Summary written in 2013-2014 - contains only a small set of chapters.

Chapter A: The exchange market

Foreign exchange: the money of a foreign country (foreign currency bank balances, banknotes, checks and drafts).

Foreign exchange transaction: an agreement between a buyer and a seller that a fixed amount of one currency will be delivered for another currency at a specified rate.

Foreign exchange rate: the price of one currency expressed in terms of another currency.

Closing prices: the official price for the day

Functions of the foreign exchange market:

1. Transfer of purchasing power across different countries.

2. Finance of inventory in transit, necessary because of the time it takes to transfer the goods between countries.

3. Providing ‘hedging’ facilities for transferring foreign exchange risk to someone else more willing to care the risk.

Foreign exchange market consists of two tiers:

1. The interbank/wholesale market

2. Client/retail market

Market participants:

• Bank and non-foreign exchange dealers: profit through buying at a bid price and reselling at the slightly higher ask price.

• Individuals and firm conducting commercial and investment transactions: importers, exporters, international portfolio investors, MNEs, tourists.

• Speculators and arbitragers: operate in their own interest. Seek profit through exchange rate changes.

• Central banks and treasuries: use the market to acquire or spend their country’s foreign exchange reserves as well as to influence the price at which their own currency is traded.

Types of transactions

1. Spot transactions: requires almost immediate delivery of foreign exchange.

   • Value date: date of settlement

2. Outright forward transactions: requires delivery of foreign exchange at some future date.

   • Outright basis

   • Futures contract

3. Swap transactions: simultaneous exchange of one foreign currency for another.

   • Forward-forward swap: dealer sells AMOUNT X forward for dollars for delivery in TIME Y at EXCHANGE RATE K and simultaneously buys AMOUNT X forward for delivery in TIME J at EXHANGE RATE S. Difference in buying price and selling price is equal to interest rate differential.

   • Non-deliverable forwards (NDFs)

Foreign exchange quotation (quote): a statement of willingness to buy or sell at an announced rate.

1. Direct – Indirect:

   • Direct quote: a home currency price of a unit of foreign currency.

   • Indirect quote: a foreign currency price of a unit of home currency

If the home currency appears on top → direct quote, if home currency appears on bottom → indirect.

Example: $1.3583/€ America (direct), Europe (indirect)

2. American – European: most foreign exchange transactions involve the US dollar.

   • European terms: the foreign currency price of one dollar (€1.5238/$), America’s indirect quote.

   • American terms: the dollar price of a unit of foreign currency ($1.3583/€), America’s direct quote.

3. Bid – Ask:

   • Bid: the price (i.e. exchange rate) in one currency at which a dealer will buy another currency.

   • Ask: the price (i.e. exchange rate) at which a dealer will sell the other currency.

Dealers bid (buy) at one price and ask (sell) at a slightly higher price, making their profit from the spread between the buying and selling prices.

4. Spot – Forward:

   • Spot rate: the currency price that is quoted for immediate (spot) settlement (payment and delivery).

   • Forward rate: an exchange rate quoted for settlement at some future date.

   • Forward rates are typically quoted in terms of points. It is the deviation from the spot rate (thus difference between forward rate and spot rate) → it is not a foreign exchange rate.

   • Forward quotations may also be expressed as the percent-per-annum deviation from the spot rate.

   • The forward premium or discount: the percentage difference between the spot and forward exchange rate, stated in annual percentage terms.

• Indirect: 

• Direct: 

Cross rate: a third, widely used currency that is used to determine the exchange rate of currency pairs that are only inactively traded.

• Example: calculate the exchange rate between Argentina Peso (Ps) and Chinese Yuan (CN¥).

• Direct Argentina quote: Ps 6.1405/$

• Direct Chinese Yuan quote: CN¥ 6.0932/$

→ Ps 6.1405/$ / CN¥ 6.0932/$ = Ps 1.0078/CN¥

• Cross rates can be used to check on opportunities for triangular arbitrage.

• Citibank quote ($/€) $1.2223/€

• Barclays quote ($/£) $1.8410/£

→ Cross rate calculation for €/£: $1.8410/£ / $1.2223/€ = € 1.5062/£

→ € 1.5062/£ unequal to €1.5100/£ (the stated exchange rate €/£)

Measuring a change in spot exchange rates:

• Direct quotations

Percentage change = ending rate – beginning rate * 100

Beginning rate

• Indirect quotations: same formula but rates are (1/exchange rate)

Chapter B: The concepts of international parity conditions

International parity conditions: the economic theories that link exchange rates, price levels (inflation rates), and interest rates together.

