UNIT 9 MEASURING AND MANAGING

TRANSLATION AND ECONOMIC

EXPOSURES
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Structure

9.0 Objectives
9.1 Introduction
9.2 Translation Exposure Defined
9.2.1 Distinction between Transaction and Translation Exposure
9.3 Currency Translation Methods
9.4 ~inancialAccounting Standards No. 8 and 52
9.5 Designing a Hedging Strategy
9.5.1 Funds Flow Adjustment
9.5.2 Forward Contracts
9.5.3 Exposure Netting
9.6 Centralisation vs. Decentralisation of Exchange Risk Management
9.7 Economic Exposure Defined
9.7.1 Measuring Economic Exposure
9.8 Managing Economic Exposure
9.8.1 Marketing Initiatives
9.8.2 Production lnitiatives
9.8.3 Financial Initiatives
9.9 Let Us Sum Up
9.10 Key Words
9.1 1 Terminal Questions/Exercises

9.0 OBJECTIVES
After studying this unit you should be able to :

explain the concepts of translation and economic exposures

discuss their impact on corporates
discuss various ways of hedging these exposures
compare and contrast various hedging techniques.

9.1 INTRODUCTION
In unit 8 you learnt about the concept, measurement and techniques of managing
transaction exposure. In this unit you will learn about two other forms of exposure
facing international business firms, namely translation (or accounting) and economic
exposure. You will also learn about their concepts and various hedging techniques and
the impact of these exposures on corporates.

9.2 TRANSLATION EXPOSURE DEFINED

Translation exposure refers to the amount of risk facing the firm as a result of the
need to translate financial statements prepared in onL currency into statements in another
currency. This is particularly true for multinational firms which must consolidate their
financial results at the end of the year. The accounting framework is the legally
required form in which companies must report operating results and financial condition
to shareholders. The financial statements contain information of interest to various other
parties viz lenders, debtors, regulators. Thus , the translation of subsidiary accounts for
consolidation into parent accounts faces translation exposure and may pose serious
implications for the parent company. ,

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 Measuring and Managing
9.2.1 Distinction between Transaction and Translation Exposure Translation and Economic
Exppsures
The addition of the word 'risk' after 'transaction' or 'translation' tends to convey that
transaction risk and translation risk are two different risks, i.e., different external threats.
Indeed, they may be more appropriately viewed as different ways of looking at and
managing the same (or at least largely overlapping) external threats. An accounting
model of receipts and payments is implicit when reference is made to translation risk,
and a cash flow model of receipts and payments is implicit when reference is made to
transaction risk.

Translation risks are commonly restricted by experts to contractually committed receipts

and payments. Uncommitted ones may never appear on financial statements at all.
Clearly, this category of contractually committed receipts and payments overlaps with a
considerable proportion of those included in transaction risks. In fact, some writers
would treat transaction and translation risks as co-terminus, whereas others would wish
to extend transaction risk to include a number of uncommitted future transactions.
What is common to all of them, however, is that the distinction is not between different
external threats, i.e., different mismatches. Transaction and translation mismatches arise
largely froni the same transactions: both threats are from the effect of adverse
movements in the same nominal exchange rates on the outcomes of largely the same
transactions, The distinction is effectively between two models of the business used by
managers, the accounting model and the future cash flows model. The contrast
concerns the values (current market or balance sheet values) and the time horizon which
the durrency manager has in mind when managing the risks. The distinction is
subjective in that it turns on manager's perceptions: if he is concerned with accounting
values and with losses or gains arising in financial reporting periods, then he is
managing the translation or accounting risk; if he is concerned with the amount of the
future cash receipt or payment on its expected date, then he is managing transaction
risk. The clistinction between translation and transaction risk is, therefore, between
management perceptions, not between external threats or risks. This is, however,
important to recognise and provide for.

Translation (position) risk can be measured either aggressively for gain or defensively to
avoid loss. Some companies prefer the objective of leaving the impact of currency
movements unchanged between successive reporting periods. They prefer to smooth
rather than sptimise or minimise the effect of currency movements. Defensive
management approach involves adjustment of each position to zero. Aggressive
management of freely floating currencies is for those who either have reason to know
they can beat market expectations of fiture exchange rates, or have special tax position
which load the dice in their favour after tax. Aggressive management is more likely to
be successfbl with controlled or managed currencies or over very short periods.
Aggressive position risk management is difficult, but not wrong in principle, as long as
it is a calculated and adequately controlled and the relevant policy disclosed to and
understood by investors.

9.3 CURRENCY TRANSLATION METHODS

Companies with international operations will have foreign currency denominated assets
and liabilities, revenues and expenses. However, because home country investors would
be interested in home currency values, the foreign currency balance sheet accounts and
income statements must be assigned home currency values. In particular, the financial
statements of an MNC's overseas subsidiaries must be translated from local currency to
home currency prior to consolidation with the parent's financial statements. If currency
values change, foreign exchange translation gains or losses may result. Assets and
liabilities that are translated at the current (post change) exchange rate are considered to
be exposed; those translated at a historical (pre change) exchange rate will maintain
their historic home currency values and hence, are regarded as not exposed. Translation
exposure is simply the difference between exposed assets and exposed tiabilities. The
difference of opinion among accountants centre around (1) which assets and liabilities
are exposed and (2) when accounting-derived foreign exchange gains and losses should
be recognised (reported on the income statement). A crucial point to see these
Foreign Exchange Risk
Management differences of opinion in perspective is that such gains and losses are of an accounting
nature - that is, no corresponding cash flows are involved. The four most common
methods of translation are, the currenvnon-current method, the monetarylnon-monetary
method, the temporal method, and'the current rate method. Let us briefly discuss these
in the following:

CurrentINon-Current Method

At one time, the current/non-current method, whose underlying theoretical basis is

maturity, was used by almost all US multinationals. Under this method, all the foreign
subsidiary's current assets and liabilities are translated into home currency at the current
exchange rate. Each non-current asset or liability is translated at its historical exchange
rate; that is, at'the rate in effect at the time the asset was acquired or the liability
incurred. Hence, a foreign subsidiary with positive local currency working capital will
give rise to a translation loss (gain) from a devaluation (revaluation) with the current/
non-current method, and vice versa if working capital is negative. The income
statement is translated at the average exch'ange rate of the period, except for those
revenue and expense items associated with noncurrent assets or liabilities. The latter
items, such as depreciation expense, are translated at the same rates as the
corresponding balance sheet items. Thus, it is possible to see different revenue and
expense items with similar maturities being translated at different rates.

MonetaryINon-monetary Method

The monetarylnon-monetary method differentiates between monetary assets and liabilitie!

