International Accounting, 6/e Frederick D.S. Choi Gary K. Meek Chapter 11: Financial Risk Management
Learning Objectives • What does risk management entail? • What are the various types of market risks that international financial managers encounter? • Identify four tasks involved in managing foreign exchange risk. • How does translation exposure differ from transaction exposure? • What is a financial derivative and how is it measured? • Identify three types of foreign currency hedges and their accounting treatments recommended by IAS 39 and FAS 133.
Enterprise Risk Management • Evaluates risk in the context of a firm’s business strategy • External risk factors to consider: • Macroeconomic factors • Exchange rate behavior • Political intelligence • Competitive environment • Revenue concentration • Inflation rates • Immigration regulations • Physical security • Data security • Technological obsolescence • Internal risk factors • Financial reporting risks • Liquidity and leverage • Commodity price changes • Equity price changes • Liquidity • Credit exposure • Regulatory compliance • Tax exposure • Accounting risk
Why Manage Financial Risks? • Stabilize expected cash flows • Facilitate concentration on primary business risk • Align interests of shareholders and bondholders • Maximize returns on pension fund investments • Limit exposure of firm’s clients to financial risks
Accounting Dimension of FX Risk Management • Identify potential FX risk. • Quantify tradeoffs associated with alternative risk-response strategies. • Measure a firm’s FX exposure. • Account for specific hedge products. • Evaluate effectiveness of hedging programs.
Translation Exposure • Translation exposure: measures impact of FX changes on domestic currency equivalents of foreign currency assets and liabilities. • Current rate translation method • Exposure = total assets minus total liabilities • Temporal method • Exposure = monetary assets (including nonmonetary assets measured at current values) minus monetary liabilities • Monetary-nonmonetary method • Exposure = monetary assets minus monetary liabilities • Current-noncurrent method • Exposure = current assets minus current liabilities
Translation Exposure (contin) • Multiple currency translation exposure report • Enables a parent company to aggregate its translation exposure reports for all foreign subsidiaries. • Company can analyze its worldwide translation exposure by currency.
Transaction Exposure • Measures exchange gains and losses that arise from the settlement of foreign currency sales, purchases, borrowing, or lending transactions. • Multicurrency transaction exposure report • Enables parent company to monitor its global transaction exposure by currency.
Transaction Exposure (contin) • Involves assessing corporate strengths and weaknesses as a basis for strategy formulation
Economic Exposure • Translation and transaction exposure are static concepts. • Economic exposure is future-oriented and examines the impact of exchange rate changes on the future performance and cash flows of the firm.
Hedging Strategies • Balance sheet hedges: adjusts the levels and currency of a firm’s exposed assets and liabilities. • Operational hedges: adjusts variables, such as selling prices and currency of denomination, that impact foreign currency sales and expenses.
Hedging Strategies (contin) • Contractual hedges: uses financial instruments to hedge a firm’s exposed assets and liabilities. • Most financial instruments used for hedging are derivatives in that their values are derived from some underlying instrument. • Types of financial instruments: • FX forward contract: an agreement to deliver or receive a specified amount of foreign currency in exchange for domestic currency on a fixed future date at a fixed rate. • Financial futures: a commitment to purchase or deliver a specified amount of foreign at a future date at a set price. These instruments are traded on an organized exchange. • Currency option: gives the buyer the right to buy or sell a currency from the seller at a specified price on or before a specified expiration date. • Currency swap: a current and future exchange of two different currencies at predetermined rates.
Accounting Treatments per IAS 39 and FAS 133 • Financial derivatives are marked to market with unrealized gains or losses taken to income. • Exceptions are granted if management documents: • the item being hedged exposes the firm to a market risk. • the firm’s hedging strategy. • the instruments to be employed as a hedge. • the rationale as to why the hedge will be effective.
Accounting Treatments per IAS 39 and FAS 133 (contin) • For fair value hedges (i.e., hedges of recognized foreign currency assets and liabilities): • Unrealized gains and losses on marking the derivative to market are included in current income. • Changes in the value of the foreign currency asset or liability being hedged are also recognized in current income. • For cash flow hedges: • Unrealized gains or losses on the derivative are initially recognized as an element of comprehensive income. • These gains or losses are subsequently recognized in earnings when the forecasted transaction affects earnings.
Accounting Treatments per IAS 39 and FAS 133 (contin) • For hedges of a foreign currency net investment (i.e., translation exposure on a foreign subsidiary): • Unrealized gains or losses on the derivative are included in comprehensive income. • These gains or losses are recognized in earnings when the foreign subsidiary is sold or liquidated.