Exsposure
PAT24
financial_234-286.pdf
Foreign Exchange Rate Deterrntnatton and Forecastlng
The herd instinct among forecasters makes sheep look like
independent thinkets- -Edgar R Fiedler'
LEARNING OBJECTIVES
*E,xaminehowthesupplyanddemandforanycunencycanbeviewedaSanassetchoice issue within the portfolio of investors'
{& -bxplore how the three malor approaches to excnange rate determlnatron-pailty con- ditioot, the balance of payments, and the asset approach-combine to explain the
numerous emerging market currency crises experienced in recent yeals.
* Observe how forecasters combine technical analysis with the three major theoretical approaches to forecasting exchange rates'
What determines the exchange rate between currencies? This has proven to be a very diffi-
cult question to answer. Companies and agents need foreign currency for buying imports, or
*uy "urn
foreign currency by exporting. Investors, investing in interest-bearing instruments
in ioreign "orrntri"5
and currencies, fixed-income securities like bonds, shares in publicly traded cimpanies, or other new types of hybrid instruments in foreign markets, all need for-
eign currenty. Tourists, migrant workers, speculators on currency movements-all of these
ec;nomic agents buy and sell and supply and demand currencies.every day.This chapter
offers somJ basic theoretical frameworks to try to organize these elements, forces, and principles.'
Cirapter 7 described the international parity conditions that integrate exchange rates
with inflation and interest rates and provided a theoreticai framework for both the globai
financial markets and the management of international financial business. Chapter 4 pro- vided a detailed analysis of how an individual country's international economic activity, its
balance of payments, can impact exchange rates. This chapter extends those discussions of
exchange rate determination to the third school, the asset market approach. gxiiOit 9.1 provides an overview of the many determinants of exchange rates. This road
map is first organized by the three major schools of thought (parity conditions, balance of
payments appioach, asset market approach), and second by the individual drivers within
i6or" uppro*hes. At first glance the idea that there are three sets of theories may appear daunting, but it is important to remember that these are not competing theories, but rather contplementary theories.Without the depth and breadth of the various approaches combined-
out ubility to capture the complexity of the global market for currencies is lost. The chapter concludes with the Mini-Case, The Japanese Yen Intervention of 2010, detailing Japan's return to its guidance of market value.
234
cHAPTER I Foreign Exchange Rate Determination and Forecasting
The Determinants of Foreign Exchange Rates
Parity Conditions
1. Reiative inflation rates 2. Relative interesl rates 3. Forward exchange rates 4. lnterest rate parity
235
ls there a well-developed and liquid money and capital market in that currency?
Asset Approach
Relative real interest rates Prospects for,eeonomic growth Supply and demand for assels Outiook for political stability Speculation and liquidlty Political risks and controls
Is there a sound and secure banking system in-place to support currency trading activities?
Balance ol Payments '1. Current account balances 2, Portfolio investment 3. Foreign direct investment 4. Exchange rate regimes 5. Official monetary reserves
Spot Exchange
Rate
1,
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4. E
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oad eoi thir )ear ther ned. pter an's
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In addition to gaining an understanding of the basic theories, it is equally important to gain a working knowledge of how the complexities of international political
".ono*y, societal
and economic infrastructures, and random political, economic, or social events affect the exchange rate markets.Here are a few exarnples:
* Infiastructttre weaknesses' were among the major causes of the exchange rate collapses in emerging markets in the late 1990s. On the other hand, infrastructure strengths help explain why the U.S. dollar continued to be strong, at least until the September"11,2oo1 terrorist attack on the United States, despite ,""oid balance of payments deficits on cur- rent account.
* Speculatiori contributed greatly to the emerging market crises. Some characteristics of speculation are hot money flowing into and out of currencies, securities, reai estate, and commodities. IJncovered interest arbitrage caused by exceptionally low borrowing inter- est rates in Japan coupled with high real interest rates in the United States was a pioblem in much of the 1990s. Borrowing yen to invest in safe U.S. government securitieg hoping that the exchange rate did not change, was popular.
* Cross-border foreign direct investment and. international portfotio investment into the emerging markets dried up during the recent crises. This has proven to be a very serious issue both for MNEs from the industrialized countries operating in emerging markets, and even more serious for the multinationals that call these emerging market countries home.
* Foreign political rlsks were much reduced in recent years as capital markets became less segmented from each other and more liquid. More countries adopted democratic forms of government. However, recent occurrerlces of terrorism within the U.S. may be changing perceptions of political risk.
236 PART 3 Foreign Exchange Exposure
Finaliy, note that most determinants of the spot exchange rate are also in turn a.ffected bt changes in the spot rate. In other words, they are not only tnted but also mutually d#rmined
Exchange R.ate Deterrnination: The Theoretical Thread
Under the skin of an interncttional economist lies a deep-seated belief in sctme variant o!'the PPP theory of the exchange rate.
-Paul Krugman, 1976. There are basically three viev,s of the exchange rate.The first takes the exchange rate as the relative price of monies (the monetary approach); the seioncl, as the rel{ilive p"rice of goocls (the purchasing-power-parity approach); and the thirct, the relative price of i:onds.
-Rudiger Dornbusch, "Exchange Rate Economics:where Do we stand'r. B ro o kings pap ers on Econornic Activ ity 1, 19g0, pp. 143*194.
Professor Dornbusch's tripartite categorization of exchange rate theory is a good starting point, but in some ways not robust enough-in our humble opinion-to capture the multr- tude of theories and approaches. So. in the spirit of both traditibn and compieteness, we have amended Dornbusch's three categories with several additional streams of ihought in the fol- iowing discussion. The next section will provide a brief overview of the many lifferent, but related, theories of exchange rate determination, and their reiative usefulnesS in forecastins for business purposes.
Furchasing Power Farity,&pproaehes The most widely accepted for all exchange rate determination theories, the theory of purchasing power parity (PPP) states that the long-run equilibrium exchange rate is Oeter- mined by the ratio of domestic prices relative to foreign prices, as explained in Chapter 7. PPP is both the oldest and most widety followed of the exchange rate theorier, ui *ort theories of exchange rate determination have PPP elements embedded within their frameworks.
There are a number of different versions of PPP, the Law of One price, Absolute ptu'- chasing Power Parity,and Relative Purchasing Power Parity (discussed in detail in Chapter 7). The latter of the three theories, Relotive Purchasing Power Parity,is thought to be the most relevant to possibly explaining what drives exchange rate values. In essence, it states that changes in relative prices between countries drive the change in exchange rates over time.
If, for exampie, the current spot exchange rate between the Japanese yen and U.S. doltar was Y90.00 : $1.00, and Japanese and U.S. prices were to change at 2o/o and 1"lo over the coming period, respectively, the spot exchange rate next period would be y90.g9/$.
