CHAPTER 9: MEASURING AND MANAGING ACCOUNTING EXPOSURE
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CHAPTER 9
MEASURING AND MANAGING TRANSLATION AND TRANSACTION EXPOSURE
This chapter introduces the concept of accounting exposure and describes the various alternatives
available to measure accounting exposure and to manage it. A key point is the wide disparity in results
possible for similarly situated firms when using different measures of translation exposure. Although the
material is fairly mechanical, financial officers of MNCs should understand how companies measure
exposure, at least for reporting purposes. When it comes to managing accounting exposure, companies
have a number of different alternatives. Before deciding on which hedging alternatives to use, however,
companies must first decide what they are trying to accomplish through their hedging programs.
KEY POINTS ON MEASURING ACCOUNTING EXPOSURE
1. Accountants are concerned with the appropriate way to translate foreign-currency-denominated
3. The past and present mandated translation methods are FASB-8 and FASB-52, respectively.
4. Regardless of the translation method selected, measuring accounting exposure is conceptually the
same. It involves determining which foreign-currency-denominated assets and liabilities will be
5. By far the most important feature of the accounting definition of exposure is the exclusive focus on
the balance sheet effects of currency changes. This focus is misplaced since it has led firms to ignore
the more important effect that these changes may have on future cash flows.
KEY POINTS ON MANAGING ACCOUNTING EXPOSURE
1. Hedging cannot provide protection against expected exchange rate changes. Firms ordinarily cope
with anticipated currency changes by engaging in forward contracts, borrowing locally, and adjusting
their pricing and credit policies. However, there is reason to question the value of much of this
activity.
2. A policy of continual hedging will not reduce fluctuations in earnings caused by currency
changes. It is true that a U.S. company selling to French customers, for example, can fix the dollar
value of its franc revenues for the next three months or so, perhaps up to one year. For anything
beyond that, however, the firm faces exchange risk, even if it plans on using the forward market
consistently, since it must eventually roll these forward contracts over. Several studies have shown
CHAPTER 9: MEASURING AND MANAGING ACCOUNTING EXPOSURE
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SUGGESTED ANSWERS TO “CHRYSLER SHARES ITS CURRENCY RISK WITH
MITSUBISHI” MINI-CASE
1. Show how the dollar cost to Chrysler of an engine changed over the range ¥240/$ to ¥100/$.
ANSWER. According to the case, from ¥240 to ¥220 to the dollar, Mitsubishi would absorb the entire
cost of an exchange rate change. Within the range ¥220/$ to ¥190/$, Chrysler and Mitsubishi split the
2. Show how Mitsubishi’s yen revenue per engine changed over the range ¥240/$ to ¥100/$.
ANSWER. At any given exchange rate, Mitsubishi’s yen revenue equals Chrysler’s dollar price times the
3. Suppose at the time of a new engine shipment, the exchange rate was ¥150/$. What was the
dollar cost to Chrysler per engine? What was Mitsubishi’s yen revenue per engine?
SUGGESTED ANSWERS TO DKNY MINI-CASE
DKNY owes Mex$7 million in 30 days for a recent shipment from Mexico. It faces the following
interest and exchange rates:
Spot rate: Mex$10.93/$
Forward rate (30 days): Mex$11.03/$
30-day put option on dollars at Mex$ 10.83/$: 1% premium
30-day call option on dollars at Mex$ 11.03/$: 3% premium
U.S. dollar 30-day interest rate (annualized): 7.5%
Peso 30-day interest rate (annualized): 15%
1. What hedging options are available to DKNY?
2. What is the hedged cost of DKNY‘s payable using a forward market hedge?
3. What is the hedged cost of DKNY‘s payable using a money market hedge?
ANSWER. DKNY can hedge its payable by borrowing the dollar equivalent of the present value of the
4. What is the hedged cost of DKNY’s payable using a put option?
5. At what exchange rate is the cost of the put option just equal to the cost of the forward market
hedge? to the cost of the money market hedge?
ANSWER. The answer to this question depends on recognizing that at any exchange rate less than
Mex$11.03/$, the forward contract will always be less expensive than the put option by the amount of
6. How can DKNY construct a currency collar? What is the net premium paid for the currency
collar? Using this currency collar, what is the net dollar cost of the payable if the spot rate in
30 days is Mex$10.75/$? Mex$11.03/$? Mex$11.25/$?
