Print Email Download Reference This Send to Kindle Reddit This
submit to reddit

Why Should Translation Exposure Be Hedged Finance Essay

The purpose of this paper is to explain “Should translation exposure be hedged? Why or why not”. First of all, I will discuss what does translation exposure means? Translation exposure also called accounting exposure which means the risk that a company’s equities assets, liabilities or income will change in value due to exchange rate changes. On the other hand, this requires that balance sheets and translation exposure to foreign exchange (FX) risk refers to the impact of FX exchange on the parent’s consolidated financial statement, the parent company must translate its foreign operations into the home country currency using home country generally accepted accounting principals (GAPP). Therefore, translation exposure should be hedged, economic is reduced.

Hedging translation exposure:

In my opinion, Hedging or risk management adds values because:

It helps ensure that the corporation has sufficient funds available to take advantage of attractive investment opportunities.

It can help mitigate the underinvestment problem by reducing the cost of obtaining external funds (via the conservation of adequate financial ratios).

Investors might not be able to replicate an optimal hedge: Sometimes firms can do a better job at hedging than individuals.

Hedging as a tool to reduce the risk of bankruptcy: if cash flows are very volatile, a firm might be faced with the problem of needing cash to meet its debt obligations.

Hedging as a tool to reduce investment uncertainty: Firms should hedge to ensure they always have sufficient cash flow to fund their planned investment plan. For example, an exporting firm might have cash flows problems in periods when the USD appreciates.

Thus, firms with higher leverage should be more willing to hedge, in order to avoid the consequences of deteriorating financial ratios on the cost of capital.

Furthermore, Translation exposure is a real risk which affects the reserve of a company. I will give four reasons that can justify the relevant hedging translation exposure:

First, the foreign subsidiary may remit a portion of the earnings to its parent or there could be the possibility of a subsidiary disposal. A weak foreign currency could adversely affect the global amount of cash flow the parent will receive in the parent-currency or at the time of the subsidiary disposal.

Second, managerial compensation could be based on post-translation financial ratios. During periods of appreciation of the consolidation currency, management of subsidiary operations may feel that they are being unfairly held to account for the movement of currencies, rather than for their ability to manage and grow the subsidiary.

Third, companies may need to protect consolidated reported earnings. In recent years a number of major multinational firms have discovered that they can protect the reported value of foreign earnings by hedging them. For example, in 2003, a number of major European multinationals grew increasingly concerned over the depreciation of the dollar. Given the significant contribution of profits earned in dollars to total profits, the depreciation of the dollar resulted in deterioration of reported earnings per share.

Fourth, MNCs could be interested in preserving the integrity of balance sheet ratios, particularly in light of covenants or other restrictions by creditors. Firm experiencing continuous translation losses accumulating in their equity accounts may see deteriorating leverage and profitability ratios. To the extent that this process leads to an increase in the cost of debt financing, it could affect the value of the firm.

Particularly, firms decide to hedge translation exposure, they must also choose the instruments they want to use to manage their exposure that is:

Adjusting fund flows: altering either the amounts or the currencies of the planned cash flows of the parent or its subsidiaries to reduce the firm’s local currency accounting exposure. For example, a company will reduce its translation loss if, before an LC devaluation, it converts some of its LC cash holdings to the home currency.

Forward contracts: reducing a firm’s translation exposure by creating an offsetting asset or liability in the foreign currency. For example, suppose that IBM UK has translation exposure of $40 million, so IBM UK can eliminate its entire translation exposure by selling $40 million forward.

Exposure netting:

Offsetting exposures in one currency with exposures in the same or another currency.

Gains and losses on the two currency positions will offset each other.

Conclusion:

In my opinion, I think the firm should only consider hedging risk exposures that are related to firm value. Because:

Hedging can increase firm value by reducing expected taxes, costs of financial distress or agency costs.

There is no value in hedging non- cash transactions that do not cost or risk cash.

Moreover, investors don’t have enough information to estimate cash flows and instead must rely on reported earnings. If reported earnings are distorted by translation issues, investors will disvalue the firm.

799 words

References:

Books:

Madura, J 2006, International Financial Management, 8th edn, Thomson, South-Western, Mason, Ohio.

Shapiro, A.C (2010). Multinational Financial Management. 9th ed. Asia: John Wiley & Sons. p345-348.

Journals:

Nazarboland, G. (2003). The Attitude of Top UK Multinationals towards Translation Exposure. Journal of Management Research. Vol. 3 (No.3), pp. 119 – 126.