Law of one price: the products price should be the same in both markets if identical product or service can be 1) sold in two different markets, and 2) there exist no restrictions on the sale or transportation costs of moving the product between markets (e.g. Big Mac Index).

Big Mac is a good candidate for the application of the law of one price because:

1. The product itself is nearly identical in each market.

2. The product is a result of predominantly local materials and input costs.

Competitive market principle: prices will equalize across markets if frictions or transportation costs do not exist → comparing prices only requires a conversion from one currency to another.

Purchasing power parity (PPP): the ‘real’ prices of goods and services, these are present when the ‘law of one price’ condition is true for all goods and services.

• Absolute version of the PP theory: states that the spot exchange rate is determined by the relative prices of similar baskets of goods.

Relative purchasing power parity (RPPP): states that PPP is not particularly helpful in determining what the spot rate is today, but that the relative change in prices between two countries over a period of time determines the change in the exchange rate over that period.

• “If the spot exchange rate between two countries starts in equilibrium, any differential of inflation rate between them tends to be offset over the long run by an equal but opposite change in the spot exchange rate.”

• Spot rate stated in direct quote (h/f)

S = spot rate

π = inflation rate

h = home currency

• Spot rate stated in indirect quote (f/h) f = foreign currency

Application of PPP:

1. PPP holds up well over the very long run but poorly for shorter time periods.

2. Theory holds better for countries with relatively high rates of inflation and underdeveloped capital markets.

In order to discover whether an exchange rate is overvalued or undervalued in terms of PPP one calculates exchange rate indices.

1. Nominal effective exchange rate index: uses actual exchange rates to create an index, on a weighted average basis, of the value of the subject currency over time. It simply calculates how the currency value relates to some arbitrarily chosen base period.

2. Real effective exchange rate index: indicates how the weighted average purchasing power of the currency has changed relative to some arbitrarily selected base period.

• Exchange rate index home country = nominal effective exchange rate index home country * (home currency costs / foreign currency costs)

• Index = 100 → PPP holds (changes in exchange rates offset differential inflation rates)

Index > 100 → exchange rate strengthened more than was justified by differential inflation, currency is overvalued.

Index < 100 → currency is undervalued.

Pass-through: the degree to which the prices of imported and exported goods change as a result of exchange rate changes.

• Incomplete exchange rate pass-through is one reason that a country’s real effective exchange rate index can deviate for lengthy periods from its PPP-equilibrium.

Price elasticity of demand = the percentage change in quantity of the good demanded divided by the percentage change in the good’s price.

• Price elasticity < 1.0 → relatively inelastic good

• Price elasticity > 1.0 → relatively elastic good

Fisher Effect: nominal interest rates in each country are equal to the required real rate of return plus a compensation for expected inflation.

i = nominal interest rate

r = real interest rate

π = inflation rate

International Fisher Effect: the relationship between the percentage change in the spot exchange rate over time and the differential between comparable interest rates in different national capital markets.

• It states that the spot exchange rate should change in an equal amount but in the opposite direction to the differential of interest rates between two countries.

• Spot rate stated in direct quote (h/f)
  

• Spot rate stated in indirect quote (f/h)
  

Forward rate: an exchange rate quoted today for settlement at some future date.

• A forward exchange agreement between currencies states the rate of exchange at which a foreign currency will be bought/sold forward at a specific date in the future.

Forward premium/discount: the percentage difference between the spot and forward exchange rate, stated in annual percentage terms.

Theory of interest rate parity (IRP) provides the link between foreign exchange markets and the international money markets.

• The difference in the national interest rates for securities of similar risk and maturity should be equal to, but opposite in sign to, the forward rate discount/premium for the foreign currency, except for transaction costs.

• F = forward rate

→ F is equal to St+1

Forward exchange rate can act as the unbiased predictor for future spot rate (St+1).

• Assumption: foreign exchange market is reasonably efficient. Market efficiency assumes:

1. All relevant information is quickly reflected in both the spot and forward exchange markets.

2. Transaction costs are low.

3. Instruments denominated in different currencies are perfect substitutes for one another.

• Forecast error: difference between the predicted future spot rate and the actual future spot rate at a certain period in time.

• Unbiased predictor means that the forward rate over- or underestimates the future spot rate with relatively equal frequency and amount. The sum of the errors equals zero.

Covered interest arbitrage (CIA): situation when the market is not in equilibrium and the potential for arbitrage profit exists.

• Requirement: interest rate parity does not hold.