: Yeo.oo/$ . i#: yeo.Ber$. Although PPP seems to possess a core element of common sense, it has proven to be
quite poor at forecasting exchange rates. The problems are both theoretical and empirical. The the<rretical problems iie primarily with its basic assumption that the only thing that mat- ters is relative price changes. Yet many currency supply and demand forces are driven by other forces including investment incentives and economic growth. The empirical issues are primariiy in deciding which measures or indexes of prices to use across countries, in addition to the ability to provide a "predicted change in prices" with the chosen indexes.
c . ., I + AinJapaneseprices Ji -t r), n' l* AinU.S.prices
CHAPTERgForeignExchangeRateDeterminationandForecasting 237
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Balanee o? Payn:ents {Fl*ws} Approaehes
After purchasing power parity, the most frequently used theoretical approach.to.exchange
rate determination is proOaUty ihat involving the suppty and demand for currencies in the for-
eign exchange market.These "xchange
rute flows reflect current account and financial account
transactions recorded in a nation's balance of payments, as described in Chapter 4' The basic
balance of payments approachargues that the equilibrium exchange rate is found when the net
inflow ioutnow; of tor"ign exch"ange arising from current account activities matches the net
outflow (inflow) of foreign exchange arising from financial account activities'
The balance of paynients approach continues to enjoy a wide degree of appeal as the bal-
ance of payments transactions ui" o.t" of the most frequently captured and reported of inter-
national economic activity. Tiade surpluses and deficits. current account growth in service
activity, and recently the irowth and significance of international capital flows continue to
fuel this theoretical fire' criticisms of the balance of payments approach arise from the theory's emphasis
on
flows ofcurrency and capitai rather inan ttot-t i of money or financial assets' Relative stocks
tf *on"y or financial assets play no role in exchange rate determination in this theory' a weakness explored in the following monetary and asset m-ar\gt approaches'
Curiously, the balance of payments appioach is la,rgely dismissed by the academic com-
munity today, while the practitioner public-market participants including currency traders
themselves-still rely on different vaiiations of the thiory for much of their decision making'
Nlanetary APPraaehes The monetary approach in its simplest form states that the exchange rate is determined
by
the supply and demand for national monetary stocks, as well as.the expected future levels and
rates of growth of monetary stocks. Other financial assets, such as bonds, are not considered
relevant for exchange rate determination as both domestic and foreign bonds are viewed as
perfect substitutes. It is all about money stocks' The monetary approach focuses on changes in the supply and demand for money
as the
primary determinant of inflation. Changes in"relative inflation rates in turn are expected to
alter exchange rates through a purchasiirg power parity affect' The monetary approach then
. assumes that prices are fleiible in the shori ,u.t ui well as the long run, so that the transmis- sion mechaniim of inflationary pressure is immediate in impact'
ln monetary models of exchange rate determination, real economic activity is relegated
to a role in which it only influences exchange rates through any alterations to the demand for
ffi^nA\rThetheonsi.ol.n aritlaizerl.rr-rit".ri,i""ionof anttmheroffactorswhiChgenefallV-afe agreed by area experts as importanr to "t"ftu"g;
;;; ij;6;ltiatioii,'inctuding l) the failure of ppp to hold in the short to medium term;2) iror"y demand appears to be
relatively unsta-
ble over rime; and :j tii"l""a of economic activity und tn" -9o"y supply appeff to be inter-
dependent, not independent. Therefole, we will not pursue the monetary approach {urther'
Asset fvlarket Approae h iFlelative Price ef Bond*)
The asset market approach,sometimes called the relative price of bonds ot portfolio^balance
approach,argues that exchange rates are determined by the supply and demand for financial
assets of a wide variet.v. stritti in the supplv and demand for financial assets alter exchange
rates. Changes in monetary and fiscal poliry alter expected returns and perceived relative
risks of financial assets, which in turn alter rates'
Many of the macroeconomic theoretical developments in the 1980s and 1990s focused on
how monetary and fiscal policy changes altered the relative perceptions of return and risk to
the stocks of financial assets driving exchange rate changei. Th" ft"q,rentiy cited. w.orks of
Mundell-Fleming are in this genre. Theories 3f ,u,'""y sibstitLttion'the ability of individual
PART 3 Foreign Exchange Exposure
and commercial investors to alter the composition of their monetary holdings in their portfo- lios, follow the same basic premises of the portfolio balance and re-balance framework.
Unfortunately, for all of the good work and research over the past 50 years, the ability to forecast exchange rate values in the short term to long term is-in the words of the authors below-sorry. Although academics and practitioners alike agree that in the long-run funda- mental principles such as purchasing power and external balances drive currency values, none of the fundamental theories has proven that useful in the short to medium term.
. . . the case for rnacroeconomic determinants of exchange rates is in a sorry state . . . [TheJ results indicqte that no model based on such standard fundamentals like money supplies, real income, interest rates, inflation rates and current account balances will ever succeed in explaining or predicting a high percentage of the variation in the exchange rate, at least at short- or medium-term frequencies.
-Jeffrey A. Frankel and Andrew K. Rose.'A Survey of Empirical Re-searci
on Nominal Exchange Rates," NBER Working Paper no.4865,1994.
Teehni*al Analysis The forecasting inadequacies of fundamental theories has led to the growth and popularity of tecltnical analysis, the belief that the study of past price behavior provides insights into future price movements.The primary feature of technical analysis is the assumption that exchange rates, or for that matter any market-driven price, follows trends.And those trends may be analyzed and projected to provide insights into short-term and medium-term price movements in the future.
Most theories of technicai analysis differentiate fair value from market value. Fair value is the true long-term value which the price will eventually retain. The market value is subject to a multitude of changes and behaviors arising from widespread market participant percep- tions and beliefs.
The Asset Market Approach t* Feireeasting The asset market approacft assumes that whether foreigners are willing to hold claims in mon- etary form depends on an extensive set of investment considerations or drivers.These drivers, as previously depicted in Exhibit 9.1, include the following elements:
i Relative real interest rates are a major consideration for investors in foreign bonds and short-term money market instruments.
I Prospects for economic growth and profitability are an important determinant of cross- border equity investment in both securities and foreign direct investment.
? Capital market liquidity is particularly important to foreign institutional investors. Cross- border investors are not only interested in the ease ofbuying assets,but also in the ease of selling those assets quickly for fair market value if desired.
* A country's economic and social infrastructure is an important indicator of its ability to survive unexpected external shocks and to prosper in a rapidly changing world economic environment.
C, Political safety is exceptionally important to both foreign portfolio and direct investors' The outlook for political safety is usually reflected in political risk premiums for a coun- try's securities and for purposes of evaluating foreign direct investment in that country.
t The credibility of corporate governance practices is important to cross-border portfolio investors. A firm's poor corporate governance practices can reduce foreign investors' influence and cause subsequent loss of the firm's focus on shareholder wealth objectives.
* Contagion is defined as the spread of a crisis in one country to its neighboring countries and other countries with similar characteristics-at least in the eyes of cross-border
lel ;es.
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C ii A P T E l-l I Foreign Exchange Rate Determination and Forecasting 239
investors. Contagion can cause an "innocent" country to experience capital flight with a resulting depreciation of its currency.
