Question

Examples of balance sheet exposure and transaction exposure to foreign exchange risks.

Answer 1

Transaction exposure measures gains or losses that arise from the settlement of existing financial obligations the term of which are stated in a foreign currency.

Transaction exposure arises from:

1. Purchasing or selling on credit goods and services when prices are stated in foreign currencies.
2. Borrowing or lending funds when repayment is to be made in a foreign currency.
3. Acquiring assets or incurring liabilities denominated in foreign currencies.

Example

An Indian firm sells merchandise on open account to a US buyer for US$ 2,85,000/- payment to be made in 30 days. The current exchange rate is Rs.48/- per US$ and the Indian seller expects to exchange the US$ received for Rs.136, 80,000/- when payment is received. In this case, transaction exposure arises because of the risk that the Indian seller will receive something other than the Rs.136,80,000/- expected. If US$ depreciate then the Indian seller would receive less and it may happen that Indian rupee depreciate where the Indian seller get more than the expected. Thus, exposure is the chance of either a loss or gain.

Balance Sheet/Translation exposure

When a multinational firm has one or more foreign subsidiaries with assets and liabilities denominated in a foreign currency, it faces translation exposure. For example, if a U.S.–based multinational firm operates a subsidiary in Poland, the “zloty” value of the subsidiary’s assets and liabilities must be translated into the home (U.S. $) currency when the parent firm prepares its consolidated financial statements. When the translation occurs, there can be gains or losses, which must be recognized in the financial statements of the parent. Following are the impact:

·         Current assets, unless covered by forward exchange contracts, and fixed assets are translated into dollars at the rate of exchange prevailing on the date of the balance sheet.

·         Current and long-term liabilities payable in foreign currency are translated into dollars at the rate of exchange prevailing on the date of the balance sheet.

·         Income statement items are translated either at the rate on the date of a particular transaction or at a weighted average of the exchange rates for the period of the income statement.

·         Dividends are translated at the exchange rate on the date the dividend is paid.

·         Equity accounts, including common stock and contributed capital in excess of par value, are translated at historical rates.

·         Gains and losses to the parent from translation are not included in the parent’s calculation of net income, nor are they included in the parent’s retained earnings. Rather, they are reported in a separate equity account named “Cumulative foreign currency translation adjustments” or a similar title. Gains or losses in this account are not recognized in the income statement until the parent’s investment in the foreign subsidiary is sold or liquidated.

A decline in the value of a foreign currency relative to the U.S. dollar reduces the conversion value of the foreign subsidiary’s liabilities as well as its assets. Therefore, the parent company’s risk exposure depends on the foreign subsidiary’s net equity position (that is, assets minus liabilities). Thus, on the books of the parent company, the subsidiary’s creditors in effect bear part of the decline in the value of the subsidiary’s assets. The impact of a decrease in the exchange rate on the firm’s balance sheet can be illustrated with the following example.

American Products has a subsidiary, Canadian Products, with total assets of $12 million (Canadian) and total liabilities of $8 million (Canadian).

Based on an exchange rate of $0.80 (U.S.) per dollar (Canadian), the net equity position of the Canadian subsidiary on American Products’ balance sheet as shown in Table 22.2 is $3.2 million (U.S.). Suppose now that the exchange rate declines to $0.75 (U.S.) per dollar (Canadian) and all other things remain the same. As can be seen in the table, the net equity position of the Canadian subsidiary on American Products’ balance sheet declines to $3 million (U.S.), resulting in a $200,000 currency exchange loss.