ANSWER. DKNY can create a currency collar by simultaneously buying an out-of-the-money put option
and selling an out-of-the-money call option of the same size. In effect, the purchase of the put option is
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7. What is the preferred alternative?
8. Suppose that DKNY expects the 30-day spot rate to be Mex$11.25/$. Should it hedge this
payable? What other factors should go into DKNY’s hedging decision?
ANSWER. The key question here is where DKNY’s comparative advantage lies. Does it lie in making
SUGGESTED ANSWERS TO CHAPTER 9 QUESTIONS
1. What is translation exposure? Transaction exposure?
2. What are the basic translation methods? How do they differ?
3. What factors affect an MNC’s translation exposure? What can the company do to affect its
degree of translation exposure?
ANSWER. The factors affecting an MNC’s translation exposure under FASB 52 include the currency of
4. What alternative hedging transactions are available to a company seeking to hedge the
translation exposure of its German subsidiary? How would the appropriate hedge change if
the German affiliate’s functional currency is the U.S. dollar?
ANSWER. As mentioned in the text, the parent has three available methods for managing its translation
5. To eliminate all risk on its exports to Japan, an MNC decides to hedge both its actual and
anticipated sales. What risk is the MNC exposing itself to? How could this risk be managed?
6. Instead of its previous policy of always hedging its foreign currency receivables, Sun
Microsystems has decided to hedge only when it believes the dollar will strengthen. Otherwise,
it will go uncovered. Comment on this new policy.
ANSWER. Sun is engaging in selective hedging, which is really speculation. Sun faces the risk that it will
7. Your bank is working with an American client that wishes to hedge its long exposure in the
Malaysian ringgit. Suppose it is possible to invest in ringgit but not borrow in that currency.
However, you can both borrow and lend in U.S. dollars.
7.a. Assuming there is no forward market in ringgit, can you create a homemade forward
contract that would allow your client to hedge its ringgit exposure?
7.b. Several of your Malaysian clients are interested in selling their U.S. dollar export earnings
forward for ringgit. Can you accommodate them by creating a forward contract?
8. Eastman Kodak gives its traders bonuses if their selective hedging strategies are less expensive
than the cost of hedging all transaction exposure. What are the problems with this bonus plan?
9. Many managers prefer to use options to hedge their exposure because doing so allows them the
possibility of capitalizing on favorable movements in the exchange rate. In contrast, a company
using forward contracts avoids the downside but also loses the upside potential. Comment.
ANSWER. Options are clearly more valuable than forward contracts for the reasons stated in the question.
10. In January 1988, Arco bought a 24.3% stake in the British oil firm Britoil PLC. It intended to
buy a further $1 billion worth of Britoil stock if Britoil was agreeable. However, Arco was
uncertain whether Britoil, which had expressed a strong desire to remain independent, would
accept its bid. To guard against a possible a pound appreciation in the interim, Arco decided
to convert $1 billion into pounds and place them on deposit in London, pending the outcome
of its discussions with Britoil’s management. What exchange risk did Arco face and did it
choose the best way to protect itself from that risk?
ANSWER. The exchange risk faced by Arco was that it had a contingent pound liability (the cost of its
possible purchase of Britoil) offset by a fixed pound asset (the deposit). If the deal went through, Arco
11. Sumitomo Chemical has one week in which to negotiate a contract to supply products to a
U.S. company at a dollar price fixed for one year. What advice would you give Sumitomo?
ANSWER. This problem is identical to that faced by Weyerhaeuser in the text example. The general rule
12. U.S. Farm-Raised Fish Trading Co., a catfish concern in Jackson, Mississippi, tells its
Japanese customers that it wants to be paid in dollars. According to its director of export
marketing, this simple strategy eliminates all its currency risk. Is he right? Why?
13. The Montreal Expos is a major-league baseball team located in Montreal, Canada. What
currency risk is faced by the Expos, and how can this exchange risk be managed?
ANSWER. Payroll costs account for the lion’s share of baseball costs. The team has currency risk since it
pays its players in U.S. dollars while its principal source of income, from home game ticket sales, is in
14. General Electric recently had to put together a $50 million bid, denominated in Swiss francs,
to upgrade a Swiss power plant. If it won, GE expected to pay subcontractors and suppliers in
five currencies. The payment schedule for the contract stretched over a five-year period.
14.a. How should GE establish the Swiss franc price of its $50 million bid?
14.b. What exposure does GE face on this bid? How can it hedge that exposure?