* Speculation can both cause a foreign exchange crisis or make an existing crisis worse. We will observe this effect through the three illustrative cases that follow shortly.
Foreign investors are willing to hold securities and undertake foreign direct investment in highly developed countries based primarily on relative real interest rates and the outlook for economic growth and profitability. All the other drivers described in Exhibit 9.1 are assumed to be satisfied.
For example, during the 1981-1985 period, the U.S. dollar strengthened despite growing current account deficits. This strength was due partly to relatively high real interest rates in the United States. Another factor, however, was the heavy inflow of foreign capital into the U.S. stock market and real estate, motivated by good long-run prospects for growlh and prof- itability in the United States.
The same cycle was repeated in the United States in the period between 1990 and 2000. Despite continued rvorsening balances on current account, the U.S. dollar strengthened in both nominal and real terms due to foreign capital inflow motivated by rising stock and real estate prices, a low rate of inflation, high real interest returns, and a seemingly endless "irrational exuberance" about future economic prospects. This time the "bubbie" burst follow- ing the September 11,2001terrorist attacks on the United States.The attack and its aftermath caused a negative reassessment of long-term growth and profitability prospects in the United States (as well as a newly formed level of political risk for the United States itself). This neg- ative outlook was reinforced by a very sharp drop in the U.S. stock markets based on lower expected earnings. Further damage to the economy was caused by a series of revelations about failures in corporate governance of several large corporations (including overstate- ment of earnings, insider lrading, and self-serving executives).
Loss oT contrdence'rn the-US. economy-leil to a'Iarge wttnbrandi tfr'rorergl caliltdr"rruur U.S. security markets. As wouid be predicted by both the balance of payments and asset mar-
ket approaches, the U.S. dollar depreciated. Indeed, its nominal rate depreciated by 18% between mid-January and mid-July 2002 relative to the euro alone.
The experience of the United States, as well as other highly developed countries, illus- trates why some forecasters believe that exchange rates are more heavily influenced by eco- nomic prospects than by the current account. One scholar summarizes this belief using an interesting anecdote.
Many economists reject the view that the short-term behsvior of exchange rates is determined
in flow ntarkets. Exchange rates are asset prices traded in an fficient financial market. Incleerl, an exchange rate is the relative price of two currencies and therefore is determined by
the willingness to hold each cutency. Like other asset prices, the excliange rate is determined by expectations about the future, not clffrent trade flows.
A paralletwith. other asset prices may illustrate the approuch. Let's consider the stock price
of a winery traded on tlxe Bordeaux stock exchange. A {rost in late spring results in a poor harvest, in terms of both quantity antl quality. After the harvest the wine is finally sold, snd
the inconte is much less thsn the previous year. On the duy of the final sale there is no reason
for the stock price to be influenced by this flow. First, the poor itcome has already been dis- counterl for several months in the winery stock price. Second, the stock price is affected by
future, in addirion to current, prospects. The stock price is based on expectations of fitture earnings, and the major cause for a change in stock price is a revision of these expectations.
A similqr reasoning applies to exchange rates: ContemporaneoL; internationsl flows should hqve little effect on exchange rates to the extent they have already been expected.
)n- )rs,
rnd
'SS-:of
240 l'lriiT 3 Foreign Exchange Exposure
only news obout fiiure .economic prospects will affict excltange rcttes. since economicexpectations are potentially votatile and influenc"d i) ^nrry
variibles, especiolly varioblesof a political natltre, the short-ru, behctvior of exchaige raies is voratile.
MA : Addison wes,ey,,#llTr:iHl',#;:::::;!,#J,',::'#f ":::":till;liilillThe asset market approach to forecasting is also appiicable to emerging markets. In thiscase, however, a number of additional variables contribute to exchange rate determination.These variables. as described previously, are illiquid capital markets, weak economic andsocial infrastructure, political instability, corporate gou"rnan.", contagion effects, and specu-lation' These variables witl be illustrated in the sections on crises that follow.
ilLcr"r*;-tcy &rtar3<et F srter€/efi t;$:T A fundamental problem with exchange r(ttes is that no commonly accepted ntethod exists to estimate the effectiveness of of/icial intervention into foreign exchaige markets. Many interrelated fctctors affect the exchange rate at any given timi, and no cltutntitative moclel exists that is oble to provide the nzagniturle of cmy ciusctl relatii.onship belween intervention and an exchange rate when so many intertlependent variables are-acting'simtiltaneously.
-"Japan's Currency Intervention:policy Issues,', Dick K. Nanto. CRS Report to Congress, July 13,2007. CRS-7.
The value of a country's curtency is of significant interest to an individual government,s eco- nomic and political policies and objectives. Those interests sometimes eitend beyond the individual country, but may actually reflect some form of collective country interest. Aithough many countries have moved from fixed exchange rate values long ago, tire govern- ments and central bank authorities of the multitude of floating rate currencies still piivaleiy and publicly profess what value their currency "should hold" in their eyes, regaidless of whether the market for that currency agrees at that time. Foreign currency intervention,the active management, manipulation, or intervention in the market's valuation of a countrv's currency, is a component of currency valuation and forecast that cannot be overlooked.
$d*tiveti**s f*r !nterv**ti*n There is a long-standing saying that "what worries bankers is inflation, but what worries elected officials is unemployment." The principle is actually quite usefui in understanding the various motives for currency market intervention. Depending upon whether a country'sien- tral bank is an independent institution (e.g., the U.S. Federal Reserve), or a subsidiary of its elected government (as the Bank of England was for many years), the bank's policies may either fight inflation or fight slow economic growth.
Historically, a primary motive for a government to pursue currency value change was to keep the country's currency cheap so that foreign buyers would find its exports cheap. This policy, long referred to as "beggar-thy-neighbor," gave rise to several competitive devalua- tions over the years. It has not, horvever, fallen out of fashion. The Asian financial crisis of 1997 (discussed in detail in the following section), resulted in a number of countries devalu- ing their currency when they did not have to; they devalued their currencies intentionally to remain competitive with neighboring countries with competing export products. The slow econorpic growth and continuing employment problems in many countries in 2070 and 2017 led to some countries, the United States and the European Union being prime examples, working to hold their currency values down.
Alternatively, the fall in the vaiue of the domestic currency will sharply reduce the pur- chasing power of its people. If the economy is forced. for a variety of reasons, to continue to
C H A. P T E F S Foreign Exchange Rate Determination and Forecasting 257
the ny's
The CollaPse of the Argentine Peso
Argentine pesos/U.S. dollar
4.00
3.50
300
RouEhly six months pass before stabilzation
250
2.00
Feb 3 the government offlciallY announces the flotation of the peso
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. the
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1.50
Argentina:s Currency Board was an extreme systern designed to
!fii.'rin"t"ifl" ability of government to conduct independent monetary
fof i"y-it *u. m* result"of years ol disasirous inflationary sufferlng fram poor PolicY control.
