative be explored, including: Revenue management: A company must often select the market to which it offers a product or service. This means a company can choose a country or market segment within a country. Managing operating exposure can be accomplished by careful market selection. For example, a company can export to a stable country or sell to a market within a country that is not very price-sensitive. In the latter case, the company can pass on any costs from price movements to its customers. When currency movements occur that negatively impact a firm s overseas sales, a company must choose between a loss of market share (keep the domestic value of sales the same by raising the foreign price) or loss of profit margin (keep the foreign price the same but lower the domestic value of sales). This is a choice that has important long-run implications for future cash flows. Conversely, when currencies move in the favor of an exporter, the exporter must choose between profit skimming (higher domestic margins) or market penetration (lower foreign price). Promotional decisions should be made in light of expected or realized currency movements and, therefore, can complement market share decisions. Finally, like choosing a country or market within a country, a firm may simply decide what products to produce or sell in the first place and how many product lines to produce or sell within a given product category. 9 Cash flow from operations Change from base conditions = $3,840,000 $5,600,000 = -$1,759, Cash flow from operations Change from base conditions = $3,418,200 $640,000 = $2,778, At the end of 2018, the cash outflows for working capital should be recaptured.

12 Cost management: The major tools for managing costs in light of currency movements are to adjust input sources (a shortterm decision) and to decide on facility locations (a long-term decision). Adjusting inputs is simply a matter of choosing to source inputs where they are cheaper. One can easily trace the movement of companies from one country to another as they manufacture where labor is relatively cheapest. The same logic applies to most inputs. Another possibility is to raise productivity when difficulties arise. While it might seem that this should always be done, the decision can be complicated. Increasing efficiency is costly. The cost may become small relative to the gains from efficiency only when currencies move so as to create difficulties. Locating plants, and making the related decision of selecting their number and size, should be done in such a way that a firm can adjust to currency movements. Whereas a very large plant might be less efficient, for example, smaller plants in a number of locations might allow better management of currency exposure. Financial management: Financing costs are another input to the production decision over which a firm may have control. Thus, a company may choose to finance its operations in the country it expects to generate revenues since the inflows from sales can be used to pay the financing costs. Of course, financial cash flows are typically contracted whereas operating cash flows may be highly variable. Furthermore, a firm may not always be able to borrow in a local currency. Nevertheless, financial cash flows can certainly be used to some extent to offset local currency exposure. 5. Concluding remarks Accounting or Translation exposure reflects the changes in the dollar value of balance sheet items resulting from fluctuations in the exchange rates of currencies. Transaction exposure reflects the impact of settling all outstanding obligations (including off balance-sheet receivables and payables) at a different exchange rate from the rate prevailing when these obligations were made. The simplest tools for hedging involve the use of forward markets and money markets. Operating exposure is economic exposure that occurs because the firm has foreign currencydenominated costs or revenues. In general, operating exposure does not include contracted cash flows (transaction exposure). This makes management much more difficult since the amount of future cash flows can only be approximated. Furthermore, these cash flows can include very longterm cash flows for which the forward market may not exist and the money market may be very costly (a schematic presentation of probable impact of depreciation of company s local currency on parent company s cash flow is depicted at the end of the report). No method can be completely effective, but the extent of operating exposure in many countries requires that all possible actions be taken and that every alternative in terms of revenue, cost and financial management be explored.

13 ANNEX: Schematic presentation of probable impact of depreciation of company s local currency (Rubles) on parent company s cash flow in US$ Category Likely Impact on Parent Company's Cash Flow in U.S. Dollars Export Markets Price and Volume Increase (by less than depreciation %) Increase Sales Revenue Strong Import Competition Price and Volume Increase Slightly Decrease Slightly Local Markets Weak or No Import Competition Price and Volume Remain the Same Decrease Low Import Component Increase Moderately Decrease Slightly Production Costs High Import Component Low Substituality Increase by Percentage of Currency Depreciation Decrease Sharply High Substituality Increase Moderately Decrease Slightly Other Costs and Working Capital Requirements Increase Moderately (depending on % increase in sales and costs) Decrease Slightly Depreciation Remain the same Decrease by Precentage of Currency Depreciation Overall Cash Flow Effect Decrease by Less than Percentage of Currency Depreciation

14 References: Economic Exposure, Darden Business Publishing, University of Virginia, 2009 Various lecture notes on Global Corporate Finance, NYU Stern School of Business, 2012 Financial Management for the Multinational Firm, Fuad A. Abdullah, 1987 Interpretation and Application of International Financial Reporting Standards, Wiley, 2013 Multinational Business Finance, Eiteman, David K.; Stonehill, Arthur I.; Moffett, Michael H., Addison Wesley, 2009

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