IDENTIFYING EXPOSURE

The first step in management of corporate foreign exchange risk is to acknowledge that such risk does exist and that managing it is in the interest of the firm and its shareholders. The next step, however, is much more difficult: the identification of the nature and magnitude of foreign exchange exposure. In other words, identifying what is at risk, and in what way.
The focus here is on the exposure of nonfinancial corporations, or rather the value of their assets. This reminder is necessary because most commonly accepted notions of foreign exchange risk hedging deal with assets, i.e., they are pertinent to (simple) financial institutions where the bulk of the assets consists of (paper) assets that have with contractually fixed returns, i.e., fixed income claims, not equities. Clearly, such timece your assets in the currency in which they are denominated" applies in general to banks and similar firms. Nonfinancial business firms, on the other hand, have, as a rule, only a relatively small proportion of their total assets in the form of receivables and other financial claims. Their core assets consist of inventories, equipment, special purpose buildings and other tangible assets, often closely related to technological capabilities that give them earnings power and thus value. Unfortunately, real assets (as compared to paper assets) are not labelled with currency signs that make foreign exchange exposure analysis easy. Most importantly, the location of an asset in a country is -- as we shall see -- an all too fallible indicator of their foreign exchange exposure.
The task of gauging the impact of exchange rate changes on an enterprise begins with measuring its exposure, that is, the amount, or value, at risk. This issue has been clouded by the fact that financial results for an enterprise tend to be compiled by methods based on the principles of accrual accounting. Unfortunately, this approach yields data that frequently differ from those relevant for business decision-making, namely future cash flows and their associated risk profiles. As a result, considerable efforts are expended -- both by decision makers as well as students of exchange risk -- to reconcile the differences between the point-in-time effects of exchange rate changes on an enterprise in terms of accounting data, referred to as accounting or translation exposure, and the ongoing cash flow effects which are referred to as economic exposure. Both concepts have their grounding in the fundamental concept of transactions exposure. The relationship between the three concepts is illustrated in the Exhibit 2. While exposure concepts have been aptly analyzed elsewhere in this Handbook, some basic concepts are repeated here to make the present chapter self contained.
Exposure in a simple transaction.
The typical illustration of transaction exposure involves an export or import contract giving rise to a foreign currency receivable or payable. On the surface, when the exchange rate changes, the value of this export or import transaction will be affected in terms of the domestic currency. However, when analyzed carefully, it becomes apparent that the exchange risk results from a financial investment (the foreign currency receivable) or a foreign currency liability (the loan from a supplier) that is purely incidental to the underlying export or import transaction; it could have arisen in and of itself through independent foreign borrowing and lending. Thus, what is involved here are simply foreign currency assets and liabilities, whose value is contractually fixed in nominal terms.
While this traditional analysis of transactions exposure is correct in a narrow, formal sense, it is really relevant for financial institutions, only. With returns from financial assets and liabilities being fixed in nominal terms, they can be shielded from losses with relative ease through cash payments in advance (with appropriate discounts), through the factoring of receivables, or via the use of forward exchange contracts, unless unexpected exchange rate changes have a systematic effect on credit risk.8 However, the essential assets of nonfinancial firms have noncontractual returns, i.e. revenue and cost streams from the production and sale of their goods and services which can respond to exchange rate changes in very different ways. Consequently, they are characterized by foreign exchange exposure very different from that of firms with contractual returns.
Accounting exposure.
The concept of accounting exposure arises from the need to translate accounts that are denominated in foreign currencies into the home currency of the reporting entity. Most commonly the problem arises when an enterprise has foreign affiliates keeping books in the respective local currency. For purposes of consolidation these accounts must somehow be translated into the reporting currency of the parent company. In doing this, a decision must be made as to the exchange rate that is to be used for the translation of the various accounts. While income statements of foreign affiliates are typically translated at a periodic average rate, balance sheets pose a more serious challenge.
To a certain extent this difficulty is revealed by the struggle of the accounting profession to agree on appropriate translation rules and the treatment of the resulting gains and losses. A comparative historical analysis of translation rules may best illustrate the issues at hand. Over time, U.S. companies have followed essentially four types of translation methods, summarized in Exhibit 3. These four methods differ with respect to the presumed impact of exchange rate changes on the value of individual categories of assets and liabilities. Accordingly, each method can be identified by the way in which it separates assets and liabilities into those that are "exposed" and are, therefore, translated at the current rate, i.e., the rate prevailing on the date of the balance sheet, and those whose value is deemed to remain unchanged, and which are, therefore, translated at the historical rate.