CurrencY Board fix
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Foreeastitlg Exr Fn"aetics Numerous foreign exchange forecasting services exist, many of which are provided
by banks
and independent consultuitr. I.t addition, some multinational firms have their own in-house
forecasting capabilities. Predictions can be based on elaborate econometric models' technical
analysis oicttattt and trends, intuition, and a certain measure of gall'
whether any of the forecasting services are worth their cost depends partly on our
motive for forecasting as well as the required accuracy of the forecast' For example' long-run
forecasts may be motivated by a multinational firm's desire to initiate a foreign investment in
Japan, or perhaps to raise long-term funds denorninated in Japanese yen. Or a portfolio man-
ager may be considering diveisifying for the long term in Japanese securities' The longer the
time horizon of the fore"cast, the moL inaccuratJut also the less critical the forecast is likely
to be. The forecaster will typically use annual data to display long-run trends in such eco-
nomic fundamentals as Japanese inflation, grorvth, and BOP'
Short-term forecasts are typically motiiated by a desire to hedge a receivable, payable, or
clividend for perhaps a period of three months. In this case, the long-run economic fundamen-
tals may not be as important as technical factors in the marketplace, government intervention'
news, and passing .him, of traders ancl investors. Accuracv of the forecast is critical, since most of the exchange rate changes are relatively small even though the day-to-day volatiiity
may be high. Forecisting services normally undertake fundamental economic analysis for long-term
forecasts, and iome base their short-term forecasts on the same basic model' Others base
their short-term iorecasts on technicai anaiysis simiiar to that conducted itr security analysis'
They attempt to correlate exchange rate changes with various other variables, regardless of
wheiher there is any economic rationale for the correlation.'fhe chances of these forecasts
Jarr 6 devaluaiion from 1.00/$ to 1.40/$ but banks closed, so no trading
1.00
\
i) hi) i .i Foreign Exchange Exposure
being consistently useful or profitable depend on whether one believes the foreign exchange
market is efficient. The more efficient the markei is, the more likely it is that exchange rates
are ..random walks," *rft pu* price behavior providing no clues to the future' The less effi-
cient the foreign "x"hunge'market
is, the betteithe chance that forecasters may get lucky and
find a key relationship tiat holds, at least for the short run. If the relationship is realiy consis-
tent, however, others will soon discover it and the market will become efficient again with
respect to that piece of information' Exhibit 9.5 summarizes the various forecasting periods, regimes' and the
authors' sug-
gested methodologies. opinions, however, are subject to change without notice! (And remem-
ber, if authors could predict the movement of exchange rates with regularity, we surely wouldn't write books.)
Tech:rieal AnalYsis Technical analysts, traditionally referred to as chartisfs, focus on price
and volume data to
determine past trends that are expected to continue into the future' The single most impor-
tant element of technical analysis is that future erchange rates are based on the current
exchange rate. Exchange rate movements, similar to equily price movements, can be subdi-
vided into three periodi: 1) day-to-day movement, which is seemingly r-an{gp 2) short-term
movements extenOrnfiroin-#u"tui Olys to trends lasting several months; 3) loqg-term move-
ments, which are chaiacterized by up and down long-term trends' Long-term technical analy-
sis has gained new popularity as i result of recent research into the possibility that long-term "wavesl'in currency movements exist under floating exchange rates'
The longer the time horizon of the forecast, the more inaccurate the forecast is likely to
be. Whereas forecasting for the long run must depend on economic fundamentals of exchange
rate determination, ma'ny of the foiecast needs of the firm are short- to medium-term in their
tnut *f llr: ant itc
r3
ex{
Exchange Rate Forecasting in Practice
Beeommended Forecast Methods
Assume the {ixed rate is maintained lndications of stress on fixed rate?
Capital controls; black market rates
lndlcators of government's capability to maintain fixed-rate?
Changes in official foreign currency reserves
Technical methods which capture trend
Forward rates as forecasts
Forecast Period
SHORT.RUN
LONG.RUN
Regime
Fixed-Rate
Ftoating-Rate 1. 2.
1. 2. 3. 4. 5.
(a) <30 days, assume a random walk (b) 30-90 daYs, forward rates
3. 90-360 days, combine trend with fundamental analysis 4. Fundamental analysis of inflationary concerns 5. Government declirations and agreements regarding exchange rate goals 6. Cooperative agreements with other countries
Fixed-Rate 1. Fundamentalanalysis 2. BOP management 3. Ability to control domestic inflation 4. Abiliti to generate hard currency reserves to use for intervention 5. AbilitY to run trade sui'Pluses
Floating-Rate 1. Focus on inflationary fundamentals and PPP 2.lndicatorsofgenerateconomichealthSuchaseconomicgrowthandstability 3. Technical anJysis of long-term trends; new research indicates possibility of long-term
technical "waves"
;,yi 7r.r: T L:F, tt Foreign Exchange Rate Determination and Forecasting 253
nge ltes :ffi- and sis- rith
ug- )m- 'ely
.to or- ent ,di- rm ve- Lly-
rm
time horizon and can be addressed with less theoretical approaches' Time series techniques
infer no theory o'- "u.r*ii,y Uur ri-pty predict future values from the recent past' Forecasters
freely mix fundamentai urrO t".t ni*iunufytii ftesumably because forecasting is like playing
horseshoes-getting close is all that counts' biomt Finance in Prsctice 9'3 provides a short
analysis of how ur"urut" orr" very prestigious currency forecaster was over a3-yeat period'
Crocs-Rat* Ccnsi*t*i1cY il"i F*re*astit"lg
International financial managels must often forecast their home culrency exchange rates for
the set of countries in which the firm operates, not only to decide whether to hedge or to
make an investment, but also as part of preparing muiticountry operating budgets in the
home country's currency. These are the op"ruiing U"uag"tt against which the performance of
foreign subsidiary -unJg"tt willbe iudgld- Ctrecting the reasonableness of the cross rates
,*pr[it in individual forJcasts acts ai a reality check to the original forecasts.
to lge eir
9.3
JPl*leirgan Chase Foreeasi sf the D*llarlEuro
There are many different foreiQn exchange forecastlng seryices
and service providers. JPMorgan Chase (JPMC) is one of the
most prestigious and widely used.1 A review of JPMC's fore-
iasting accuracy for the U.S. dollar/euro spot exchange rate
($le) ior the 2002 to 2005 period, ln 90-day increments' is
presented in the exhibit' The graph shows the aciual spot
exchange rate for the period and JPMC's forecast for the spot
exchange rate for the same Period. There is good news and there is bad news' The good
news is that JPMC hit the actual spot rate dead on in both
May and November 2002. The bad news is that after that'
they missed. Somewhat worrisome is when the forecast got
the direction wrong. For example, in February 2004' JPMC
had forecast the spoi rate to move from the cunent rate of
$1 .27/€to $1 .32l€, but in fact, the doliar had appreciateci
dramalically in the {ollowing 3-month period to close at
$1 .19/€. ihit *ut in fact a massive difference' Again' in No'rernber 2004, JPMC had foreca t the spot rate to move
from the current spot rate of $1'30/€ to $1 '23/€ ' but in fact'
the actual spot rate proved to be $1 '32l€' The lesson learned is probably that regardless of how
professional and prestigious a forecaster may be' and how
accurate they may have been in the past, lorecasting the
future-by anyone for anything-is challenging to say the
least.