Hagelin, N. (2003). Why Firms Hedge with Current Derivatives: An Examination of Transaction and Translation Exposure. EBSCO database. Vol. 13, (3), pp. 55 – 69.

Hagelin, N. & Pramborg, B. (2004). Hedging Foreign Exchange Exposure: Risk Reduction from Transaction and Translation Hedging. Journal of International Financial Management and Accounting. Vol. 15, (No. 1, ), pp. 1 – 20.

Website:

Unknown. (2001). Hedging translation exposure management. Available: http://www.finance-magazine.com/display_article.php?i=3022&pi=127. Last accessed 2 Dec 2009.

Kirt C. Butler. (2004). Multinational Finance. Available: http://www.swlearning.com/finance/butler/butler3e/powerpoint/handout13.pdf. Last accessed 3 Dec 2009.

Unknown. (2001). Translation Exposure. Available: http://www.scribd.com/doc/22273889/Translation-Exposure. Last accessed 3 Dec 2009.

Stefano Bonini*, Maurizio Dallocchio*, Philippe Raimbourg† and Antonio Salvi^. (1999). Do firms hedge the translation risk?. Available: http://www.fma.org/Texas/Papers/TranslationRisk.pdf. Last accessed 4 Dec 2009.

Commentaries:

Week 3: Outline the experience of the performance of the exchange rate for the country in which you are studying over the last year. Has this experience been significantly different to that of the previous five years?

Since April 2004, MAS has maintained the policy of a modest and gradual appreciation of the Singapore dollar nominal effective exchange rate (S$NEER) policy band. In October 2007, the policy was tightened through a slight increase in the slope of the band. The gradual appreciation of the S$ exchange rate over the past few years has helped to mitigate inflationary pressures.

Additionally, this occurred against the general weakness of the US$ and the concomitant strengthening of other currencies including the yen and euro. Amidst the cuts in US interest rates by the Federal Reserve, the domestic three-month interbank interest rate fell from 2.75% as at end-August 2007 to 1.31% at the end of March 2008.

Furthermore, appearance on foreign direct investment in Singapore, as per data released by “Singapore Department of Statistics”, Singapore's FDI stock has more than tripled in the time period from 1995 to 2005. Europe, North America and Asia were the major FDI contributors to Singapore. These regions contributed to 82% of the Singaporean FDI stock in 2005.

In conclusion, I strongly agree with Wu Xiao Qing about the exchange rate policy of the MAS in 2004.

261 words

References:

Monetary Authority of Singapore 2008, Macroeconomic Review. Retrieved 11 December, 2009, from http://www.mas.gov.sg/resource/publications/macro_review/2008/MRApr08_Complete_Upload.pdf

Jin, S. N. (2009) Discrete Choice Modeling with Nonstationary Panels Applied to Exchange Rate Regime Choice. Journal of Econometrics, 150, 312-321

Week 7: Should Translation exposure be hedged? Why or why not?

It helps ensure that the corporation has sufficient funds available to take advantage of attractive investment opportunities.

It can help mitigate the underinvestment problem by reducing the cost of obtaining external funds (via the conservation of adequate financial ratios).

Investors might not be able to replicate an optimal hedge: Sometimes firms can do a better job at hedging than individuals.

Hedging as a tool to reduce the risk of bankruptcy: if cash flows are very volatile, a firm might be faced with the problem of needing cash to meet its debt obligations.

Hedging as a tool to reduce investment uncertainty: Firms should hedge to ensure they always have sufficient cash flow to fund their planned investment plan. For example, an exporting firm might have cash flows problems in periods when the USD appreciates.

Thus, firms with higher leverage should be more willing to hedge, in order to avoid the consequences of deteriorating financial ratios on the cost of capital.

Furthermore, Translation exposure is a real risk which affects the reserve of a company. I will give four reasons that can justify the relevant hedging translation exposure:

The foreign subsidiary may remit a portion of the earnings to its parent or there could be the possibility of a subsidiary disposal.

Managerial compensation could be based on post-translation financial ratios.

Companies may need to protect consolidated reported earnings.

MNCs could be interested in preserving the integrity of balance sheet ratios, particularly in light of covenants or other restrictions by creditors.

260 words

Print Email Download Reference This Send to Kindle Reddit This

Share This Essay

To share this essay on Reddit, Facebook, Twitter, or Google+ just click on the buttons below:

Request Removal

If you are the original writer of this essay and no longer wish to have the essay published on the UK Essays website then please click on the link below to request removal:

Request the removal of this essay.


More from UK Essays