Measurement and Management of Translation
Exposure
• Module II: Forex risk & exposure
• Measurement & management of Translation, Transaction & Economic,
exposure, Interest rate exposure, Political Risk Analysis Translation
exposure: methods of measurement and hedging strategies,
Management of economic exposure-interest rate exposure-hedging-
political risk –definition and assessment.
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What Is Translation Exposure?
• Translation exposure (also known as translation risk) is the risk that a company's
equities, assets, liabilities and income will change in value as a result of exchange
rate changes.
• This occurs when a firm denominates a portion of its equities, assets, liabilities or
income in a foreign currency. It is also known as "accounting exposure.”
• In many cases, translation exposure is recorded in financial statements as an
exchange rate gain (or loss).
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• In order to properly report the organization's financial situation, the assets and
liabilities for the whole company need to be adjusted into the home currency.
• Since an exchange rate can vary dramatically in a short period of time, this
unknown, or risk, creates translation exposure.
• This risk is present whether the change in the exchange rate results in an increase
or decrease of an asset's value.
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• Translation risk can lead to what appears to be a financial gain or loss
that is not a result of a change in assets, but in the current value of
the assets based on exchange rate fluctuations.
• For example, should a company be in possession of a facility located
in Germany worth €1 million and the current dollar-to-euro exchange
rate is 1:1, then the property would be reported as a $1 million asset.
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• If the exchange rate changes, and the dollar-to-euro ratio becomes 2:1, the asset
would be reported as having a value of $500,000. This would appear as a
$500,000 loss on financial statements, even though the company is in possession
of the exact same asset it had before.
• If 10,000 is the income in euro then it becomes $5000 in US. A loss in Income.
• If 100,000 is the share holders capital in Germany in euros then it becomes
$50,000.
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MEASURING TRANSLATION
EXPOSURE
• The following are the methods of measuring translation exposure:
• CURRENT/NONCURRENT METHOD
• Current assets and liabilities having a maturity of one year or lesser are translated at the current
exchange rate.
• Noncurrent assets and liabilities are converted at the past exchange rate that prevailed at the
time the asset or liability was recorded in the books.
• The income items are usually calculated at the prevailing exchange rate.
• While, the depreciating items, falling under non-current items are calculated at the historical
exchange rate.
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• MONETARY/NONMONETARY METHOD
• In this method, all monetary balance sheet accounts such as cash, accounts
payable and marketable securities of a foreign subsidiary are converted at the
current exchange rate.
• The remaining nonmonetary balance sheet accounts ( Plant and Machinery,
Goodwill etc.,) and shareholder’s equity are converted at the past exchange rate
when the account was recorded.
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• TEMPORAL METHOD
• In the temporal method, monetary accounts, both current and
noncurrent, such as receivables, payables, cash, Plant and Machinery,
Goodwill etc., are converted at the current exchange rate.
• Cost of goods sold and depreciation are converted at the historic
rates.
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• CURRENT RATE METHOD
• Under this method, all balance sheet accounts except for
stockholder’s equity, are converted at the prevailing current exchange
rate.
• The income statement items are converted at the existing exchange
rate on the dates the items are recognized.
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• After gaining an insight on measuring translation exposure, we will now have a look at how to
manage the same.
TRANSLATION EXPOSURE MANAGEMENT
• The following are the ways to manage or hedge translation exposure:
CURRENCY SWAPS
• Currency swaps are a settlement between two entities to exchange cash flows denominated for a
particular currency for a fixed time frame.
• Currency amounts are swapped for a predetermined period and interest is paid during that time
span.
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How a Currency Swap Works
• The two principal amounts create an implied exchange rate.
• For example, if a swap involves exchanging , Party A, €10 million versus Party B, $12.5 million,
that creates an implied EUR/USD exchange rate of 1.25.
• Ex: Interest rate paid by Party A: 5% and Party B 7%, or Party A paying 5% and Party B paying
floating Interest rate, Party A paying floating interest rate and Party B paying 7%, both Party A and
B paying floating interest rates.
• At maturity, the same two principal amounts must be exchanged, which creates exchange rate
risk as the market may have moved far from 1.25 in the intervening years.
• Party A takes Euros and delivers dollars and B takes Dollars and delivers Euros.
• Pricing is usually expressed as London Interbank Offered Rate (LIBOR), plus or minus a certain
number of points, based on interest rate and the credit risk of the two parties.
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• A currency swap can be done in several ways.
• Many swaps use simply notional principal amounts, which means that the principal amounts are
used to calculate the interest due and payable each period but is not exchanged.
• If there is a full exchange of principal when the deal is initiated, the exchange is reversed at the
maturity date.
• Currency swap maturities are negotiable for at least 10 years, making them a very flexible method
of foreign exchange.
• Interest rates can be fixed or floating.
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LIBOR ( London Inter-bank Offer Rate)
• The London Interbank Offered Rate (LIBOR) is a benchmark interest rate at which
major global banks lend to one another in the international interbank market for
short-term loans.
• LIBOR, which stands for London Interbank Offered Rate, serves as a globally
accepted key benchmark interest rate that indicates borrowing costs between
banks.
• The rate is calculated and published each day by the Intercontinental Exchange
(ICE).
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• Understanding LIBOR
• LIBOR is the average interest rate at which major global banks borrow from one
another.
• It is based on five currencies including the U.S. dollar, the euro, the British pound,
the Japanese yen, and the Swiss franc, and serves seven different maturities—
overnight/spot next, one week, and one, two, three, six, and 12 months.
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• The combination of five currencies and seven maturities leads to a
total of 35 different LIBOR rates calculated and reported each
business day.
• The most commonly quoted rate is the three-month U.S. dollar rate,
usually referred to as the current LIBOR rate.
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• Each day, ICE asks major global banks how much they would charge other banks
for short-term loans.
• The association takes out the highest and lowest figures, then calculates the
average from the remaining numbers.
• This is known as the trimmed average.
• This rate is posted each morning as the daily rate, so it's not a static figure.
• Once the rates for each maturity and currency are calculated and finalized, they
are announced and published once a day at around 11:55 a.m. London time
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• LIBOR is also the basis for consumer loans in countries around the world, so it
impacts consumers just as much as it does financial institutions.
• The interest rates on various credit products such as credit cards, car loans
fluctuate based on the interbank rate.
• But there is a downside to using the LIBOR rate. Even though lower borrowing
costs may be attractive to consumers, it does also affect the returns on certain
securities.
• Some mutual funds may be attached to LIBOR, so their yields may drop as LIBOR
fluctuates.
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• CURRENCY OPTIONS
• The Currency option gives the right to the party to exchange the amount of a particular
currency at an agreed exchange rate.
• However, the party is not obligated to do so. Nevertheless, the transactions must be conducted
on or before a set date in the future.
• The Party buying the option pays the fee called premium to the seller of the option.
• Call option means Right to Buy and Put option means Right to Sell.
• Assume 1 month contract.
• Rs/$=75, Spot price= Rs./$74 Call Option- will not exercise the option
• If Spot price =Rs./$78 Call Option-will exercise the option.
• If Rs/$=75, Spot price = Rs./$70 Put option-will exercise the option
• If Spot Price =Rs./$=79 Put option- will not exercise the option
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• FORWARD CONTRACTS
• Under the forward contracts, two entities fix a specific exchange rate
for the interchange of two currencies for a future date.
• The settlement for the agreed amount of currencies is conducted on
the particular future date which is pre-decided.
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• CONCLUSION
• Translation exposure is bound to take place in entities having foreign
operations or dealing with foreign currencies.
• Nevertheless, there are ways which can be adopted to mitigate the
exposure risk involved
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