lThis analysis uses exchange rate data as published in the print edition 01
The Economist, appearing quarterly The source of the exchange rate fore-
casts, as notedin The Economlsf, is JPMorgan Chase'
$1.40
$1 30
$1.20
$1,10
$1.00
$0.90
138
13232 1.30 1.27
Actual SPol Ddt^ \ \\
1 .15.
ffi-t.ot \
1.19
102
JPMC's forecast of the sPot rate 90 daYS into the future- 090
87
$0 80
*a"86"g"**E^r*Ess"ft*.*"tfst*o*t'
:he .nd
ing
ign
m- nd /eb
ing -he
Ti'ansaction lrtal,.and I ranslatton 1ntrJ
Exposure
There are two times in a man's life when he should not speculate: when he can't afford it and when he can.
-"Following the Equator," Pudd'nhead Wilson's New Calendar, Mark Twain.
LFARNiNG 0BJICTiVES I Distinguish between the three major foreign exchange exposures experienced by firms. t| Analyze the pros and cons of hedging foreign exchange transaction exposure. I Examine the alternatives available to a firm to manage alarge and significant trans-
actiori exposure.
I Evaluate the institutional practices and concerns of conducting foreign exchange risk management.
t) Demonstrate how translation practices result in a foreign exchange exposure for the multinational enterprise.
t Explain the meaning behind the designation of a foreigrr subsidiary's "functional currenqy." I Illustrate both the theoretical and practical differences between the two primary
methods of translating foreign curency denominated financial statements into the cur- rency reporting of the parent company.
t) Compare translation exposure with operating expense. t} Analyze the costs and benefits of managing translation exposure.
Foreign exchange exposure is a measure of the potential for a firm's profitability, net cash flow and market value to change because of a change in exchange rates. An important task of the financial manager is to measure foreign exchange exposure and to manage it so as to maximize the profitability, net cash flow, and market value of the firm. This chapter describes and details both types of accounting exposure: transaction exposure and translation expo- sure. The chapter concludes with a Mini-Case, Banbury Impex (India), which involves a recent exposure management problem in India.
TVpes of Foreign Exchange Exposure What happens to a firm when foreign exchange rates change? There are two distinct cate- gories of foreign exchange exposure for the firm, those that are based in accounting and those that arise from economic competitiveness. The accounting exposures, specifically
ar- er- rrg ral
3tS
na,
ing ;US
-he
or- )nt )at
ud at- lar :al.
:al
263
264 :rA i: i .3 Foreign Exehange ExPosure
described as transaction exposure and translation exposure, arise from contracts and accounts
being denominated in foriign currency. The economic exposure, which we will describe as
opeiattng exposure,is the potential change in the value of the firm from its changing global
clmpetiliveness as determined by exchange rates. Exhibit 1.0.1 shows schematically the three
main types of foreign exchange exposure: transaction, translation, and operating.
-fi'a:-: *;l*ti** *xPq)*il4* Transaction exposure measures changes in the value of outstanding financial obligations incurred prior io a change in exchange rates but not due to be settled until after the exchange
rates change. Thus, it deals with changes in cash flows that result from existing contractual obligations.
'?=ra**i*ti*fi *xP*$i.ii* Translstion exposure is the potential for accounting-derived changes in owner's equity to
occur because of the need to "translate" foreign currency financial statements of foreign
subsidiaries into a single reporting currency to prepare worldwide consolidated financial
statcments.
*p*;'*t! r: g Hr: P*s:; re Operating exposure, also called economic exposure' competitive exposure, ot strategic expo-
,ri", -"u"rrrres the change in the present value of the firm resulting from any change in future
operating cash flows oi the firm caused by an unexpected change in exchange rates' The
"hung" in value depends on the effect of the exchange rate change on future sales volume'
prices, and costs. r ,r- _,- ^^- . Tiansaction exposure and operating exposure exist because of unexpected changes tn
future cash flows. The differen." b"t*""n the two is that transaction exposure is concerned with future cash flows already contracted for, while operating exposure focuses on expected
(not yet contracted for) futuie cash flows that might change because a change in exchange
rates has altered international competitiveness'
Corporate Foreign Exchange Exposure
Resulting from Aecounting
lmpact of setiling outstanding obligations entered into before change in exchange rates but to be settled after change in exchange rates
: : -: i
Changes in income and owners' equity in consoiidated financial statements caused bY a change in exchange rates
Resutting from Economics
Change in expected future cash flows arising from an unexPected change in exchange rates
Changes in future cash flows arising from firm and competitor firm responses
Time and Exchange Rate Changes
i..i 1p,l''t l: l:l 1 {.r Transaction and Translation Exposure
Valuation of Hedging Alternatives for an Account Payable
Cost in U.S. dollars ot Trident's g1'000'000 A/P .1
.84
1.82
1.80
1.78
1.76
1.74
1.72
1.70
1.68 1.68 1]0 1.72 1.74 1 .76 1.78 1.80 1 82 1'84
Ending SPot Exchange Rate (US$/t)
27'7
Call option strike price of $1.751e
FoMard rate is $.1 .75401t
Uncovered costs whatever lhe ending spot rate is in 90 days
186
Money market hedge locks in a cost o{ $1,781,294
Call option hedge
Forward coniract hedge locks in a cost of $1 .754,000o5
S
n
,1
rf
Lt.
to
re
rll r'e
1d
1e
ftlsk F,4sreages:1ent in Fract:ce As many dift'erent approaches to exposure management exist as there are firms'
A variety of
surveys of corporate risk management practi"", in l."."ttt years in the United States, the
United Kingdom, Finland, Austr"alia, und G".-uny, indicate no real consensus exists regard-
ing the best approach. The following is our attempt to.assimilate the basic results of these sur-
oe.-ys and "o*bitt"
them with our own personal experiences'
which Goals? The treasury function of most private firms, the group typically responsible.for
transaction exposure *unug"*"nt, is usually considered a cost center' It is not *p::::1 ' add profit to the firm's bottJm-hne (which is not the same thing as saying it is not expected
to
add value to the firm). Currency risk managers are expected to err on the conservative side
when managing the firm's moneY.