The current/noncurrent method of translation divides assets and liabilities into current and noncurrent categories, using maturity as the distinguishing criterion; only the former are presumed to change in value when the local currency appreciates or depreciates vis-à-vis the home currency. Supporting this method is the economic rationale that foreign exchange rates are essentially fixed but subject to occasional adjustments that tend to correct themselves in time. This assumption reflected reality to some extent, particularly with respect to industrialized countries during the period of the Bretton Woods system. However, with subsequent changes in the international financial environment, this translation method has become outmoded; only in a few countries is it still being used.
Under the monetary/nonmonetary method all items explicitly defined in terms of monetary units are translated at the current exchange rate, regardless of their maturity. Nonmonetary items in the balance sheet, such as tangible assets, are translated at the historical exchange rate. The underlying assumption here is that the local currency value of such assets increases (decreases) immediately after a devaluation (revaluation) to a degree that compensates fully for the exchange rate change. This is equivalent of what is known in economics as the Law of One Price, with instantaneous adjustment.
A similar but more sophisticated translation approach supports the so-called temporal method. Here, the exchange rate used to translate balance sheet items depends on the valuation method used for a particular item in the balance sheet. Thus, if an item is carried on the balance sheet of the affiliate at its current value, it is to be translated using the current exchange rate. Alternatively, items carried at historical cost are to be translated at the historical exchange rate. As a result, this method synchronizes the time dimension of valuation with the method of translation. As long as foreign affiliates compile balance sheets under traditional historical cost principles, the temporal method gives essentially the same results as the monetary/nonmonetary method. However, when "current value accounting" is used, that is, when accounts are adjusted for inflation, then the temporal method calls for the use of the current exchange rate throughout the balance sheet.
The temporal method provided the conceptual base for the Financial Accounting Standard Board's Standard 8 (FAS 8), which came into effect in 1976 for all U.S.-based companies and those non-U.S. companies that had to follow U.S. accounting principles in order to raise funds in the public markets of the United States.
The temporal method points to a more general issue: the relationship between translation and valuation methods for accounting purposes. When methods of valuation provide results that do not reflect economic reality, translation will fail to remedy that deficiency, but will tend to make the distortion very apparent. To illustrate this point: companies with real estate holdings abroad financed by local currency mortgages found that under FAS 8 their earnings were subject to considerable translation losses and gains. This came about because the value of their assets remained constant, as they were carried on the books at historical cost and translated at historical exchange rates, while the value of their local currency liabilities increased or decreased with every twitch of the exchange rate between reporting dates.
In contrast, U.S. companies whose foreign affiliates produced internationally traded goods (minerals or oil, for example) felt very comfortable valuing their assets on a dollar basis. Indeed, this later category of companies were the ones that did not like the transition to the current rate method at all. Here, all assets and liabilities are translated at the exchange rate prevailing on the reporting date. They found the underlying assumption that the value of all assets (denominated in the local currency of the given foreign affiliate) would change in direct proportion to the exchange rate change did not reflect the economic realities of their business.
In order to accommodate the conflicting requirements of companies in different situations and still maintain a semblance of conformity and comparability, at the end of 1981 the Financial Accounting Standards Board issued Standard 52, replacing Standard 8. FAS 52, as it is commonly referred to, uses the current/current method as the basic translation rule. At the same time it mitigates the consequences by allowing companies to move translation losses directly to a special subaccount in the net worth section of the balance sheet, instead of adjusting current income. This latter provision may be viewed as a mere gimmick without much substance, providing at best a signalling function, indicating to users of accounting information that translation gains and losses are of a nature different from items normally found in income statements.
A more significant innovation of FAS 52 is the "functional" currency concept, which gives a company the opportunity to identify the primary economic environment and select the appropriate (functional) currency for each of the corporation's foreign entities. This approach reflects the official recognition by the accounting profession that the location of an entity does not necessarily indicate the currency relevant for a particular business. Thus FAS 52 represents an attempt to take into account the fact that exchange rate changes affect different companies in different ways, and that rigid and general rules treating different circumstances in the same manner will provide misleading information.
In order to adjust to the diversity of real life FAS 52 had to become quite complex. The following provides a brief road map to the logic of that standard.