- that is, those items that represent a claim to receive, or an obligation to pay a fixed
amount of foreign currency units and non-monetary or physical assets and liabilities.
Monetary items (for example, cash, accounts payables and receivables and long-term
debt) are translated at the current rate; non-monetary items (for example, inventory,
fixed assets and long-term investments) are translated at historical rates. Income
statement items are translated at the average exchange rate during the period, except for
revenue and expense items related to nonmonetary assets and liabilities: The latter
items, primarily depreciation expense and cost of goods sold, are translated at the same
rate as the corresponding balance-sheet items. As a result, the cost of goods sold may
be translated at a rate different from that used to translate sales.

Temporal Method

This method appears to be a modified version of the monetarylnon-monetary method.

The only difference is that under the monetarylnon-monetary method, inventory is
always translated at the historical rate. Under the temporal method, inventory is
normally translated at the historical rate, but it can be translated at the current rate if
the inventory is shown on the balance sheet at market values. Despite the similarities,
however, the theoretical basis of these two methods is different. The choice of
exchange rate for translation is based on the type of asset or liability in the monetary/
non-monetary method; in the temporal method, it is based on the underlying approach
to valuation viz historical cost versus market value. lncome statement items are
normally translated at an average rate for the reporting period. However, cost of goods
sold and depreciation and amortisation charges related to balance sheet iiems carried at
past prices are translated at historical rates.

Current Rate Method

The current rate method is the simplest. Under this method, all balance-sheet and
income items are translated at the current rate. Thus, if a firm's foreign currency
denominated assets exceed its foreign currency denominated liabilities, a devaluation
must result in a loss and a revaluation in a gain. One variation of this method is to
translate all assets and liabilities except net fixed assets at the current rate.
 Measuring ancl Managing
9.4 FINANCIAL ACCOUNTING STANDARDS Translat'on and Economic
Exposures
NO. 8 AND 52

From our discussion above of various methods of translation available, you may easily
expect wide variation in the results reported under different methods of translation. This
precisely led the Financial Accounting Standards Board (FASB) of the US to issue
accounting standard number 8 to establish uniform standard of translating foreign
currency denominated financial statements. FASB 8, which was based on the temporal
method, became effective on January 1, 1976. Its principal virtue was its consistency
with generally accepted accounting practice that requires balance sheet items to be
valued (translated) according to their underlying measurement basis (that is, current or
historical). Almost immediately upon its adoption, controversy ensued over FASB 8. A
major source of corporate dissatisfaction with FASB 8 was the ruling that all reserves
for foreign currency losses be disallowed. Before FASB 8, many companies established
a reserve and were able to defer unrealised gains and losses by adding them to, or
chzrging them against the reserve. In that way, corporations generally were able to
cushion the impact of sharp changes in currency values on reported earnings. With
F A S B ' ~ ,however, fluctuating values of foreign currencies often had more impact on
profit and loss statements than did the sales and profit margins of multinational
manufacturers' product lines.

In 1981, widespread dissatisfaction by corporate executives over FASB 8 led to a new

-
translation standard FASB 52. According to FASB 52, firms must use the current rate
method to translate foreign currency denominated assets and liabilities into home
currency. All foreign currency revenue and expense items on the income statement
must be translated at either the exchange rate in effect on the date these items are
recognised or at an appropriately weighted average exchange rate for the period. The
most important aspect of 'the new standard was that unlike the case with FASB 8, most
FASB 52 translation gains and losses bypass the income statement and are accumulated
in a separate equity account on the parent's balance sheet. FASB 52 also, for the first
time, differentiated between the functional currency and the reporting currency. An
affiliate's functional currency is the currency of the primary economic environment in
which the affiliate generates and expends cash. If the enterprise's operations are
relatively self-contained and integrated within a particular country, the functional
currency would generally be the currency of that country. It is also possible that the
functional currency is neither the local currency nor the home currency, but rather is a
third currency. This especially happens in high inflation countries. The reporting
currency, on the other hand, is the currency in which the parent firm prepares its own
financial statements. FASB 52 requires that the financial statements of a foreign unit
first be stated in the functional currency, using generally accepted accounting principles.
At each balance sheet date, any assets and liabilities denominated in a currency other
than the functional currency, or from settling such items, generally must appear on the
foreign unit's income statement. That is, if the functional currency is identical to the
local currency, translation gains and losses must appear in the balance sheet as a
separate item called cumulative translation adjustment under the shareholder's equity
account. If the functional currency is other than the local currency, then all financial
statements prepared in local currency must first be translated into the functional
currency. This translation is done according to the temporal method previously required
by FASB 8, and therefore, the resulting translation gains and losses must be reported in
the income statemeht.

In India, Institute of Chartered Accountant of India has issued AS-1 1, which is based
on IAS-21 prescribed by International Accounting Association in this regard.

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Foreign Exchange Risk
Management 9.5 DESIGNING A HEDGING STRATEGY
14s you can see, translation exposures are serious enough to merit specially designed
hedging strategies. Firms have three available methods for managing their translation
exposure: (1) adjusting fund flows; (2) entering into forward contracts; and (3)
exposure netting. The general rule followed is as follows:

Basic Stratenv for Hed~inpTranslation Exmsure

Hard Currencies
(likely to appreciate) Increase Decrease

Weak Currencies
(likely to depreciate)

The strategy shown above essentially involves increasing hard currency (likely to
appreciate) and decreasing weak currency (likely to depreciate) assets, while
simultaneously decreasing hard currency liabilities and increasing weak currency
liabilities. For example, if a devaluation appears likely, the basic hedging strategy
would be executed as follows: reduce the level of cash, tighten credit terms to decrease .
accounts receivables, increase local currency borrowing, delay accounts payable, and sell
the weak currency forward. Despite their prevalence among firms, however, these
hedging activities are not automatically valuable. If the market already recognises the
likelihood of currency appreciation or depreciation, this recognition will be reflected in
the costs of the various hedging techniques. Only if the firm's anticipation differs from
the market' and is also superior to the market, can hedging lead to reduced costs.
Otherwise, the principal value of hedging would be to protect a fum from unforeseen
currency fluctuations.