• CIA moves the market toward equilibrium because purchasing a currency on the spot market and selling in the forward market will narrow the gap between forward premium/discount and interest rate differentials.

• Arbitrager will exploit the imbalance by investing in whichever currency offers the higher return on a covered basis.

• Difference in interest rates > forward premium → invest in higher interest yielding currency.

• Difference in interest rates < forward premium → invest in lower interest yielding currency.

Uncovered interest arbitrage (UIA): investors borrow in countries with currencies with relatively low interest rates and convert the output into currencies that offer much higher interest rates.

• ‘Uncovered’ because the investor does not sell the higher yielding currency outputs forward → accept the currency risk of exchanging the higher yield currency into the lower yielding currency at the end of the period.

Chapter C: Foreign currency issues

Foreign currency derivatives:

• Values derived from underlying assets

• Two distinct management objectives:

• Hedging: use of derivative instruments to reduce the risks associated with the corporate cash flow.

• Speculation: use of derivative instruments to take a position in the expectation of a profit.

Foreign currency futures contract: an alternative to a forward contract that calls for future delivery of a standard amount of foreign exchange at a fixed time, place and price.

1. Short positions: sell futures/forward

• Value at maturity = notional principal * (futures – spot)

2. Long positions: buy futures/forward

• Value at maturity = notional principal * (spot – futures)

Foreign currency option: a contract giving the option purchaser (the buyer) the right, but not the obligation, to buy or sell a given amount of foreign exchange at a fixed price per unit for a specified time period (until the maturity date).

1. Call: option to buy foreign currency.

2. Put: option to sell foreign currency.

Buyer = holder, seller = writer or grantor.

Every option has three different price elements:

1. The exercise or strike price: the exchange rate at which the foreign currency can be purchased (call) or sold (put).

2. The premium: the cost, price, or value of the option itself.

3. The underlying or actual spot rate in the market.

Types of options:

• American option: gives the buyer the right to exercise the option at any time between the date of writing and the expiration or maturity date.

• European option: can be exercised only on its expiration date, not before.

Types of options:

• At the money (ATM): an option whose exercise price is the same as the spot price of the underlying currency.

• In the money (ITM): an option that would be profitable, excluding the cost of the premium, if exercised immediately.

• Out of the money (OTM): an option that would not be profitable, excluding the cost of the premium, if exercised immediately.

Over the counter (OTC) market: offers custom-tailored options on all major trading currencies for any time period up to one year.

Over the counter (OTC) options: options that are tailored to the specific needs of a firm.

• Counterparty risk: the financial risk associated with the counterparty.

SPECULATION

This is an attempt to profit by trading on expectations about prices in the future.

For examples of speculation in the spot, forward and option market see page 68 until 74.

Speculation in option markets:

1. Buyer of a call

• Profit = spot rate – (strike price + premium)

2. Writer of a call

• Profit = premium – (spot rate – strike price)

3. Buyer of a put

• Profit = strike price – (spot rate + premium)

• Writer of a put

  • Profit = premium – (strike price – spot price)

Call option profile includes:

• Total value (premium) = intrinsic value + time value

• Intrinsic value: financial gain if the option is exercised immediately.

• Time value: this exists because the price of the underlying currency (spot rate) can potentially move further and further into the money between the present time and the option’s expiration date.

Currency option pricing sensitivity:

1. Forward rate sensitivity: standard foreign currency options are priced around the forward rate, because the current spot rate and both the domestic and foreign interest rates are included in the option premium calculation.

2. Spot rate sensitivity (delta): as long as the option has time remaining before expiration, it possesses a value element. The option possesses a premium that exceeds the intrinsic value of the option over the entire range of spot rates surrounding the strike rate.

• Delta = change in the option premium divided by the change in spot rate.

• The higher the delta, the greater the probability of the option expiring in the money (ITM).

  1. Deltas of 0.7 and more are considered high.

• Time to maturity, value and deterioration (theta): option values increase with the length of time to maturity.

  • Theta = change in the option premium divided by the change in time.

  • Ratio for an at the money (ATM) option (Z) = premium of X months divided by the premium of Y months.

→ X-months option’s price is Z times that of Y months option’s price.

• Normally, the trader find longer-maturity options better values, as it gives him the ability to alter an option position without suffering significant time value deterioration.

• Sensitivity to volatility (lambda): volatility is the standard deviation of daily percentage changes in the underlying exchange rate. It is important to option value because of an exchange rate’s perceived likelihood to move either into or out of the range in which the option would be exercised. It is stated in percent per annum.

