International Finance - Translation Exposure
Translation exposure, also known accounting exposure, refers to a kind of effect occurring for an unanticipated change in exchange rates. It can affect the consolidated financial reports of an MNC.
From a firm’s point of view, when exchange rates change, the probable value of a foreign subsidiary’s assets and liabilities expressed in a foreign currency will also change.
There are mechanical means for managing the consolidation process for firms that have to deal with exchange rate changes. These are the management techniques for translation exposure.
We have discussed transaction exposure and the ways to manage it. It is interesting to note that some items that create transaction exposure are also responsible for creating translation exposure.
Translation Exposure – An Exhibit
The following exhibit shows the transaction exposure report for Cornellia Corporation and its two affiliates. Items that produce transaction exposure are the receivables or payables. These items are expressed in a foreign currency.
|Parent||Ps 3,000,000||Accounts receivable||No|
|Spanish||SF 375,000||Notes payable||Yes|
From the exhibit, it can be easily understood that the parent firm has mainly two sources of a probable transaction exposure. One is the Canadian Dollar (CD) 200,000 deposit that the firm has in a Canadian bank. Obviously, when the Canadian dollar depreciates, the deposit’s value will go down for Cornellia Corporation when changed to US dollars.
It can be noted that this deposit is also a translation exposure. It is a translation exposure for the same reason for which it is a transaction exposure. The given (Peso) Ps 3,000,000 accounts receivable is not a translation exposure due to the netting of intra-company payables and receivables. The (Swiss Franc) SF 375,000 notes for the Spanish affiliate is both a transaction and a translation exposure.
Cornellia Corporation and its affiliates can follow the steps given below to reduce its transaction exposure and translation exposure.
Firstly, the parent company can convert its Canadian dollars into U.S. dollar deposits.
Secondly, the parent organization can also request for payment of the Ps 3,000,000 the Mexican affiliate owes to it.
Thirdly, the Spanish affiliate can pay off, with cash, the SF 375,000 loan to the Swiss bank.
These three steps can eliminate all transaction exposure. Moreover, translation exposure will be diminished as well.
Translation Exposure Report for Cornellia Corporation and its Mexican and Spanish Affiliates (in 000 Currency Units) −
|Canadian Dollar||Mexican Peso||Euro||Swiss Frank|
|Cash||CD0||Ps 3,000||Eu 550||SF0|
|Net Fixed Assets||0||46,000||4,400||0|
|Exposed Assets||CD0||Ps 73,000||Eu 7,645||SF0|
|A/c payable||CD0||Ps 7,000||Eu 1,364||SF0|
|Long term debt||0||27,000||3,520||3,520|
|Exposed liabilities||CD0||Ps51,000||Eu 5,819||SF0|
|Net exposure||CD0||Ps22,000||Eu 1,826||SF0|
The report shows that no translation exposure is associated with the Canadian dollar or the Swiss franc.
Hedging Translation Exposure
The above exhibit indicates that there is still enough translation exposure with changes in the exchange rate of the Mexican Peso and the Euro against the U.S. dollar. There are two major methods for controlling this remaining exposure. These methods are: balance sheet hedge and derivatives hedge.
Balance Sheet Hedge
Translation exposure is not purely entity specific; rather, it is only currency specific. A mismatch of net assets and net liabilities creates it. A balance sheet hedge will eliminate this mismatch.
Using the currency Euro as an example, the above exhibit presents the fact that there are €1,826,000 more net exposed assets than liabilities. Now, if the Spanish affiliate, or more probably, the parent firm or the Mexican affiliate, pays €1,826,000 as more liabilities, or reduced assets, in Euros, there would be no translation exposure with respect to the Euro.
A perfect balance sheet hedge will occur in such a case. After this, a change in the Euro / Dollar (€/$) exchange rate would not have any effect on the consolidated balance sheet, as the change in value of the assets would completely offset the change in value of the liabilities.
According to the corrected translation exposure report shown above, depreciation from €1.1000/$1.00 to €1.1786/$1.00 in the Euro will result in an equity loss of $110,704, which was more when the transaction exposure was not taken into account.
A derivative product, such as a forward contract, can now be used to attempt to hedge this loss. The word “attempt” is used because using a derivatives hedge, in fact, involves speculation about the forex rate changes.