Exposures, Financial Contracts, and Operational Techniques - Essay Example

Exposures, Financial Contracts, and Operational Techniques Types of exposure The main types of exchange exposure are: transaction exposure, operating exposure and accounting exposure. The first type of exposure i.e. transaction exposure appears due to a change in the value of the existing financial obligations, which happen before the change in exchange rate (Eiteman et al., 2001). An example of transaction exposure is a firm which borrows money to finance its operations in a foreign currency. Also, another example could be a firm which has receivables or payables, expressed in a foreign currency. The second type of exposure – operating exposure (or economic/competitive/strategic exposure) appears due to a change in the present value of company determined by a change in expected operating cash-flows caused by an unexpected increase or decrease in the exchange rate. An example would be that of a multinational which has fully owned subsidiaries in different countries (e.g. France and Brazil). For this multinational, unexpected changes in the value of the euro or the Brazilian real will have an impact on the value of the multinational’s subsidiaries in those countries, and finally will change the value considered for the multinational. The third type of exposure – accounting exposure (or translation exposure) appears due to changes in translation of financial statements. An example would be that of a multinational which has a domestic division with a loss or gain expressed in the domestic currency. But, it also has a foreign subsidiary which reports a loss or a gain expressed in the foreign currency. If the gain and loss for the two subsidiaries do not offset each other when the exchange rate changes the multinational would have to report a loss or a gain. Relationship and differences between the three types of exposure Transaction exposure appears in situation of companies which purchase or sell goods on credit with prices expressed in foreign currency, when they borrow or lend funds expressed in foreign currency, and acquiring assets or incurring liabilities expressed in foreign currency (Eiteman et al., 2001). The difference between transaction exposure and translation exposure is related to currency and the parent and subsidiaries companies. The translation exposure considers only the currency and effect on parent companies, whereas transaction exposure considers both (Shubita et al., 2011). The operating exposure can determine a change in the firms expected cash flow at four levels: short run, medium run and finally in the long run. Because the short run is referring to the firm one year operating cycle, it is difficult to adjust the sales prices or renegotiating factor costs due to the difference between realized and expected cash-flows. When considering medium run (period of two to five years), if a company is not able to change or adjust operations, the company would be exposed to operating exposure because of the unexpected deviations in cash flows, which will determine a lower value of the overall company. In the long run (a period higher than five years), companies which operate in an international competitive environment will be exposed to foreign exchange operating exposure in conditions of imperfect foreign exchange markets. Types of financial contracts and operational techniques The transaction exposure can be hedged through three types of contracts: forward market hedging, money market hedging, and option market hedging (Reilly & Brown, 2002). The forward market hedging supposes to enter into a derivative contract when the object of the transaction exposure is determined. The contract from the derivative market will be liquidated with the funds obtained from the spot market (covered hedge and covered transaction). In a money market hedge, the company which is exposed to transaction exposure borrows or invests in one currency and exchanges the proceeds for another currency. The proceeds for the loan or saving account are related to business operations when the hedge is covered or they are purchased from the market at the end of the contract when the hedge is uncovered. The last type of hedge i.e. option market hedge, differs in considerations of the position of the company. For instance, an exporter (or a company which has receivables in other currencies than the domestic one) would buy a put option because it has a long position on the spot market, whereas an importer (or a company which has payables in other currencies than the domestic one) would buy a call option because it has a short position on the spot market. In order to protect the company against operation exposure, various methods to modify operating policies are used: using leads and lags, currency clauses, and reinvoicing center (Eiteman et al., 2001). The first method -leads and lags supposes to pay early i.e. to use the soft currency to pay the hard currency, respectively to pay late i.e. use the hard currency to pay the soft currency. It can be made intracompany or intercompany. The second method currency clause implies a risk sharing between the company and its customers. This practically means that the two parts to the contract agree to share the change in the exchange rate, which will affect the exchange of cash-flows between the two parties. The last method i.e. reinvoicing center starts from the idea of opening a separate affiliate or subsidiary, which has as the main objective to manage the transaction exposure of the parent company. This subsidiary would not have any inventory, but will deal with the paperwork of the parent company. Operating exposure can also be offset by considering changing financing policies: using natural hedges, using back-to-back (parallel) loans, and using currency swaps. The first method considers matching the currency cash-flows. The success of this practice depends of the predictability and low volatility of cash-flows. Back-to-back loans are agreements between companies from different countries to borrow each other domestic currency for the period of contract. It is actually a credit swap, because the two companies borrow the currency which will be repaid. The last method i.e. currency swaps is similar to the back-to-back loans, with the difference that the transaction does not appear on the balance sheet of the company. The transaction considers an exchange of equivalent amount but expressed in two different currencies for a period determined at the beginning of the transaction. In order to account for the translation exposure three methods are used: the current rate method, and monetary/nonmonetary method (temporary method). The difference in these two methods is that the current methods considers that the gains or losses from the translation exposure should not be flowed to net income, but to a cumulative translation agreement account If a company wants to manage its translation exposure, it can use one of the following hedges: balance sheet hedge, forward hedge and money market hedge (Shubita et al., 2011). The balance sheet hedge considers equalization between the exposed foreign currency assets and liabilities from the balance sheet. The forward hedge supposes the following transaction: selling the exposed currency in the derivative market, buying the currency in the spot market on a later date, and finally deliver the bought currency against the forward contract obligation. The last method i.e. money market hedge involves borrowing the foreign currency which causes the translation exposure, exchanging that currency for the domestic currency, and finally investing the money received. After the obligation reaches its maturity, the money from the investment would be changed back into the foreign currency, and the loan is paid back. Reference List Eiteman, D., Moffett, M., & Stonehill, A. (2001). Multinational Business Finance (9th ed.). Boston: Addison Wesley. Reilly, F., & Brown, K. (2002). Investment Analysis and Portfolio Management (7th ed.). Boston: South-Western College Pub. Shubita, M., Harris, P., Malindretos, J., & Bobb, L. (2011). Foreign Exchange Exposure: An Overview. International Research Journal of Finance and Economics, 78, 171-177. Read More