CHAPTER 11
TRANSLATION EXPOSURE
1. Translation. How do MNEs translate foreign currency into functional currency when
consolidating their financial statements?
Foreign currency is most commonly translated into functional currency when MNEs
combine the financial statements of their subsidiaries into one consolidated financial
statement. The following are the basic steps that a parent MNE must follow to
translate foreign currency amounts into the functional currency. First, after clearly
2. Mitigation. How can a firm mitigate translation exposure?
Translation exposure results from the currency in which the firm invoices and transacts its
sales, purchases, borrowings, and securities. This means that to reduce its translation
exposure the firm can borrow, invest, and invoice both sales and purchases in the local
3. Hedging against exposure. How do MNEs hedge against translation exposure and
foreign exchange exposure?
Foreign exchange risk can cause actual changes in the monetary valuations of the
MNE. Financial specialists use hedging techniques to coordinate buying and selling
foreign currencies to insulate themselves from foreign exchange fluctuations. They
can also include risk sharing, risk shifting, or price adjustment clauses in their
4. Subsidiaries’ Functional Currencies. What would be the functional currency of a
self-sustaining foreign subsidiary and an integrated foreign subsidiary?
An integrated foreign subsidiary operates as an extension of the parent company, with
5. Self-Sustaining Subsidiaries. Explain the two dimensions that determine the
translation methods that a parent company would use for consolidating its financial
statements.
When consolidating its financial statements, the translation methods used by the
parent company depend on the degree of independence of the subsidiary from the
6. Functional Currency. What are the factors involved in the determination of the
functional currency of a firm?
A functional currency is the primary currency and the monetary unit of account that a
company uses in its business activities. There are a number of factors that an MNE
considers when determining the functional currency of each of its subsidiaries. If
most of the operations of the subsidiary are in the form of sales in the domestic
7. Translation Methods. What are the two basic methods for translation used globally?
Two basic methods for translation are employed worldwide: the current rate method
and the temporal method. Regardless of which method is employed, a translation
8. Current Versus Historical. One of the major differences between translation
methods is which balance sheet components are translated at which exchange rates,
current or historical. Why would accounting practices ever use historical exchange
rates?
Equity investments in subsidiaries (initially and when added equity investments are
9. Translating Assets. What are the major differences in translating assets between the
current rate method and the temporal method?
Under the current rate method, all assets are translated at the current period (end of
10. Translating Liabilities. What are the major differences in translating liabilities
between the current rate method and the temporal method?
11. Selective Hedging. How do you evaluate the decision of an MNE to hedge its foreign
currency receivables only when it believes that its domestic currency will strengthen?
In this case, the MNE is engaging in selective hedging, which is very similar to
foreign exchange speculation. In this case, the MNE faces the risk that it will be
remain exposed and non-hedged when foreign currencies weaken, and be hedged
12. Translation Exposure Management. What are the primary options firms have to
manage translation exposure?
The main technique to minimize translation exposure is called a balance sheet hedge.
A balance sheet hedge requires an equal amount of exposed foreign currency 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.
13. Changes in Translation Strategies. What are the various hedging transactions that
are available to an MNE that is seeking to hedge the translation exposure of its
foreign subsidiaries? Do you think that the pertinent hedge strategy would change if
the foreign affiliates have the same functional currency as their parent MNE?
The parent MNE has three available methods for managing its translation exposure. It
can adjust fund flows, enter into forward contracts, or use exposure netting. It can use
direct funds-adjustment by pricing exports and imports in MNE and affiliate
14. MNE Exposures. What are various risks faced by MNEs and their subsidiaries?
During their operations, MNEs and their sub-units can incur either realized or
unrealized losses due to their exposure to various types of risks. In the case of
transaction risks, the units can incur cash losses incurred in the near term because of
the time delay between entering into a contract and settling it, causing changes in
prices of inputs or fluctuations in exchange rates. These losses should be realized and
15. Realization and Recognition. When would a multinational firm, if ever, realize and
recognize the cumulative translation losses recorded over time associated with a
subsidiary?
A U.S.-based multinational firm will realize and recognize in current income the
cumulative translation gains and losses associated with an individual foreign affiliate
when that affiliate is sold or closed. Also, if a foreign affiliate is operating in an
16. Tax Obligations. How does translation alter the global tax liabilities of a firm? If a
multinational firm’s consolidated earnings increase as a result of consolidation and
translation, what is the impact on tax liabilities?
This is in effect a trick question. Translation does not alter taxable income.
Multinational companies do not pay taxes on a consolidated basis. They pay taxes in
17. Inflation and Hyperinflation. Should MNEs be worried about inflation and
hyperinflation in countries where they operate? How can they hedge against
inflation?
Inflation is the persistent rise in the price of goods and services in a country.
Hyperinflation occurs when a country experiences excessively high accelerating rises
in prices. Inflation results in a lower purchasing power if people’s earnings are not
18. Forecasting. MNEs closely monitor forecasts about interest rates and inflation. How
can they profit from such future expectations?
If future forecasts are that domestic interest rates will rise, then the MNE should
immediately consider issuing bonds or borrowing from banks. If expectations are that
future prices will rise, the MNE should covert part of its liquid assets into assets or