Which Exposures? Tiansaction exposures exist before they are actually booked as foreign
currency-denominated receivables and payables. However, many firms do not allow the
hedging of quotation exposure or backlog exposure as a.matter.of policy' The reasoning is
straightforward: until the transaction exists o1 ih" accounting books of the firm' the probabil-
ity of the exposure actually occurring is considered to be less than 100%' Conservative hedg-
ing policies di"tut" that contractual hedges be placed oniy on existing exposures'
An increasing number of firms, however, are actively hedging not only backlog expo-
sures, but also selectively hedging quotation and anticipated exposures' Anticipated exposures
are transactions for which there are-at present-no contracts or agreements between.par- ties, but are anticipated on the basis of hisioricai trends and continuing business relatioaships'
Although this may appear to be overly speculative on the part of these firms, it ma-v be that
hedginf expected foi"igrr-"urr"tr"y puyuLtes and receivables for future periods is the most
conservative approach to protect the firm's future operating revenues'
Which Contractual Hedges? As might be expected, transaction exposure management plo-
grams afe generally divided along an "option-line," those that use options and those that do
Lre
lr- in-
rce
lge lar rld or-
278 PAFT 3 Foreign Exchange ExPosure
10.1
The Credit Grisis and Option Volatilities in 2S09
The global credit crisis had a number of lasting impacts on
corporate foreign exchange hedging practices in late 2008
and eariy 2009. Currency volatilities rose to some of the high-
est levels seen in years, and stayed there. This caused option
premiums to rise so dramatically that many companies were
much rnore selective in their use of currency options in their
risk management Programs. The dollar-euro volatilit-v was a prime example' As
recently as July 2007, the implied volatility for the most widely
traded currency cross was below 7% for maturities from one
week to three years. By October 31, 2008, the .1 -month
implied volaiility had reached 29%. Although this was seem-
ingly the peak, l-month implied volatilities were still over 20%
on January 30, 2009.
This makes options very expensive. For example, the
premium on a 1-month call option on the euro with a strike
rate forward-at-the-money at the end of January 2009 rose
from $0.0096/€ to $0.0286/€ when volatility is 2A%' nolTa/o
For a noiional principai of €1 million, that is an increase in price from $9,580 to $28,640. That will put a hole in any treasury department's budget.
not. Firms that do not use culrency options rely almost exclusively on forwald contracts and
money market hedges. Global Finan-ce in Practice J0.7 demonstrates how market condition
may change firm hedging choices. Many MNEs have e"stablished rather rigid transaction exposure risk management poli-
cies which mandale proportional hedging.These policies generally require the use of forward
contract hedges on u pir"".ttage 1e.g-., 5b, 60, ot 70"/o) of existing transaction exposures' As
the maturity of tir" ""porrrr"*-i"ngtiens, the percentage forward-cover required decreases'
The remaining portion of the expJsure is then selectively hedged on the basis of the firm's
risk tolerance, view of exchange rate movements' and confidence level' Although rarely
acknowledged by the firms thernselves, selective hedging is essentially speculation' Signifi-
cant questi6n remains as to whether a firm or a financial manager can consistently predict the
future direction of exchange rates'
Ti'ansl ation HxPostl re Translation exposure,the second category of accounting exposures, arises because
financial
statements of foreign subsidiaries-which are stated in foreign currency-must be restated
in the parent's repolting currency for the firm to prepare consolidated financial statements'
Foreign subsidiarles of il.S. companies, for example, must restate local euro, pound' yen, etc''
statements into U.S. dollars ,o tht foreign valuis can be added to the parent's U'S' dollar-
denominated balance sheet and income statement. This accounting process is called
"translation ." Translation exposure is the potential for an increase or decrease in the pareni's
net worth and reported net income caused by a change in exchange rates since the last
translaiion. Although the main purpose of translation is to prepare consolidated statements,
trans-
lated statements are also used by management to isseis the performance of foreign sub-
sidiaries. Although such assessment might be performed from the local culrency statements'
restatement of all subsidiary statemenis into ihe single "common denominatot" of one cut-
rency facilitates management comparison'
Overviequ of Translation There are trvo financial statements for each subsidiary which must be translated
for consoli-
dation: Ihe irucome statement and the balance sheet. (Statements of cash flow are not trans-
lated from the foreign subsidiaries.) The consolidated statement of cash flow is constructed
CHAPTEFI 1 0 Transaction andTranslation Exposure 279
'I
;
1
v
from the consolidated statement of income and consolidated balance sheet' Because the
consoiidated results for any multinational firm are constructed from all of its subsidiary
operations, including foreign subsidiaries, the possibility of a change in consolidated net
income or consolidated neiworth from period to period, as a result of a change in exchange
rates, is high. Fo, ariy individual financial statement, internally, if the same exchange rate were
used to
remeasule each and every line item on the individuai statement, the income statement and
balance sheet, there would be no imbalances resulting from the remeasurement' But if a dif-
ferent exchange rate were used for different line iteml on an individual statement, an imbal-
ance would result. Differenl exchange rates are used in remeasuring different line items
because translation principles are a cJmpiex compromise b-etrveen historical and current val-
ues. The question, then, is what is to be done with the imbalance?
subsidiary characterization. Most countries specify the translation method to be used by a
foreign subsidiary based on its business op"ruiionr' For example, a foreign subsidiary's busi-
ness can be categorized as either an integrated foreign entiry' or a s.el'f-sustaining foreign entity'
An integrated foreign entity is one which opelates as al extension of the parent company' with cash flows and g"rr"rul business lines that are highly interrelated with those
of the par-
ent. A self-sustaining foreign erctity is one which operates in the iocal economic environment
independent of the parent"company. 1ihe differeniiation is important to the logic of transla-
tion. A foreign subsidiary shouid be valued principaily in terms of the currency that is the
basis of its economic viabilitY. It is not unusual for a single company to have both types of foreign subsidiaries'
integrated and self-sustaining. FJt "*u-pi", a U'S.-based manufacturer that produces sub-
assemblies in the United States which are then shipped to a Spanish subsidiary for finishing
and resale in the European union would likely characterize the Spanish subsidiary as an
htegrated foreign entity.The dominant currency of economic operation is likely the U'S' dol'
lar. That same U.S. parent may also own an agricultural marketing business in Venezuela that
has few cash flows or operarions related tI tire U.S. parent company.or U'S'-dollut'..fr" Venezuelan subsidiary -uy ,our"" all inputs and sell a1l products in Venezuelan
bolivar'
Because the Yenezuilan subsidiary's operations are independent of its parent' and its
functional currency is the venezuelan bolivar, it would be classified as a self-sustaining
foreign entitY.
