International Short-Term Financing and Investment 251

(1 + e_y ⁾ > (1 + L ) 291

(1+f ) 300

(1+f ) 302

International Long-Term Financing, Capital Structure and the Cost of Capital 284

D = Z D, 283

E = Z 283

k = Z 289

International Long-Term Portfolio Investment 296

Rj,t = b 0,j + b 1, jR m,t + b 2,j$t + e j,t (11.40) 311

dL 319

dm ₁ -¹'—-¹'-²'"² --v-^"³ '-³ (1149) 319

+ 2ct(S 1, S ₄)w 4 +1 1 = 0 319

= 2w3 s ² (S3 ) + 2s(S 1 , S3 )w 1 + 2s(S2 , S3 )w2 320

+ 2s(S 3 , S₄ )w 4 +2 1 = 0 = 2w4 s ² (S4 ) + 2s(S 1 , S4 )w 1 + 2s(S 2 , S4 )w2 + 2s(S 3 , S4 )w 4 + 2 2 = 0 320

= w 1 + W2 + w 3 -1 = 0 320

w' = [w 1 w 2 w 3 w 4 2 1 2 2] and 331

Foreign Direct Investment 344

i 341

References 341

i 361

Index 363

From equation (4.66), we have dPy/dS = -Py/S. Hence

^dRy = CxQh > o (4.77)

dS S²

which means that a rise in the exchange rate raises revenue in terms of y. We

dC

also have

y= _c dQS=fxdQ _-CxQ ₍₄.₇₈₎

dS dS S dS S²

Since

(4.79)

dQ = dQdFy = _ dQ Py= Qh dS dP_y dS dP_y S S

it follows that

^dCy = ^cx^Qh ^cx^Q = ^cx ⁽h ^-1)Q > ₀ (₄₈₀)

dS S² S² S^{2 (}.⁾

which means that a rise in the exchange rate raises costs in terms of y. Hence, the effect on profit in terms of y is given by

^dp y ^dRy ^dCy cxQh cx (h -1)Q cx Q

> 0 (4.81)

dS dS dS S² S² S²

Equation (4.81) implies that profit in terms of y increases as a result of the depreciation of x.

Case 3: The importer in terms of currency x For the importer, revenue and cost are given by

Rx = PxQ (4.82)

Cx = ScyQ (4.83)

where Q is now the quantity imported. Hence

dRx _PxQ,

^dRx = Px + Q ^dP^x = Px f 1 -¹ ö (4.84)

dQ dQ \ h

dCf=^Sc y (⁴.⁸⁵)

For profit maximisation, dR_x/dQ = dC_x/dQ, which gives

P_x = ^SCy (4.86) ^x 1 -(1/h)

Hence

^dpx -_ÎJL. - llL > 0 (4.87) dS 1 -(1/h) S

which means that a depreciation of x raises the x-price of imported goods. The effect of changes in the exchange rate on revenue is given by

dRx dQ dPx dPx

—- = P_x — + Q—^x = Q(1 - h) —^x (4.88)

dS ^x dS dS dS

which gives

'-(1 - h) < 0 (4.89)

dS S

because h > 1 for any profit maximising firm. This means that a depreciation of x leads to an a decline in revenue in terms of x.

The effect of a change in the exchange rate on costs in terms of x is given by

^ - ^C,^Q + ^Scy f " ^Cy^Q + ^Scy dP^ ^{(4 90}>

which can be simplified to dC

= Cy Q - CyQh = CyQ(1 - h) < 0 (4.91)

dS

This means that a rise in the exchange rate reduces the cost of imported goods, in which case the effect on profit is given by

Px - _c s ^cy

(4.92)

< 0

dp v dR_x dC _v

= Q(1 - h)

dS dS dS

because h > 1 and (P_x/S) - Cy > 0 for a profit maximiser, which means that a rise in the exchange rate reduces profit.

Case 4: The importer in terms of currency y In this case, revenue and costs are given by

P Q

Ry = pSQ (4.93)

Cy = CyQ (4.94) For profit maximisation, we have

(4.96)

(4.97)

P_x = ^SCy (4.95) ^X 1 -(1/h)

which gives

dpv = ^cy = Pv_ dS 1 -(1/h) S

We know that

^dRy = S(d(PxQ)/dS) - PxQ = PxQ(1 - h) _- PxQ dS S² S² S²

which gives ^dR y _ PxQh

< 0 (4.98)

dS S ²

implying that a rise in the exchange rate reduces revenue in terms of y. Likewise

^dC y dQ dF_x ^cy^Qh _n

—- = c_y— ^x = —-—< 0 (4.99)

dS ^y dP_x dS S

which again means that a rise in the exchange rate reduces costs in terms of y. Finally, the effect on profit is given by

dPy = dKy_d^ = _PxQh + OyQh = Qhr c_y _M<0 (4.100)

dS dS dS S² S S { ^y S 0

which means that profit in terms of y decreases as a result of a rise in the exchange rate. All of the results are summarised in Table 4.5.

TABLE 4.5 The effect of changes in exchange rates on importers and exporters.