9.5.1 Funds Flow Adjustment

Most techniques for hedging an impending local currency devaluation reduce local
currency assets or increase local currency liabilities, thereby generating local currency
cash. If accounting exposure is to be reduced, these funds must be converted into hard
currency assets. For example, a company will reduce its translation loss if, before local
currency devaluation, it converts some of its local currency cash holdings to the home
currency. Th$ conversion can be accomplished, either directly or indirectly, by means
of various funds adjustment techniques.
G
Funds adjustment involves altering either the amounts or the currencies (or both) of the
planned cash flows of the parent and/or its subsidiaries to reduce the firm's local
currency accounting exposure. If a local currency devaluation is anticipated, direct
finds-adjustment methods include pricing exports in hard currencies and imports in the
local currency, investing in hard currency securities, and replacing hard currency
borrowings with local currency loans. The indirect methods include adjusting transfer
prices on the sale of goods between affiliates, speeding up the payment of dividends,
fees and royalties, and adjusting the leads and lags of inter subsidiary accounts. The
latter method, which is the one most frequently used by multinationals, involves
speeding up the payment of inter subsidiary accounts payables and delaying the
collection of inter subsidiary accounts receivables. These hedging procedures would be
reversed for an appreciation of the local currency. Some of these techniques or tools
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may require considerable lead time and as is the case with a transfer price once they
are introduced, they cannot be easily changed. In addition, techniques such as transfer
price, fee and royalty, and dividend flow adjustments fall into the realm of corporate
policy and are not usually under the treasurer's control. It is, therefore, incumbent on
the treasurer to educate other decision makers about the impaqt of these tools on the
costs and management of corporate exposure. For those countries in which a formal
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 Measuring and Managing
market in local currency forward contracts does not exist, leading and lagging and local Translation and I:cosomic
currency borrowing are the most important techniques. The bulk of international Exposures
business, however, is conducted in those few currencies for which forward markets do
exist. A summary of the fund flow adjustment hedging actions under currency
depreciation / appreciation scenarios may be given as follows:

Currencv Deoreciation Currency Aooreciation

Sell local cwrency forward Buy local currency forward

Reduce levels of local currency Increase levels of local currency cash

cash and marketable securities and marketable securities

Tighten credit (reduce local Relax local currency credit terms

currency receivables)
Speed up collection of weak currency
receivables
Increase imports of hard currency Reduce imports of soft currency goods

Borrow locally Reduce local borrowings

Delay payment of accounts payables Speed up payment of accounts payables
Speed up dividend and fee remittances Delay dividend and fee remittances to
to parent and other subsidiaries parent and other subsidiaries
Speed up payment of inter subsidiary Delay payment of inter subsidiary
accounts payables accounts payables
Delay collection of inter subsidiary Speed up collection of inter subsidiary
accounts receivables- accounts receivables
Invoice exports in foreign currency and Invoice exports in local currency and
imports in local currency imports in foreign currency

9.5.2 Forward Contracts

You have already studied in unit 8, how forward contracts can reduce a fum's
transaction exposure. Forward contract can also be used to hedge translation exposure
by creating an offsetting asset or liability in a foreign currency. For example, suppose
that IBM U.K has translation exposure of 40 million pounds (that is, sterling assets
exceed sterling liabilities by that amount). IBM U.K can eliminate its entire translation
exposure by selling 40 million pounds forward. Any loss (gain) on its translation
exposure will then be offset by a corresponding gain (loss) on its forward contract.
However, it is to be noted that the gain (or loss) on the forward contract is of a cash
flow nature and is netted against an unrealised translation loss (or gain).

9.5.3 Exposure Netting

Exposure netting is another hedging technique that can be used by a multinational

firms with positions in more than one foreign currency or with offsetting positions in
the same currency. As explained in unit 8, this technique involves offsetting exposures
in one currency with exposures in the same or another currency such that gains and
losses on the two currency positions will offset each other.

Selecting convenient (less risky) currencies for invoicing exports and imports and

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Foreign Exchange Risk
Management 9.6 CENTRALISATION VS. DECENTRALISATION OF
EXCHANGE RISK MANAGEMENT
Centralisation or decentralisation is a particularly important issue in exchange risk
management. The choice depends not only on the company's management style, but
also on the nature of its business. In any case, the logistics of management influence
the handling of currency risk in a variety of ways. In the area of foreign exchange risk
management, there are good arguments both for and against centralisation. Favouring
centralisation is the reasonable assumption that local treasurers want to optimise their
own financial and exposure positions regardless of the overall corporate situation. Many
companies take the view that their group's commercial success requires strong local
control. Local here refers to any profit centre, be it geographical, product or a market
segment. It is hard for such a structure to be effective if there are any unnecessary
restrictions on the local manager's power to take decisions which influence profit
centre's commercial success. Many currency risk decisions are highly germane to
'
commercial success. Secondly, the local currency manager is closer to the transactions
of the local unit, and also to the local banking system and foreign exchange market.
This is espkcially important if the local currency market is insulated by controls from
the world banking market in which the parent deals.

There is much diversity in the extent to which companies centralise currency dealing,
currency invoicing decisions, and risk management and hedging decisions. Practice in
multinational groups can vary from total centralisation, where all dealing is done by the
parent, to a high degree of freedom for every world-wide profit centre to manage its
own currency risks by its own criteria. The variety of practice is likely to owe much
to differences between the products, market positions and international spread of each
group of companies. Few companies stand at the extreme ends of the spectrum. Most
international companies, as a minimum:

issue guidelines stating the corporate objectives in managing currency risks;

require prompt and accurate information about currency positions, so that
the corporate can then at the centre adjust the consolidated position of the
group to the desired level; and
monitor and take central action to manage the group position.

On the other hand, very few groups centralise:

currency dealing for all their foreign subsidiaries, or

decisions about the currencies in which units sell, or
decisions about the exchange rates used to calculate export selling prices.

Many give guidance and advice, but few directly interfere in the affairs of overseas
subsidiaries. Domestic subsidiaries are another matter, for the prevailing practice is to
have only one currency dealing centre per country.

Total centralisation of currency dealing may be appropriate in a very monolithic single

product group. However, there are diseconomies of dealing from a distance besides '
possibility of demotivation of local managers. A decentralised group that wishes to
manage currency risk for gain may, therefore, ask its overseas subsidizfries to adopt a
defensive, hedge only policy, leaving the corporate centre to deal aggressively for gain.
It might seem as the way to get the best of both worlds. However, there are some other
ways also. A devolved structure may be adopted which permits all profit centres to
make their own currency risk management decisions, but requires them to deal
exclusively with the group centre as their in-house banker. The group centre then, at
their request, gives the profit centre spot or forward deals, swaps, or options, quoting
the best market prices that they could have obtained by dealing direct. It then makes its
own decisions about dealings with the outside world. The group centre is then in
complete control of the group position, free to pursue its own policies; yet, the
operating units are equally free to run their affairs as they choose.
52
 Where currency expertise is for one reason or another centralised as an exception to an Measuring a ad Managing
Translation and Economic
otherwise decentralised management structure, there are two implications. First, the Exposures
need for team work is paramount. Secondly, the central currency management function
should, as far as possible, play a detached part, relying as much as possible on
'guidelines, routine advice on exchange rates and currencies, and as little as possible on
an imposed right to be consulted on day-to-day decisions. This helps to reinforce the
motivation of line managers to run their businesses successfully. The corporate centre
needs a clear view of what exposures are too small and fragmented to be worth
managing, and to issue carefully defined authority limits. Units are free to manage
exposures below those limits as they think fit. All currency positions must, however, be
reported to the centre so that the group exposure can be monitored. The ultimate
constraints on delegation are:

the integral nature of the group's standing in its financial markets; and
the threshhold of tolerable risk.