Functional Currency. A foreign subsidiary's functional currency is the currency of the pri-
mary economic environmentln which the subsidiary operates and in which it generates cash flows. In other words, it is the dominant currency used by that foreign subsidiary
in its
day-to-day operations. It is important to note that the geogfaphic location of a foreign sub-
sioiary uno iti functional "urr"n"y
may be different. The Singapore subsidiary of a U'S' firm
may find thar its functional currency ii tire U.S. dollat (integrated subsidiary), the Singapore dollar {selJ'-susta-nLng subsidiary), or a third currency such as the British
pound (also a sef sustain'ing subsidiaryi. The Uniied States, rather than distinguishing a foreign subsidiary
as
either integrated or self-sustaining, requires that the functional currency of the subsidiary
be determined. Management must evaiuate the nature and purpose of -each
of its individual foreign sub-
sidiaries to determine the appropriate functionul ".,tt"n"y for each' If a foreign subsidiary of
a U.S.-based company is deiermined to have the U.S. dollar as its functional currencY' it is
essentially an extension of the parent company (equivalent to.the integrated foreign entity
designation used by most countiies). If, however,'the functional currency of the forelgn sub-
sidia-ry is determined to be different from the U.S. clollar, the subsidiary is considered a sepa-
rate entity from the parent (equivalent to the self-sustaining entity designation)'
rd ln
,li- rd As es.
rl's rly ifi- .he
:ial ted rts. tc., lar- led It's Last
lnS-
ub- nts, )ur-
roli- lns- :ted
r.'i I :j Foreign Exchange ExPosure
Tc"ensl ation lr4ethCId s Two basic methods for translation are employed worldwide, the current rate method and the
temporal method. Regardless of which method is employed, a translation method must not
only designate at what exchange rate individual balance sheet and income statement items
ar"-r"*"irrrred, but also designate where any imbalance is to be recorded, either in current income or in an equity reserve account in the balance sheet.
Current Rate Method. The current rate method is the Under this method, all financial statement line items are
rate with few exceptions.
most prevalent in the world todaY. translated at the "current" exchange
* - sse/s and Liabilities. A1l assets and liabilities are translated at the current rate of exchange; thal is, at the rate of exchange in effect on the balance sheet date.
* Income Statement ltems. A1l. items, including depreciation and cost of goods sold, are trans- lated at either the actual exchange rate on the dates the various revenues, expenses, gains, and
losses were incurred oI at an appropriately weighted average exchange rate for the period'
* Distributions. Dividends paid are translated at the exchange rate in effect on the date of nqrrment
* EEtitv ltems. Common stock and paid-in capital accounts are translated at historical rates. year-end retained earnings consist of the original year-beginning retained earnings
plus or minus an,v income or loss for the year'
Gains or losses caused by translation adjustments are nol included in the calculation of
consolidated net income. Rather, translation gains or losses are reported separately and accu-
mulated in a separate equity reserve account (on the consolidated balance sheet) with a title
such as ,,cumulative translaiion adjustment" (CTA), but it depends on the country. If a for- eign subsidiary is later sold or liquidated, translation gains or losses of past years accumu-
lated in the C'lA account are reported as one component of the total gain or loss on sale or
liquidation. The totai gain or lois is reported as part of the net incAme or loss for the time
period in which the sale or liquidation occurs.
Temporal Method. Under the temporai method, specific assets and liabilities are transiated at
exchange rates consistent with thatiming of the item's creation.The temporal metltod assumes
that a n-umber of individual line item assets such as inventory and net plant and equipment are
restated regularly to reflect market value. If these items were not restated but were instead
carried at historical cost, the temporal method becomes the monetary/nonmonetary method of
translation, a form of translation that is still used by a number of countries today' Line items
include the following:
* Monetary assefs (primarily cash, marketable securities, accounts receivable, and long-term receivables) and monetaiy tiabitities (primariiy current liabilities and long-term debt).
These are translated at cuirent exchange rates. Nonmonetory assets and liabilities (prima-
rily inventory and fixed assets) are translated at historical rates.
* Inconte Statement ltems.These are translated at the avetage exchange rate for the period, except for items such as depreciation and cost of goods sold that are directly associated
with nonmonetary assets or iiabilities. These accounts are translated at their historical rate'
& Distribtttions. Dividends paid are translated at the exchange rate in effect on the date of payment.
* Equity ltems. Common stock and paid-in capital accounts are translated at historical rates' year-end retained earnings consisi of the original year-beginning retained earnings plus or
minus any income or loss for the year, plus or minus any imbalance from translation'
+ * *.
F
s :3 aa,
,3-
t-6
,*i
* :s e ;g
$l & +
ri: ,1!i
i: F
ii ,*.
4.
'.*.
* i{ €* *- .k
E* tr {1.
*
{lliAP Il:lt i (i Transaction andTranslation Exposure 281,
Under the temporal method, gains of losses resulting from remeasurement are carried
directly to current Consolidated income, and not to equity reserves, Hence, foreign exchange
gains and losses arising from the translation process do introduce volatility to consolidated earnings.
U.S. Translation Procedures. The United States differentiates foreign subsidiaries on the
basis of functional currency, not subsidiary characterization. A note on terminology: Under U.S. accounting and translation practices, use of the current rate method is termed "transla-
tion" while use of the temporal method is termed "remeasurement." The primary principles
of U.S. translation are summarized as follows:
+ If the financial statements of the foreign subsidiary of a U.S. company are maintained in U.S. doliars, translation is not required.
* If the financial statements of the foreign subsidiary are maintained in the local currency and the local currency is the functional cltrrency, they are translated by the current rate
method.
If the financial statements of the foreign subsidiary are maintained in the local currency and the U.S. dotlar is t\te fiinctional currency, they are remeasured by the temporal method'
If the financial statements of foreign subsidiaries are in the local currency and neither the local currency nor the dollar is the functional currency, then the statements must first be
remeasured into the functional currency by the temporal method, and then translated into
doilars by the current rate method.
f
the not )mS
ent
lay lge
of
rns-
rnd od.
:of
ical ngs
rof :cu-
itle ,or- nu- )or .me
lat nes are ead lof )ms
)rm bt). ma-
iod, rted ate.
eof
rtes.
sor
* U.S. translation practices have a special provision for translating statements of foreign sub- sidiaries operating in hyperinftation countries. These are countries where cumulative infla-
tion has been 1007" or'more over a 3-year period. In this case, the subsidiary must use the
temporal method.
A final note:The selection of the functional currency is determined by the economic real- ities of the subsidiary's operations, and is not a discretionary management decision on pre-
ferred procedures or elective outcomes. Since many U.S.-based multinationals have numerous
foreign subsidiaries, some doiiar-functional and some foreign currency-functional, currency
gains and losses may be passing through both current consolidated income and/or accruing in
equity reserves.
lnternational Translation Practices. Many of the world's largest industrial countries use International Accounting Standards Committee (IASC), and therefore the same basic trans-
lation procedure. A foreign subsidiary is an integrated foreign entity or a self-sustaining for- eign eitity; integratecl forign entities are typically remeasured using the temporal method (or some slight variation thereof); and self-sustaining foreign entities are translated at the current
rate method,also termed the closing-rate method.
-h'ielcnt Corp<x"ati ott's -ii"ar n sl a t io I t [ixllttstt rr Tiident Corporation, first introduced in Chapter 1 and shown in Exhibit 10.7, is a U.S'-based corporation, with a U.S. business unit, as well as foreign subsidiaries in both Europe and China. The company is publicly traded and its shares are traded on the New York Stock Exchange (NYSE).
