Common Methods for Controlling Translation Exposure
Multi-National Companies have established subsidiary companies across the world; hence they face the challenge of trading in different currencies. Each subsidiary will most likely record their books in the local currency but when the parent company makes their books they have to consider the conversion of each of the currencies to one single currency for the consolidated accounts. In such a case, the Multi-National company faces a currency risk where any changes in the foreign exchange values may cause either losses or gains. There are two main types of foreign exchange risks or exposure that can be analyzed which include transaction and translation exposure (Nelken, 2008). Translational exposure is the danger that a multi-national company’s capital, assets, and liabilities will change in value due to exchange rate change. On the other hand, transaction exposure implies the risk that companies are exposed to when exchange rates change after the company has already committed to financial obligations for example loans or credit purchases.
Transaction risks are similar to economic exposure although they differ to some extent. Foreign exchange exposures are not always obvious to deal with because the elimination of one may lead to the elimination or creation of another exposure. Translation exposure is managed statically and has a historical orientation since they correct past accounting entries. Transaction exposure involves present and future cash flows, hence it’s more forward-looking compared to the management of translation exposure (Eun & Resnick, 2008). Therefore, the management of transaction exposure becomes more important since it involves the projection of future situations. Most importantly, it involves handling real cash flows compared to translational exposure that only goes as far as books of accounts and financial statements. This way, the translational risks are always covered and future adjustments due to changes in foreign exchange values will not be necessary. Translational exposure has an effect in case of sale or liquidation of company assets.
Translational exposure can be controlled using two main methods which include a balance sheet hedge and a derivative head, which are broad in their application (Nelken, 2000). The balance sheet hedge is applied by first numbering the number of exposed assets and liabilities. The number of exposed assets are usually valued in terms of the exposure currency the same as the liabilities, and the result is that the two offset each other. This means that if the exchange rate between the two currencies changes, the change in assets will nullify the change in liabilities. This method has its disadvantage in that when the hedge is created, some transaction exposures are controlled, but concurrently others are created. Consequently, real cash flow losses result which is disadvantageous to the company.
A derivative hedge is mainly based on speculation. The size of the hedge is based on the expected rate of exchange for the exposed currency against the reporting currency (McDonald, 2003). The disadvantage of this method is that if the actual spot rate is different from the expected one, the company suffers the loss of real cash flows just like in the case above. However, if the actual spot rate is right, the company saves a lot of cash and gains from the translations. Basically, hedging strategy is to raise, hard currency assets and soft currency liabilities. At the same time, reduce soft currency assets and hard currency assets. Hedging is not always obvious as it seems and therefore, it needs a lot of practice to perfect.
Companies established around the world cannot evade the issue of foreign currency exposure because different countries around the world use different currencies. However, the need for prudent management of exposure will maintain profitability of such companies. The accounting officers of such companies will be required to be speculative and experienced in this field to avert large losses.
References
Eun, S. C., & Resnick, G. B. (2008). International Financial Management. (5th ed.). Irwin, Ir: McGraw-Hill.
McDonald, R. L. (2003). Derivative Markets. (2nd ed.). Boston, Massachusetts: Addison Wesley.
Nelken, I. (2000). Pricing, Hedging and Trading Exotic Options. New York, NY: McGraw-Hill.