The process of delegation needs so much care because currency exposures have a way
of being correlated and of being cumulative, both in time and across the spectrum of a
group's sub-units. However, few groups' inflows and outflows are so naturally
balanced that a policy of laissez-faire is safe. Small individual exposures, instead of
cancelling out, have a way of accumulating to major gains or losses for the group. The
most effective place for the head office to manage this is in the parent company,
leaving the profit centres to watch their own solvency criteria. An effective
decentralised structure should be impeded as little as possible. Currency risk
management should achieve its central objectives as unobtrusively as possible.

The dimensions in which currency risk management can be either centralised or

decentralised are:

1. where and by whom currency dealing is done;

2. where and by whom exposures can be authorised and hedging decisions taken;
3. where and by whom it is decided in what currencies to quote prices; and
4. in what currencies intragroup sales are invoiced.

The extreme form of centralisation is where the group centre does all dealing and takes
all decisions. However, a complete absence of central guidelines and authority limits is
rare. The first reason for it is that a group of companies cannot decentralise its credit
rating and investment status in its financial markets. If the parent IS listed, it will have
its stock market quotation on a stock exchange. The stock market treats such a group
as a single financial entity with an integral investment and credit status. Similarly,
banks tend to regard subsidiaries as extensions of the parent, even if the parent will not
formally guarantee them. The parent alone, therefore, has the critical interface with the
fmancial markets. Partly owned subsidiaries may be an exception to this rule. It
follows that only the corporate centre is sensitive to the effect of currency exposures on
the group's financial standing and cost of capital. Managers outside the corporate
centre may take decisions which are either imperfectly targeted or convey unhelpful
signals to the financial markets.

Secondly, because only the centre has the key interface with the financial markets,
wholly owned subsidiaries tend to need less experts for dealing with those markets than
the parent. They may, therefore, lack some of the technical sophistication and
experience needed to handle currency risk in volatile markets. Currency risk is not easy
to handle; few groups can afford expertise in all their subsidiaries or other sub-units.
Where the skills are concentrated at the centre, there is a strong case for letting the
central experts take the critical decisions.

Thirdly, it is often contended that there are economies, particularly in dealing costs, if
transactions are minimised, netted and then centrally handled. On the whole, centralised
exchange risk management seems better option.

53
Foreign E:change Risk Check Your Progress A
Management

1. Define translation exposure.

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2. What was the rationale behind introduction of FASB-8 and FASB-52?
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9.7 ECONOMIC EXPOSURE DEFINED

Economic exposure relates to 'cash flow' risks. The term cash flow has been defined in
different ways. Cash flow means (1) the total net dividends and liquidation proceeds
available to the owners over future years, (2) the free cash flow, that is earnings before
depreciation minus capital expenditure minus increases in working capital, (3) the future
earnings of the company defined in such a way as to reflect cash earnings rather than
earnings computed on the accrual concept of accounting. The following distinguishing
- . features apply to cash flow risk:

One, the threat is to the competitiveness of costs; it affects the ability of the business to
compete, to obtain sales at a remunerative margin of profit over cost.

Two, the threat is from movements of the real, not the nominal exchange rate. A rise in
the real rate of exchange erodes either margins or sales volume or a mixture of both.
Rise and fall in the real exchange rate of selling currencies tend to affect all
competitors, and are part of the wider phenomenon of macroeconomic uncertainty which
every business must manage. It is thus not primarily a currency risk. This is a trading
risk. All businesses have to watch the forces which affect demand and supply of what
they are offering. This is a wider macroeconomic risk and not just a currency risk.
Currencies are an important part, but not the whole of the relevant economic
environment. Consequently, if there are only two competing suppliers, one with French
avd one with Geman costs, and if the bulk of sales are in the USA or in US dollars, a
fall in the real exchange rate of the dollar would not cause economic or competitiveness
risk. What could cause it is a change in the real FFrIDM exchange rate.

competitiveness risk. In these cases, management task is concerned with nominal, 'not
real exchange rates. Competitiveness risk, thus, excludes all potential sales for which
the business has quoted prices, as well as actual sales, regardless of whether they have
reached the balance sheet as receivables or payables.

Four, the threat is to the competitive position of a business. Strictly, it is to a business

in one or more of its commercial markets, where it incurs appreciable costs in a
currency which may become less competitive.

In sum, economic (competitiveness) risk is concerned with threats from changes in real
exchange rates to the competitiveness of costs.The seriousness of the risk depends on
how hard it is t o shift costs between currencies. For example, the value added by the
contractor for a petrochemical process plant is largely design and management, the
hardware is all procured from manufacturers. The largest item, the compressor, can be
ordered from manufacturers in a number of countries, and if a high real exchange rate
makes the British compressor maker uncompetitive, then the contractor has little
difficulty in switching this major cost item to a supplier with costs in a more
competitive currency. Procurement costs are seldom locked into a particular currency,
- 4
 +
c.

Measuring and Managing

whereas la&& and capital costs are. not easily or rapidly switched. So, contractors are Translation and Economic
better placed than manufacturers to switch costs by switching subcontracts. If the main Exposures
contractor had been a British compressor manufacturer, it would have found it much
harder to purchase the compressor from its Swiss competitor, leaving its own British
workforce to face redundancies.

The sensitivity of a business to competitiveness risk depends on its elasticity of demand.

A competitive strategy of differentiation aims precisely at a more steeply sloping
demand curve. The less price-sensitive customers are, the less damaging is a
deterioration in cost competitiveness.

Competitiveness risk is a long term problem. Trends in real exchange rates can
sometimes be assessed for a few years ahead. Companies can profit from this either by
switching costs to currencies likely to become more competitive or by competitive
strategies which modify sensitivity to cost differentials. The essence of this risk is its
effect on the competitive position, and responses should concentrate on commercial
rather than financial action.