ANSWER. To begin, GE is not certain of winning the bid. To hedge this quantity risk (it’s uncertain as to
15. Dell Inc. produces its machines in Asia with components largely imported from the U.S. and
sells its products in various Asian nations in local currencies.
15.a. What is the likely impact on Dell’s Asian profits of a strengthened dollar? Explain.
15.b. What hedging technique(s) can Dell employ to lock in a desired currency conversion rate
for its Asian sales during the next year?
15.c. Suppose Dell wishes to lock in a specific conversion rate but does not want to foreclose the
possibility of profiting from future currency moves. What hedging technique would be most
likely to achieve this objective?
15.d. What are the limits of Dell’s hedging approach?
ADDITIONAL CHAPTER 9 QUESTIONS AND ANSWERS
1. Why was FASB-8 so widely criticized? How did the Financial Accounting Standards Board
respond to this criticism?
2. A U.S. firm has fully hedged its sterling receivables and has bought credit insurance to cover
the risk of default. Has this firm eliminated all risk on these receivables? Explain.
3. What is the basic translation hedging strategy? How does it work?
3. MNCs can always reduce the foreign exchange risk faced by their foreign affiliates by
borrowing in the local currency. True or false? Why?
ANSWER. False. Currency risk is reduced when swings in operating profits due to currency changes are
4. Can hedging provide protection against expected exchange rate changes? Explain.
5. What is the domestic counterpart to exchange risk? Explain.
6. If a currency that a company is long in threatens to weaken, many companies will sell that
currency forward. Comment on this policy.
ANSWER. A reasonable working hypothesis is that financial markets are efficient. If so, the expected
7. Studies have shown that in trade dealings between nations that have high and volatile inflation
rates, most export prices are quoted in dollars. What might account for this finding?
8. Kemp & Beatley is a New York importer of table linens and accessories. It hedges all its import
orders using forward contracts. Does Kemp & Beatley face any exchange risk? Explain.
9. Liz Claiborne contracts out much of its production to foreign manufacturers. As such, the
company faces currency risk.
9.a. What currency risk does Liz Claiborne face?
9.b. How might Liz Claiborne go about hedging its currency risk?
ANSWER. Liz Claiborne can hedge its transaction exposure (equal to the amount of current orders
9.c. What danger does it face from locking in currency rates today?
ANSWER. This question is similar to that in Problem 17. The assumption in the hedging analysis so far is
INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.
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SUGGESTED SOLUTIONS TO CHAPTER 9 PROBLEMS
1. Suppose that at the start and end of the year, Bell U.K., the British subsidiary of Bell U.S., has
1.a. What is Bell U.K.’s translation exposure under the current/noncurrent, monetary/
nonmonetary, temporal, and current rate methods?
ANSWER. Under the current/noncurrent method, Bell U.K.’s translation exposure is £1 million – £1 million,
1.b. Assuming the pound is the functional currency, if the pound depreciated during that year
from $1.50 to $1.30, what is the FASB 52 translation gain (loss) to be included in the equity
account of Bell’s U.S. parent?
1.c. Redo part b assuming the dollar is the functional currency. Included in current assets is
inventory of £0.5 million. The historical exchange rates for inventory and fixed assets are
$1.45 and $1.65, respectively. If the dollar is the functional currency, where does Bell U.K.‘s
translation gain of loss show up on Bell U.S.’s financial statements?
2. Rolls-Royce, the British jet engine manufacturer, sells engines to U.S. airlines and buys parts
from U.S. companies. Suppose it has accounts receivable of $1.5 billion and accounts payable
of $740 million. It also borrowed $600 million. The current spot rate is $1.9528/£.
2.a. What is Rolls-Royce’s dollar transaction exposure in dollar terms? In pound terms?
2.b. Suppose the pound appreciates to $2.064/£. What is Rolls-Royce’s gain or loss, in pound
terms, on its dollar transaction exposure?
3. Zapata Auto Parts, the Mexican affiliate of American Diversified, Inc., had the following
balance sheet on January 1:
Assets (Mex$ millions) Liabilities (Mex$ millions)
3.a. What is Zapata’s FASB 52 peso translation exposure on January 1?
ANSWER. Zapata’s translation exposure depends on the functional currency used. If, over the past three
3.b. Suppose the exchange rate on December 31 is Mex$12,000. What will be Zapata’s translation
loss for the year?