CURRENCY ARBITRAGE
4.7 TRANSLATION EXPOSURE
TABLE 4.5 The effect of changes in exchange rates on importers and exporters.
Item Effect An increase in S leads to
Exporters
Rx d Rx / dS=hPyQ>0 Increase in Rx Cx d Cx / dS=h cxQ/S>0 Increase in Cx px d px /dS=hQ(Py -cx/S)>0 Increase in px
Ry d Ry / dS=cxQh/S2 >0 Increase in Ry Cy d Cy /dS=cx(h-1 )Q/S2 >0 Increase in Cy py d py / dS=cxQ/S2 >0 Increase in py
Importers
Rx d Rx /dS=PxQ(1 -h)/S<0 Decrease in Rx Cx d Cx / dS=cyQ( 1 -h)<0 Decrease in Cx px d px /dS=Q(1 -h)(Px /S-cy)<0 Decrease in px Ry d Ry / dS= -PxQh/S2 <0 Decrease in Ry Cy d Cy / dS= - cyQh/S<0 Decrease in Cy py d py /dS =(Q h/S )(c y -P x/S)<0 Decrease in py
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 trans
lation 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 expo
sure 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 repre
sent future cash flows, not all cash flows appear there. Investors may see behind accounting conventions and understand the firm’s true economic situ
ation, even though translation exposure affects the reported financial state
ments. 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 compensa
tion 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 transla
tion 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 multina
tional was instructed to reduce its working capital and, therefore, curtail
operations. Given that the subsidiary was selling all of its output to subsid
iaries in Germany and Belgium, devaluation would lead to an increase in prof
itability (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.
Thecurrent/non-currentmethod
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-denomi- nated 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.
Thetemporalmethod
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 histor
ical 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.