Economic or competitiveness risk is not restricted to businesses which trade with other
countries. If, for example, the business is a single hotel, and the home currency
becomes uncompetitive, less tourists will come and the hotel will lose business. Some
authors like Adler and Dumas (1984) and Wihlborg (1987) treat currency risk as one
element of the wider concept of macroeconomic threats to real (inflation-adjusted) cash
flows. One diffictilty with this is that it ignores the difference between threats caused
by nominal, as op#osed to real exchange rate movements. At a more fundamental
level, however, exchange rates are themselves correlated with, and caused by
macroeconomic phenomena which affect business profitability directly, as well as
indirectly via currency movements. It is thus suggested that a sharp distinction should
be made between external influences on (a) costs; and (b) selling prices. Real
exchange rates tend to have a much more dramatic impact on the competitive costs of a
given competitor than on the market price of what he is offering. This is because only
in conditions of absolute or near monopoly, will the individual competitor set market

9.7.1 Measuring Economic Exposure

Determining a f m ' s true economic exposure is a daunting task, requiring a singular

ability to forecast the amounts and exchange rate sensitivities of future cash flows.
Most f m s that follow the economic approach to managing exposure, therefore, must
settle for a measure of economic exposure and their resulting exchange risk which is
nothing more than intuition. A workable approach may be to use historical data from
the firm's actual operations or, in the case of a new venture, data from a comparable
business. This approach is based on definition of the exchange risk faced by a parent
or one of its foreign affiliates as follows:

A company faces an exchange risk to the extent that variations in the dollar value of
the unit's cash flows are correlated with variations in the nominal exchange rate. This
correlation is precisely what a regression analysis seeks to establish. Specifically, this
involves running the following regression equation:

[CFt = a+ bEXCHt +ut

CFt = the dollar value of total affiliate (parent) cash flows in period t
EXCHt = the average exchange rate during ptriod t
u = a random error term with mean 0

The output from such a regression analysis includes three key parameters: (1) the
fofeign exchange beta 'b' coefficient, which measures the change in cash flow
corresponding to one unit change in exchange rate; (2) the 't' statistic which measures
55
Foreign Exchange Risk the statistical significance of the beta coefficient, and (3) the R square [R~] which
Management
measures the fraction of cash flow variability explained by variation in the exchange
rate. The higher the beta coefficient, the greater the impact of a given exchange rate
change on the home currency value of cash flows. Conversely, the lower the beta
coefficient, the less exposed the firm is to exchange rate changes. A larger 't' statistic
means a higher level of confidence in the value of the beta coefficient. However, even,
if a firm has a large and statistically significant beta coefficient and, thus, faces real
exchange risk, this situation does not necessarily mean that currency fluctuations are an
important determinant of the overall firm risk. What really matters is the percentage of
total corporate cash flow variability that is due to these currency fluctuations. Thus, the
most important parameter in terms of its impact on the firm's exposure management
policy is the regression's R2. For example, if exchange rate changes explain only 1%
of total cash flow variability, the firm should not devote much in the way of resources
to foreign exchange risk management, even if the beta coefficient is large and
statistically significant. The validity of this method is clearly dependent on the
sensitivity of future cash flows to exchange rate changes being similar to their historical
sensitivity. In the absence of additional information, this assumption seems to be
reasonable. But the firm may have reason to modify the implementation of this
method. For example, the nominal foreign currency tax shield provided by a foreign
affiliate's depreciation is fully exposed to the effects of currency fluctuations. If the
amount of depreciation in the future is expected to differ significantly from its historical
values, then the depreciation tax shield should be removed from the cash flows used in
the regression analysis and treated separately. Similarly, if the firm has recently entered
into a large purchase or sales contract fixed in terms of the foreign currency, it might .
decide to consider the resulting transaction exposure apart from its economic exposure.

9.8 MANAGING ECONOMIC EXPOSURE

A manager whose costs become uncompetitive must either get out of that particular
product in its present form, or seek to make his costs competitive. He can only use a
hedge against his costs becoming uncompetitive if he treats the effect of that hedge as
part of the cost structure. In other words, if the hedge does its job, i.e., provides a
financial gain which offsets his costs, he must look at his costs as reduced by the gain
from the hedge. Conversely, however, if his own currency of cost falls in real terms,
he must treat the loss from the hedge as an extra cost which denies him the benefit of
the improvement in the competitiveness of his own currency. It is not easjl to see
many managers readily accepting that. It would obviously be dangerous commercial
policy where the company has a local competitor in its own country. With a falling
real exchange rate, it would lose market share to that competitor unless that competitor
had adopted an identical hedging policy. Otherwise, the competitor would be free to
reduce prices or collect higher margins. Generally speaking, no manager will handicap
his company when its economic environment is favourable.

Practical opportunities to manage competitiveness risk occur in two types of

circumstances. The first is whenever plans are made. A business can seek to improve
its competitive position by arranging, as far as practicable, to incur its costs in
currencies expected to be relatively competitive during the critical period. '
Competitiveness risk and the real exchange rate should be taken into account in all
investment and other planning decisions. How decisive a role this consideration will
play will depend on the circumstances of each case. Often, it will play only a minor
role. In.any event, the planning process will be better informed if t r d s in the real
exchange rate and its effect on costs over the planning period are taken into account.
The second set of circumstances is whenever a deterioration in trading performance is
being analysed, or where other evidence comes to hand that the currency of major costs
is becoming less competitive. Where trading performance has deteriorated, a rising real
exchange rate is, of course, only one of many possible explanations. However,
whenever other explanations have been eliminated and yet market share is being lost to
foreign competitors, there must be a strong chance that the real exchange rate has done
the damage. Again, the opportunity to manage such situation will depend on whether
some of the following courses of action are available to the management:
.One, shift costs into a more competitive currency, or Measuring r~ndManaging
Translation r~ndEconomic
Two, increase the degree of differentiation of the company's competitive offering, so as Exposures
to make it less price-sensitive.

The first can be used aggressively, the second is defensive in the context of the real
exchange rate. It can, of course, be used as an aggressive competitive strategy.
However, neither of these remedies is always promptly available. Competitiveness risk
has to be managed opportunistically. Where there are opportunities, they must be
seized. Where they do not exist, they can sometimes be created. In any case, it is
difficult to believe in effective countermeasures outside the commercial markets.
-Financial hedges can at best be a temporary palliative, at worst a millstone around the
company's own neck.

A cost portfolio may also be considered. The more balanced the production is a h m g
different currencies of cost, the less the risk of the total portfolio. Two-pronged
benefits result from this approach. The portfolio may by itself bring reduction of risk;
and a portfolio of underutilised capacity could be exploited to switch production from
less to more competitive currencies when real exchange rates move. However, this
concept can be contemplated only by multinationals. The deliberate creation of spare
capacity may not be economic. Labour relations might be difficult if work is shifted as
an explicit act of policy rather than as a last resort after a site has become manifestly
uneconomic. Besides, a commercial response to a rise in the real exchange rate
requires strong evidence of the rise in the real exchange rate. Any minor change in the
real exchange rate is unlikely to justify action.