Each subsidiary of Tiident-the United States, Europe, and China-will have its own financial statement. Each set of financials will be constructed in the local currency (yuan, dol- lar, euro), but the subsidiary insome statements and balan9e sheets will also be translated into U.S. dollars, the reporting currency of the company, for consolidation and reporting. As a
CHAPTFf? I0 Transaction and Translation Exposure 285
il; i;'. ;tpoi'i rtrr"t'"0 J31!"-lY ?12911
Exchange Rate Translated Accounts (US$J
. P-9t:.*9": ?::,?91.9 - Exchange Bate Translated
)__
ioss
the
ncy,
cia- rsed
are tive
the 1.10.
ans-
rted that
,uity bal- arn- ;ains .tion
This t for pass
Assets ln Euros {€) (US$/euro) Accounts (US$) (US$/euro)
Cash
Accounts receivable
lnventory
Net plant and equiPment
Total
Liabilities and Net Worth
Accounts payable
Shod-term bank debt
Long{erm debt
Common stock
Retained earnings
Translation gain (loss)
Toial
1,600,000
3,200,000
2,400,000
4,800,000
1.2000
1.2000
1 .2180
1.2760
1.2000
1.2000
1.2000
1.2764
1.2437 (a)
$ 1,92o,ooo s,840,000
2,923,204
6,124,80O
1.0000
1.0000
't.2180
1.2760
1.c000
.,.2740
1.2437 (b)
c
$ 1,600,000 3,200,000
2,923,200
6,124,800
12,000,000
800,000
1,600,000
1,600,000
1,800,000
6,200,000
$14,808,000
$ 960,000 1,920,000
1,920,0a0
2,296,840
7,711,200
$13,848,000
$ 800,000 1,600,000
1,600,000
2,296,844
7 ,711,200
$ (160,000)
12,000,000 $14,808,0c0 s13.848,000
(a) Dollar retained earnings before depreciation are the cumulative sum of addttions to reiained earnings o{ all prior years, translated ai exchange rates in each year'
(b) Translated into dollars at the same rate as before deprecia'tion of the euro'
(c) uncer tre temporal meihod, the translation loss of $160,000 would be closed into retained earnings through the income statement rather than left as a
separate line item as shown here. Ending retained earnings would aciually be $7,711,200 - s160 000: $z'551 '200'
through the income statement, reducing reported net income and reducing retained earnings'
Endirig retained earnings would in fact be $7 ,11'1'200 minus $160'000' or $7'551'200' Whether
gains ancl losses pass tf,rough the income statement under the temporal method depends
upon the countrY.
ManageriaE Implications In the case of Tiident, the translation loss or gain u'as larger under the current rate method
because inventory and net plant and equipmJnt. as rvell as all monetary assets' are deemed
exposed. When net exposed assets are lirger, gains or losses from translation are also larger'
If management expecis a foreign currency to bepreciate, it could minimize translation expo-
sule by ieducing net exposed issets. If management anticipates an appreciation of the for- eign currency, itihould increase net exposed assets to benefit from a gain."
Depending on the accounting method. managetnent might select different assets and lia-
bilities for reduction or increase-Thus, "real" decisions about investing and financing might
be dictated by which accounting technique is required, when in fact, the method of reporting
should be neutral in its influence on operating and financing decisions.
Managing Translatian fxposure The main technique to minimize translation exposure is called a balance sheet hedge' At
times, some firms have attempted to hedge translition exposure in the forward market' Such
action amounts to speculating in the forward market in the hope that a cash profit will be
realizedto offset the noncash loss from translation. Success depends on a precise prediction
286 PART 3 Foreign Exchange Exposure
of future exchange rates, for such a hedge wiil not work over a range of possible future spot rates. In addition, the profit from the forward "hedge" (i.e., speculation) is taxable, but the translation loss does not reduce taxable income.
Balance Sheet Hedge Defined. A balance sheet hedge requires an equal amount of exposed foreign cuffency assets and liabilities on a firm's consolidated balance sheet. If this can be achieved for each foreign currency, net translation exposure will be zero. A change in exchange rates will change the value of exposed liabilities in an equal amount bui in a direc- tion opposite to the change in value of exposed assets. If a firm translates by the temporal method, a zero net exposed position is called monetqly balance. Complete monetary balance cannot be achieved under the current rate method because total assets would have to be matched by an equal amount of debt, but the equity section of the balance sheet must still be translated at historic exchange rates.
The cost of a balance sheet hedge depends on reiative borrowing costs. If foreign cur- rency borrowing costs, after adjusting for foreign exchange risk, are higher than parent cur- rency borrowing costs, the balance sheet hedge is costly, and vice versa. Normal operations, however, aiready require decisions about the magnitude and currency denomination of spe-
crfic $aiance sheet accounis. Thus, balance sheet hedges are a compromise in which the denomination of balance sheet accounts is altered, perhaps at a cost in terms of interest expense or operating elficiency, to achieve some degree of foreign exchange protection.
To achieve a balance sheet hedge, Tiident Corporation must either 1) reduce exposed euro assets without simultaneously reducing euro liabilities, or 2) increase euro liabilities without simultaneously increasing euro assets. One way to do this is to exchange existing euro cash for dollars. IfTiident Europe does not have large euro cash balances, it can borrow euros and exchange the borrowed euros for dollars. Another subsidiary could borrow euros and exchange them for dollars. That is, the essence of the hedge is for the parent or any of its
subsidiaries to create euro debt and exchange the proceeds for dollars.
Current Rate Method. Under the current rate method, Tiident should borrow as much as
€8,000,000. The initial effect of this first step is to increase both an exposed asset (cash) and
an exposed liability (notes payable) on the balance sheet of Tiident Europe, with no immedi- ate eflect on net exposed assets. The required follow-up step can take two forms: 1) Tiident
Europe could exchange the acquired euros for U.S. doliars and hoid those dollars itseif, or 2) it could transfer the borrowed euros to Trident Corporation, perhaps as a euro dividend or
as repayment of intracompany debt. Tiident Corporation could then exchange the euros for
dollars. In some countries, local monetary authorities will not allow their currency to be so freely exchanged.
Another possibility would be for Tiident Corporation or a sister subsidiary to borrow the
euros, thus keeping the euro debt entirely off Tiident's books. Howevet, the second step is
still essential to eliminate euro exposure; the borrowing entity must exchange the euros for
doilars or other unexposed assets. Any such borrowing should be coordinated with all other euro borrowings to avoid the possibility that one subsidiary is borrowing euros to reduce translation exposure at the same time as another subsidiary is repaying euro debt. (Note that
euros can be "borrowed," by simply delaying repayment of existing euro debt; the goal is to
increase euro debt, not borrow in a literal sense.)
Temporal Method. If translation is by the temporal method, the much smaller amount of only €800.000 need be borrowed. As before, Tiident Europe could use the proceeds of the loan to
acquire U.S. dollars. F{owever, Tiident Europe could also use the proceeds to acquire inven-
tory or fixed assets in Europe. Under the temporal method, these assets are not regarded as
exposed and do not drop in dollar value when the euro depreciates'
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