Item	Effect		An increase in S leads to
Exporters
Rx	dRx /d5:	= hPyQ > 0	Increase in Rx
Cx	dCx /d5	= hCxQ/S > 0	Increase in Cx
px	dp x /dS	= hQ(Py - c x/S) > 0	Increase in px
Ry	dRy /d5:	= cxQh/S2 > 0	Increase in Ry
Cy	dCy /d5	= c x (h -1) Q/S2 > 0	Increase in Cy
Py	dp y /dS	= cxQ/S2 > 0	Increase in py
Importers
Rx	dRx /dS:	= PxQ( 1- h)/S < 0	Decrease in Rx
Cx	dCx /dS	= c yQ(1 - h) < 0	Decrease in Cx
px	dp x /dS	= Q(1 - h)(Px/S - cy) < 0	Decrease in px
Ry	dRy /dS:	= -PxQh/S2 < 0	Decrease in Ry
Cy	dCy /dS	= -cyQh/S < 0	Decrease in Cy
Py	dp y /dS	= (Qh/S)(cy - Px/S) < 0	Decrease in py

4.7 TRANSLATION EXPOSURE

Translation exposure arises from the consolidation of foreign currency assets, liabilities, net income and other items in the process of preparing base currency consolidated financial statements (balance sheet and income state­ment). Also called accounting exposure, it may be defined as the potential that a firm's consolidated financial statements can be adversely affected (showing more inferior figures than otherwise) by changes in exchange rates. Consoli­dation involves the translation of subsidiaries' financial statements to the base currency. When exchange rates change, the value of the assets and liabilities of a subsidiary, whose base currency is different from that of the parent firm, may change when viewed from the perspective of the parent firm. In this respect a distinction is sometimes made between the functional currency, which is the currency of the primary economic environment in which the firm (or subsidiary) operates, and the reporting currency, which is the currency in which the firm prepares its consolidated financial statements. In the case of a multinational firm, the functional and reporting currencies correspond to the base currencies of the subsidiary and the parent firm respectively.

Translation exposure gives rise to the possibility that the conversion of foreign currency-denominated items into the base currency for the purpose of consolidation may show a loss or gain. It is, therefore, a function of the accounting system and may have little to do with the true value in an economic sense. Firms with identical balance sheet and income statement items may show different consolidated results, depending on the translation method used. It is important to bear in mind that the difference between trans­lation and operating exposure is that the measurement of translation exposure is retrospective (as it is based on activities that occurred in the past), whereas the measurement of operating exposure is prospective (as it is based on future activities and hence future cash flows). The measurement of transaction expo­sure is both retrospective and prospective, because it is based on activities that occurred in the past but will be settled in the future.

The importance of translation exposure lies in the distinction between the economic value and the book value of a firm, which are based on the historical value and future cash flows respectively. The change in accounting net worth produced by a movement in exchange rates often has little relevance to the change in the market value of the firm, because economic exposure is a measure of the extent to which a change in exchange rates affects the present value of future cash flows. Although all items on a firm's balance sheet repre­sent future cash flows, not all cash flows appear there. Investors may see behind accounting conventions and understand the firm's true economic situ­ation, even though translation exposure affects the reported financial state­ments. A problem arises when investors rely on financial statements as a source of fundamental information to the extent that they are unable to discern when financial statements reflect the true economic value and when not. Thus, translation exposure tends to confuse investors to the extent of perceiving it as a real problem itself.

The management of the firm may be concerned, particularly if compensa­tion and performance evaluation are based on reported financial statements. Indeed, managers may not aim at maximising risk-adjusted cash flows, because they are preoccupied with accounting-based foreign exchange gains. Apart from the compensation motive, they may behave in this way because they believe that the stock market evaluates a firm on the basis of its reported earnings or changes in accounting net worth, regardless of the underlying cash flows. It remains true, however, that managers can make serious errors of judgement by failing to distinguish between the accounting description of foreign exchange risk and the effect of exchange rate movements on the economic value of the firm. However, the distortions associated with transla­tion exposure do not mean that accounting statements are irrelevant. A large body of research on financial markets suggests that investors are relatively sophisticated in responding to publicly available information. They appear to understand detailed financial statements and properly interpret various accounting conventions.

Dufey (1978) presents a good example on this issue. Because of an expected devaluation of the French currency, the French subsidiary of a US multina­tional was instructed to reduce its working capital and, therefore, curtail operations. Given that the subsidiary was selling all of its output to subsid­iaries in Germany and Belgium, devaluation would lead to an increase in prof­itability (the value of output would remain constant, whereas costs would decline in dollar terms). As a result, the French manager argued correctly for expanding operations.

Translation methods

Translation methods refer to the choice of the exchange rate used for converting (translating) the values of foreign currency items into the base currency. The balance sheet contains the values of assets and liabilities as at the end of the accounting period (which may be a year, a quarter or a month). The income statement reports items such as revenues, costs and net income realised over the accounting period. The following three rates can be used for conversion:

1. The closing (or current) rate, which is the rate prevailing at the end of the accounting period (coinciding with the balance sheet date).