In applying FAS 52 a company and its accountants must make two decisions in sequence. First, they must determine the functional currency of the entity whose accounts are to be consolidated. For all practical purposes, the choice here is between local currency and the U.S. dollar. In essence, there are a number of specific criteria which provide guidelines for this determination. As usual, extreme cases are relatively easily classified: a foreign affiliate engaged in retailing local goods and services will have the local currency as its functional currency, while a "border plant" that receives the majority of its inputs from abroad and ships the bulk of the output outside of the host country will have the dollar as its functional currency. If the functional currency is the dollar, foreign currency items on its balance sheet will have to be restated into dollars and any gains and losses are moved through the income statement, just as under FAS 8. If, on the other hand, the functional currency is determined to be the local currency, a second issue arises: whether or not the entity operates in a high inflation environment. High inflation countries are defined as those whose cumulative three-year inflation rate exceeds 100 percent. In that case, essentially the same principles as in FAS 8 are followed. In the case where the cumulative inflation rate falls short of 100 percent, the foreign affiliate's books are to be translated using the current exchange rate for all items, and any gains or losses are to go directly as a charge or credit to the equity accounts.
FAS 52 has a number of other fairly complex provisions regarding the treatment of hedge contracts, the definition of transactional gains and losses, and the accounting for intercompany transactions.
In essence, FAS 52 allows management much more flexibility to present the impact of exchange rate variations in accordance with perceived economic reality; by the same token, it provides greater scope for manipulation of reported earnings and it reduces comparability of financial data for different firms.
Critique of the Accounting Model of Exposure
Even with the increased flexibility of FAS 52, users of accounting information must be aware that there are three system sources of error that can mislead those responsible for exchange risk management (Adler, 1982):
1. Accounting data do not capture all commitments of the firm that give rise to exchange risk.
2. Because of the historical cost principle, accounting values of assets and liabilities do not reflect the respective contribution to total expected net cash flow of the firm.
3. Translation rules do not distinguish between expected and unexpected exchange rate changes.
Regarding the first point, it must be recognized that normally, commitments entered into by the firm in terms of foreign exchange, a purchase or a sales contract, for example, will not be booked until the merchandise has been shipped. At best, such obligations are shown as contingent liabilities. More importantly, accounting data reveals very little about the ability of the firm to change costs, prices and markets quickly. Alternatively, the firm may be committed by strategic decisions such as investment in plant and facilities. Such "commitments" are important criteria in determining the existence and magnitude of exchange risk.
The second point surfaced in our discussion of the temporal method: whenever asset values differ from market values, translation--however sophisticated--will not redress this original shortcoming. Thus, many of the perceived problems of FAS 8 had their roots not so much in translation, but in the fact that in an environment of inflation and exchange rate changes, the lack of current value accounting frustrates the best translation efforts.
Finally, translation rules do not take account of the fact that exchange rate changes have two components: (1) expected changes that are already reflected in the prices of assets and the costs of liabilities (relative interest rates); and (2) the real goods and services, the basic rationale for corporate foreign exchange exposure management is to shield net cash flows, and thus the value of the enterprise, from unanticipated exchange rate changes.
This thumbnail sketch of the economic foreign exchange exposure concept has a number of significant implications, some of which seem to be at variance with frequently used ideas in the popular literature and apparent practices in business firms. Specifically, there are implications regarding (1) the question of whether exchange risk originates from monetary or nonmonetary transactions, (2) a reevaluation of traditional perspectives such as "transactions risk," and (3) the role of forecasting exchange rates in the context of corporate foreign exchange risk management
Contractual versus Noncontractual Returns
An assessment of the nature of the firm's assets and liabilities and their respective cash flows shows that some are contractual, i.e. fixed in nominal, monetary terms. Such returns, earnings from fixed interest securities and receivables, for example, and the negative returns on various liabilities are relatively easy to analyze with respect to exchange rate changes: when they are denominated in terms of foreign currency, their terminal value changes directly in proportion to the exchange rate change. Thus, with respect to financial items, the firm is concerned only about net assets or liabilities denominated in foreign currency, to the extent that maturities (actually, "durations" of asset classes) are matched.
What is much more difficult, however, is to gauge the impact of an exchange rate change on assets with noncontractual returns. While conventional discussions of exchange risk focus almost exclusively on financial assets, for trading and manufacturing firms at least, such assets are relatively less important than others. Indeed, equipment, real estate, buildings and inventories make the decisive contribution to the total cash flow of those firms. (Indeed companies frequently sell financial assets to banks, factors, or "captive" finance companies in order to leave banking to bankers and instead focus on the management of core assets!) And returns on such assets are affected in quite complex ways by changes in exchange rates. The most essential consideration is how the prices and costs of the firm will react in response to an unexpected exchange rate change. For example, if prices and costs react immediately and fully to offset exchange rate changes, the firm's cash flows are not exposed to exchange risk since they will not be affected in terms of the base currency.