The focus on the real (economic) effects of currency changes and how to cope with the
associated risks suggests that a sensible strategy for exchange risk management is one
that is designed to protect the home currency earning power of the company as a
whole. But whereas firms can easily hedge exposures based on projected foreign
currency cash flows, competitive exposures - those arising from competition with firms
based in other currencies - are longer-term, harder to quantify, and cannot be dealt with
solely through financ,ial hedging techniques. Rather, they require making longer-term
operating adjustments such as the following:

9.8.1 Marketing Initiatives

To the extent that exchange rate changes do bring about relative price changes, the
firm's competitive situation will be altered. As a result, management may wish to
adjust its marketing m k o r its production process to accommodate the new set of
relative prices. Market selection, market segmentation, product strategy, pricing strategy
and promotional strategy may all form part of marketing initiatives.

Market Selection and Segmentation

Major strategic considerations for an exporter are the markets in which to sell - that is,
-
market selection and the relative marketing support to devote to each market. It is
also necessary to consider the issue of market segmentation within individual countries.
A firm that sells differentiated products to more affluent customers may not be harmed
as much by a foreign currency devaluation as will a mass marketer. On the other hand,
%llowing a depreciation of the home currency, a firm that sells primarily to upper
income groups may find it is now able to penetrate mass markets abroad. Market
selection and segmentation provide the basic parameters within which a company may
adjust its marketing mix over time. In the short term, however, neither of these two
basic strategic choices can be altered in reaction to actual or anticipated currency
changes. Instead, the firm must select certain tactical responses such as adjustments of
pricing, promotional and credit policies. In the long run, if the real exchange rate
change persists, the firm will have to revise its marketing strategy.

Pricing Strategy

Two key issues that must be addressed when developing a pricing strategy in the face
of cl1rrencv volatility are whether to emphasise market share or profit margin and how
Foreign Exchange Risk frequently to adjust prices. To begin the analysis, a firm selling overseas should follow
Management the standard economic proposition of setting the price that maximises profits in home
currency. In making this determination, however, profits should be translated using the
forward exchange rate that reflects the true expected home currency value of the
receipts upon collection. Following appreciation of the home currency, which is
equivalent to a foreign currency depreciation, a firm selling overseas should consider
opportunities to increase the foreign currency prices of its products. The problem, of
course, is that local producers will now have a competitive advantage, limiting an
exporter's ability to recoup home currency profits by raising foreign currency selling
prices. At best, therefore, an exporter will be able to raise its product prices by the
extent of the foreign currency devaluation. In the most likely case, foreign currency
prices can be raised somewhat, and the exporter will make up the difference through a
lower profit margin on its foreign sales.

Under conditions of home currency depreciation, it follows that exporters will gain a
competitive advantage on the world markets. An exporter now has the option of
-
increasing unit profitability that is, by price skimming or expanding its market share
by penetration pricing . 'The decision is influenced by such factors as (1) whether this
change is likely to persist, (2) economies of scale, (3) the cost structure of expanding
output, (4) consumer price sensitivity, and (5) the likelihood of attracting competition if
-
high unit profitability is obvious. The greater the price elasticity of demand the
-
change in demand for a given change in price the greater the incentive to hold down
price and thereby expand sales and revenues. Similarly, if significant economies of
scale exist, it will generally be worthwhile to hold down price, expand demand, and
thereby, lower unit production costs. The reverse is true if economies of scale are
nonexistent or if price elasticity is low.

As regards frequency of price adjustments, firms in international competition differ in

their ability and willingness to adjust prices in response to exchange rate changes.
Some firms constantly adjust their prices for exchange rate changes. However, other
companies feel that stable prices are a key ingredient in maintaining their customer
base. It is also important not to neglect the effect of frequent price changes on the
exporters' distributors who must constantly adjust their margins to conform to the prices
they pay. A number of firms now have different list prices for domestic and foreign
customers in order to shield their foreign customers - especially those who sell through
-
catalogues from continual revisions of overseas prices.

In .respect of domestic price after devaluation, a domestic firm facing strong import
competition may have much greater latitude in pricing. It then has the choice of
potentially raising prices consistent with import price increases or of holding prices
constant in order to improve market share. Again, the strategy depends on such
variables as economies of scale and consumer price sensitivity.

Promotional Strategy

Promotional strategy should similarly take into account anticipated exthange rate
changes. A key issue in any marketing programme is the size of the promotional
budget for advertising, personal selling and merchandising. Promotional decisions
should explicitly build-in exchange rates, especially in allocating budgets among
countries. A firm exporting its products after a domestic devaluation may well find that
the return per rupee expenditure on advertising or selling is increased because of the .
product's improved price positioning. Foreign currency devaluation, on the other hand,
is likely to reduce the return on marketing expenditures and may require a more
fundamental shift in the firm's product policy.

Product Strategy

Companies often respond to exchange risk by altering their product strategy which deals
with such areas as new product introduction, product line decisions and product
innovation. One way to cope with exchange rate fluctuations is to change the timing of
the introduction of new products. For example, the period after a home currency
depreciation, because of the competitive price advantage, may be the ideal time to
develop a brand franchise. Exchange rate fluctuations also affect product line decisions.
Following home currency devaluation, a firm will potentially be able to expand its Measuring and Managing
Translation and Economic
product line and cover a wider spectr~mof consumers.both at home and abroad. Exposures
Conversely, following appreciation of the home currency, a firm may have to reorient
its product line and target it to a higher-income, more quality conscious, less price
sensitive constituency. The equivalent strategy for firms selling to the industrial rather
than the consumer market and confronting a strong home currency is product innovation
financed by an expanded research and development budget.

9.8.2 Production Initiatives

The adjustments discussed above involve attempts to alter the home currency value o f
foreign currency revenues. But, sometimes exchange rates move so much that pricing
or other marketing strategies cannot save the product. Product sourcing and plant
location are the principal variables that companies manipulate to manage competitive
risks that cannot be dealt with through marketing changes alone. Consider, for
example, the possible responses of Indian firms to a strong rupee. The basic strategy
would involve shifting the firm's manufacturing base overseas which can be
accomplished in more than one way as discussed below:

Outright additions to facilities overseas naturally acconiplish a manufacturing shift. A

more flexible solution is to purchase more components overseas. For a firm already
manufacturing overseas, the cost savings associated with using a higher proportion of
domestically produced goods and services, following local currency depreciation, will
depend on subsequent price behaviour. Goods and services used in international trade,
or with a high import content, will exhibit greater home currency price increases than
those with a low import content or with little involvement in international trade. For
the longer term, while increasing production capacity, the firm should consider the
option of designing new facilities that provide added flexibility in making substitutions
among various sources of goods. The advantages of being able to respond to relative
price differences among domestic and imported inputs must be weighed, of course,
against the extra design and construction costs.