2. The average rate, which reflects the average value of the exchange rate over the accounting period. The simplest procedure is to take a simple average of the closing rate and the rate prevailing at the beginning of the period. Otherwise a time-weighted average may be used.

3. The historical rate, which is the rate prevailing on the date when an asset is acquired or a liability is committed. The historical rate may, therefore, fall outside the current accounting period. In fact, this is invariably the case for long-term assets and liabilities.

In translating the income statement items, either the closing rate or the average rate are used, which means that the amount exposed is net income. The possibility of using historical rates in translating balance sheet items makes the matter more complicated. For the purpose of translating balance sheet items, the following methods are used.

The current/non-current method

The current/non-current method is based on the traditional accounting distinction between current items (for example, short-term deposits and inventory) and long-term items (for example, real estate and long-term debt). According to this method, current items are translated at the closing rate, whereas long-term items are translated at the historical rate. Obviously, the use of the historical rate precludes foreign exchange risk, whereas the use of the closing rate does not. Hence, if this method is used, the amount exposed to foreign exchange risk is net current assets. A foreign subsidiary with current assets in excess of current liabilities will cause a translation gain (loss) if its functional currency appreciates (depreciates). There is an obvious problem with this method, which is that items such as long-term loans are portrayed as not being subject to foreign exchange risk, which does not make sense. This is why there has been a move away from this method.

The current rate method

The current rate method is the most widely used worldwide for its simplicity. All items are translated at the current exchange rate prevailing at the end of the accounting period (the closing rate). When this method is used, the amount exposed is shareholders' equity. If a firm's foreign currency-denomi­nated assets exceed its foreign currency liabilities, a depreciation of the foreign currency will result in a loss and vice versa.

The monetary/non-monetary method

Monetary items are those items whose values are fixed in terms of the number of units of the currency of denomination. For example, a bond is a monetary item since its par (or face) value (the value received by the bondholder on maturity) is fixed by contract and displayed on the face of the bond. Real estate, on the other hand, is a non-monetary item, since its value in the currency of denomination may rise or fall. According to this method, the monetary items are translated at the closing rate, whereas non-monetary items are translated at the historical rate. The amount exposed in this case is the value of net monetary items.

The temporal method

According to the temporal method, the use of the closing rate or the historical rate is determined by the valuation of the underlying item. The closing rate is used for items stated at replacement cost, realisable value, market value or expected future value. The historical rate is used for all items stated at histor­ical cost. The rationale for this method is that the translation rate should preserve the accounting principles used to value assets and liabilities in the original (foreign or functional currency) financial statements.

The temporal method appears to be a modified version of the monetary/ non-monetary method. The only difference is that under the monetary/non- monetary method inventory is always translated at the historical rate. Under the temporal method, inventory is normally translated at the historical rate, although it can be translated at the current rate if the inventory is shown on the balance sheet at market value. The choice of the translation exchange rate is based on the type of assets and liabilities in the monetary/non-monetary method, but in the temporal method it is based on the underlying approach to evaluating cost (historical versus market).

What is used in practice?

In general, the following principles are observed in practice:

1. The translation of the balance sheet items is based on the closing rate.

2. Transactions gains and losses are accounted for in the income statement.

3. Non-transaction gains and losses are recorded on the balance sheet as reflected by changes in reserves.

4. If a transaction profit or loss arises from foreign currency borrowing designed as a hedge for a net investment in the same foreign currency, then the gain or loss (if less than that on the investment) will be accounted for by movements in reserves. Otherwise, the excess will be reported on the income statement.

CHAPTER 5

Financial and Operational Hedging of Exposure to Foreign Exchange Risk

5.1 WHY DO FIRMS HEDGE EXPOSURE TO FOREIGN EXCHANGE RISK?

Management of exposure to foreign exchange risk centres on the concept of hedging, which is a process whereby a firm can be protected from unanticipated changes in exchange rates. As business becomes global, firms get increasingly engaged in international activities such as exports, cross-border sourcing, joint venture with foreign partners, and establishing production and sales affiliates abroad. As a result, firms find it necessary to pay careful attention to the exposure to foreign exchange risk and to the design and implementation of appropriate hedging strategies. This is because changes in exchange rates affect the values of cash flows (costs and revenues), assets, liabilities, market share and the competi­tive position of the firm.

As we have seen, not even purely domestic firms can insulate themselves from the ramifications of exchange rate fluctuations. Indicative of the impor­tance of foreign exchange exposure is the documented evidence on a signifi­cant relationship between stock returns and exchange rate movements (for example, Jorion, 1990; Choi and Prasad, 1995; Simkins and Laux, 1996). Simkins and Laux (1996) distinguish between market betas and Forex betas, which are measured as the sensitivities of an industry or a portfolio to the market index and the effective exchange rate respectively. However, Dominguez and Tesar (2001) examined the relationship between stock prices and exchange rates, arguing that the evidence should be stronger if it was not for "the restrictions imposed on empirical specifications used in previous studies".