Shifting Production among Plants

Multinational firms with worldwide production systems can allocate production among
their 'several plants in line with the changing costs of production; increasing production
in a country whose currency has devalued, and decreasing production in a country
whose currency has revalued. Multinational firms may well thus be subject to less
exchange risk than an exporter, given the MNC's greater ability to adjust its production
(and marketing) operations on a global basis, in line with changing relative production
costs. Of course, the theoretical ability to shift production is more limited in reality.
The limitations depend on many factors, not the least of which is the power of the local
labour unions involved. However, the innovative nature of the typical MNC means a
continued generation of new products. The sourcing of those new products from among
the firm's various plants can certainly be done with an eye to the costs involved. A
strategy of production shifting presupposes that the MNC has already created a portfolio
of plants worldwide. Multiple sources allow a company to offer the best economies of
production, given exchange rates at any moment. But multiple plants also create
manufacturing redundancies and impede cost cutting. The cost of multiple sourcing is
especially excessive where there are economies of scale that would ordinarily dictate the
establishment of only one or two plants to service the global market. But most firms
have found that in a world of uncertainty, significant benefits may be derived from
production diversification. Hence, despite the higher costs associated with smaller
plants, currency risk may provide one more reason for the use of multiple production

Plant Location

An exporter, without foreign production facilities, may find that sourcing components
abroad is not sufficient to maintain unit profitability in the fact; of currency devaluation
of its importer. Despite its previous hesitancy, the firm may now locate new plants
59
; Foreign Exchange Risk abroad. Third country plant locations are also a viable alternative in many cases,
Management
dependin,wspecially on the labour intensity of production or the projections for fbther
monetary realignments. Many Japanese firms, for example, have shifted production
offshore - to Taiwan, South Korea, Singapore and other developing nations, as well as
to the United States - in order to cope with the high yen. Before making such a major
commitment of its resources, management should attempt to assess the length of time a
particular country will retain its cost advantage. Yet, shifting production abroad when
the home currency rises is not always the best approach. Production at home improves
coordination between design and manufacturing and avoids problems of quality control.
For firms that rely heavily on such coordination and closeness to suppliers, raising .
domestic productivity is preferable to producing abroad.

Raising/F'roductivity
/
Ma y companies assaulted by foreign competition make prodigious efforts to improve
-
P("
t eir productivity closing inefficient plants, automating heavily, and negotiating wage
and benefit cut-backs and work-rule concessions with unions. Many also begin
programmes to heighten productivity and improve product quality through employee
motivation. Others, however, seek import restrictions from the government.

The marketing and production strategies advocated thus far assume knowledge of
exchange rate changes. Even if currency changes are unpredictable, however,
contingency plans can be made. This planning involves developing several plausible
currency scenarios, analysing the effects of each scenario on the firm's competitive
position, and deciding on strategies to deal with these possibilities. When a currency
change actually occurs, the firm is able to quickly adjust its marketing and production
strategies in line with the plan. Given the substantial costs of gathering and processing
information, a firm should focus on scenarios that have a high probability of occurrence
and that would also strongly impact it. The ability to plan for volatile exchange rates
has fundamental implications for exchange risk management because there is no such
thing as the 'natural' or 'equilibrium' rate. Rather, there is a sequence of equilibrium
rates, each of which has its own implications for corporate strategy. Success in such
an environment depends on a company's ability to react to change within a shorter time
horizon than ever before. To cope, companies must develop competitive options - such
as outsourcing, flexible manufacturing systems, a global network of production facilities
and shorter product cycles. In a volatile world, these investments in flexibility are
likely to yield h~!zll returns. For example, flexible manufacturing systems permit faster
production respurlse times to shifting market demand. Similarly, foreign facilities, even
if they are uneconomical at the moment, can pay off by enabling companies to shift
production in response to changing exchange rates or other relative cost shocks.

The greatest boost to competitiveness comes from compressing the time it takes to bring
new and improved products to market. The edge a company gets from shorter product
cycles is dramatic. Not only can it charge a premium price for its exclusive products,
but it can also incorporate more up-to-date technology in its goods and respond faster to
emerging market niches and changes in taste.

9.8.3 Financial Initiatives

The one attribute that all the strategic marketing and production adjustments have in
common is that they take time to accomplish in a cost-effective manner. The role of
financial management in this process is to structure the firm's liabilities in such a way
that drving the time the strategic operational adjustments are underway, the reduction in
asset earnings is matched by a corresponding decrease in the cost of servicing these
liabilities. One possibility is to finance that portion of a firm's assets used to create
export profits in such a way that any shortfall in operating cash flows due to an
exchange rate change is offset by a reduction in debt servicing expenses. For example,
a firm that has developed a sizable export market should hold a portion of its liabilities
in that country's currency. The portion to be held in the foreign currency depends on
the size of the loss in profitability associated with a given currency change. No more
definite recommendations are possible because the currency effects will vary from one
company to another. The implementation of a hedging policy is likely to be quite
difficult in practice, if only because the specific cash'flow effects of a given currency
change are hard to predict. Trained personnel are required to implement and monitor Measuring and Managing
Translation and Ecornomic
an active hedging programme. Consequently, hedging should be undertaken only when Exposures
the effects of anticipated exchange rate changes are expected to be significant. The
approach, of course, concentrates exclusively on risk reduction rather than on cost
re~luction. Where financial market imperfections are significant, a firm might consider
exposing itself to more exchange risk in order to lower its expected financing costs.

Currency risk affects all facets of a company's operations; therefore, it should not be
the concern of financial managers alone. Operating managers, in practice, should
d~:velop marketing and production initiatives that help to ensure profitability over the
long run. They should also devise anticipatory or proactive, rather than reactive
slrategic alternatives in order to gain competitive leverage internationall- The key to
effective exposure management is to integrate currency considerations into the general
management process. One approach used by a number of MNCs is to develop the
r~ecessarycoordination among executives responsible for different aspects of exchange
risk management by constituting committee for managing foreign exchange exposures.
13esides financial executives, such committees should - and often do - include senior
officers of the company such as the vice president - international, top marketing and
.production executives, the director of corporate planning, and the chief executive officer.
This arrangement is desirable as top executives are exposed to the problems of
exchange risk management and they can then incorporate currency expectations into
their- own decisions. In this kind of integrated exchange risk management programme,
the role of the financial executive is fourfold: (1) to provide local operating
management with forecasts of inflation and exchange rates, (2) to identifL and highlight
the risks of competitive exposure, (3) to .structure evaluation criteria such that operating
managers are not rewarded or penalised for the' effects of unanticipated currency
changes, and (4) to estimate and hedge whatever operating exposure remains after the
appropriate marketing and production strategies have been put in place.

Check Your Progress B

1. What is economic exposure?

............................................................................................................................................
...........................................................................................................................................
...........................................................................................................................................
2. Among three exposures which is difficult to manage and why?
...........................................................................................................................................
...........................................................................................................................................
...........................................................................................................................................
3. Distinguish between transaction and economic exposure.
...........................................................................................................................................
...........................................................................................................................................
...........................................................................................................................................

9.9 LET US SUM UP

Exposure is the amount at risk. Exposures to foreign exchange rate fluctuations can be
defined either in accounting terms or in future cash inflow and outflow terms. While the
fonner is generally referred to as translation exposure,, the latter is more appropriately
called the economic exposure. Economic exposure indudes all those hture sales,
purchases and other transactions which are either uncommitted or commercially
uncertain. Many of these like uninvoiced postnatal trading risks, will not be included
in an accounting balance sheet. The position is measured in the yardstick currency in
which the company monitors its performance and net worth. Economic exposure leads
to competitiveness risk - the threat to the competitiveness of a company's costs from
rise in real terms of the currency in which those costs a, .: incurred. The cause of the 61
Foreign Exchange Risk risk is the interaction between commercial and currency markets, in which prices move
Managenlent
at very different speeds. Competitiveness risk is not a short tcrm phenomenon. It
cannot be managed day by day. It takes longer periods to recognise shifts in real
exchange rates, and the management actions to deal with the risk are strategic rather
than tactical, and can only be taken infrequently. The risk affects companies in their
commercial rather than in their financial markets . The action can be on the demand
side, by repositioning commercial offerings in less competitive submarkets or segments,
or on the supply side by shifting costs into a more competitive currency. This last
action is possible because real exchange rates are slower to move and more predictable
than nominal rates. Financial market hedges are unlikely to provide suitable answers to
problems in the commercia! markets. Thus, although exchange risk is conceptually
easy to identify, it is difficult in practice to determine what the actual economic impact
of a currency change will be. For a given firm, this impact depends on a large number
of variables including the location of its major markets and competitors, supply and
demand elasticities, substitutability of inputs, and offsett~nginflation. Regression
techniques may be applied, of course with the assumption that the past is representative
of the future.

The parent needs to control the group's currency gains and losses over the short and
long periods for which it plans. This is important because group currency gains and
losses have a direct impact on the reported group results, net worth and gearing, which
are the focus of attention in financial markets. Even if the group does not wish to
hedge its accounting exposure, it may still wish to watch it. For this task, the parent
needs to know all non-parent currency positions. The parent can then restore zero risk
by taking a mirror-image position to the rest of the group's net total in each currency.
It can do this, for example, by the use of spot or forward hedges or currency swaps.
The biggest problem is often to get accurate up-to-date information on the net non-
parent positions. The most extreme form of centralistion is to make not only risk
management, but also dealing, the sole prerogative of the corporate centre; currency
management in that case simply bypasses the subsidiaries and other profit centres.

9.10 KEY WORDS

Accounting Exposure: Accounting exposure arises from the need to convert the
financial statements of foreign operations from foreign currencies to home currency; the
restatement of assets, liabilities, revenues and expenses at prevailing exchange rates will
result in exchange gains and losses.

Economic Exposure: Economic exposure is based on the extent to which the value of
the company - as measured by the present value of its expected future cash flows - will
change when exchange rates change.

CurrenUNon-Current Method: Under this method of translation of financial statements,

current assets and liabilities of a foreign subsidiary are translated at the current rate and
non-current assets and liabilities are translated at the historical rate. Depreciation is
similarly translated at the historical rate. The other items of the income statement are
translated at the average exchange rate prevailing during the given period.

MonetaryINon-Monetary Method: Under this method of translation of financial

statements, all monetary items like cash, accounts payablestreceivables, short-termllong-
term debt, etc. of a foreign subsidiary are translated at the current rate and all non-
monetary, i.e., physical assets are translated at the historical rate.

Temporal Method: This method resembles the monetarylnon-monetary method in all

respects, except that inventory under this method may be translated at the current rate if
it is shown at market value in the balance sheet.

Current Method: This method is the simplest of all in the sense that all items of
income statement and balance sheet are translated at the current rate.

FASB 8: This was an accounting standard issued by the US FASB under which all
gains and losses arising as a result of foreign exchange rate fluctuations were required
62
 to tle shown in the income statement. No reserve was allowed to be maintained in the Measuring and Managing
Translation and Economic
balance sheet. Expofiures

FASB 52: This accounting standard reversed the earlier FASB 8. A reserve capturing
foreign exchange gains and losses was, thereby, permitted to be maintained under this
i standard. This method also distinguished between functional and local currency.
Foreign subsidiaries must prepare their accounting statements in functional currency if
the local currency is one affected by high inflation.

Funds Adjustment: This method of managing translation exposure involves altering

. either the amounts or the currencies (or both) of the planned cash flows of the parent
at~dlorits subsidiaries to reduce the firm's local currency accounting exposure.

Marketing Initiatives: The design of a firm's marketing strategy under conditions of

home currency fluctuation presents considerable opportunity for gaining competitive
Izverage. Thus, one of the international marketing manager's tasks should be to identify
the likely effects of a currency change and then act on them by selecting appropriate
markets, and adjusting pricing and product policies which may involve changing the
foreign currency price andlor introduction of new products.

Production It~itiatives: Multinational firms with worldwide production systems use this
method of exchange risk management effectively as they are able to allocate production
among their several plants, locating new plants overseas and improving productivity
through employee motivation, automation, etc.

Financial Initiatives: This involves managing cash flows in such a way that any
sl~ortfallin operating cash flows due to an exchange rate change is offset by a
reduction in debt servicing expenses. The approach, of course, concentrates exclusively
on risk' reduction rather than on cost reduction.

9 . 1 TERMINAL QUESTIONSIEXERCISES
1. Distinguish between translation and transaction exposure?
2. Discuss various translation methods in vogue?
3. What hedging strategies would you employ in order to manage translation and
economic exposures? How do these strategies differ from those usually
employed to manage transaction exposures?
4. What are the factors determining centralisationldecentralisation of exchange risk
management? Which policy would you advocate for Indian multinationals?

63
Foreign Excbangc Risk
Manmcmcnt SOME USEFUL BOOKS 1
Dombusch, Adler, 'Currency Risk Management', Oxwell Publishing House, London,
1991 I