  • Lambda = change in the option premium divided by the change in volatility

Problem: volatility is unobservable → forecasting.

Three ways to view volatility:

1. Historic volatility: volatility is drawn from a recent period of time.

2. Forward-looking volatility: historic volatility is altered to reflect expectations about the future period over which the option will exist.

3. Implied volatility: volatility is backed out of the market price of the option.

• Traders who believe that volatilities will fall significantly in the near term will sell options now, hoping to buy them back for a profit immediately after volatilities fall, causing option premiums to fall.

• Sensitivity to changing interest rate differentials (rho and phi): interest rate changes in either currency will alter the forward rate, which in turn will alter the option’s premium or value.

  • rho = the expected change in the option premium divided by the change in the domestic interest rate.

  • phi = the expected change in the option premium divided by the change in the foreign interest rate.

  • A trader who is purchasing a call option on foreign currency should do so before the domestic interest rate rises in order to purchase the option before its price increases.

• Alternative strike prices and option premiums: a firm purchasing an option in the over the counter (OTC) market may choose its own strike rate. How to choose? See exhibit 8.14, p. 84.

Chapter D: The concepts of transaction exposure

Foreign exchange exposure: a measure of the potential for a firm’s profitability, net cash flow, and market value to change because of a change in exchange rates.

Types of foreign exchange exposure:

1. Transaction exposure: measures changes in the value of outstanding financial obligations whose terms are stated in a foreign currency, incurred prior to a change in exchange rates but not due to be settled until after the exchange rates change. Arise from:

• Purchasing or selling on credit goods or services with prices in foreign currencies. Example p. 103.

• Borrowing or lending funds when repayment is to be made in a foreign currency. Example p. 104.

• Being a party to an unperformed foreign exchange forward contract.

• Otherwise acquiring assets or incurring liabilities denominated in foreign currencies.

2. Operating exposure: measures the change in the present value of the firm resulting from any change in expected future operating cash flows of the firm caused by an unexpected change in exchange rates.

3. Translation exposure: the potential for accounting-derived changes in owner’s equity to occur because of the need to ‘translate’ foreign currency financial statements of foreign subsidiaries into a single reporting currency to prepare worldwide consolidated financial statements.

Hedging: the taking of a position (acquiring a cash flow, an asset, or a contract) that will rise (fall) in value and offset a fall (rise) in the value of an existing position.

• Key issue: Is a reduction in the variability of cash flows sufficient reason for currency risk management?

• Impact of hedging on the expected cash flows of the firm, exhibit 11.2, p. 101.

Advantages:

1. Reduction in risk in future cash flows improves the planning capability of the firm

2. Reduction of risk in future cash flows reduces the likelihood that the firm’s cash flows will fall below a necessary minimum (the point of financial distress).

3. Management has a comparative advantage over the individual shareholder in knowing the actual currency risk of the firm

4. Management is in better position than shareholders to take advantage of disequilibrium conditions in the market (selective hedging).

Disadvantages:

1. Shareholders are much more capable of diversifying currency risk than the management of the firm.

2. Currency risk management does not increase the expected cash flows of the firm.

3. Management often conducts hedging activities that benefit management at the expense of the shareholders (agency conflict).

4. Managers cannot outguess the market.

5. Management’s motivation to reduce variability is sometimes driven by accounting reasons.

6. Efficient-market theorists state that investors see the true value of a potential investment and thus already factored the foreign exchange effect into a firm’s market valuation.

CASE

Accounts payable in 90 days.

Amount: ₤1,000,000.

Interest rate: 8%

current spot rate: $1.7640/₤.

Weighted average cost of capital (WACC): 12%

Premium: 1.5%.

The CFO has four alternatives:

1. Remain unhedged: costs unknown as they depend on the ending spot rate in 90 days.

Calculation: ₤1,000,000 * ending spot rate = total cost.

2. Forward market hedge: a forward (or futures) contract used to lock the forward rate → no uncertainty and no risk.

Calculation: ₤1,000,000 * forward rate = total fixed cost.

3. Money market hedge: exchange $ for ₤ on spot market now, and invest it for 90 days in a ₤-denominated interest-bearing (savings) account. Subsequently, use the principal and interest in ₤ at the end of 90-day period to pay the ₤1,000,000.
   A. Calculation
   In order to determine the pounds needed today, the investment must be discounted by the interest rate for 90 days.
   
   To determine how many dollars are needed today one should multiply the previous outcome by the current spot rate → ₤980,392.16 * $1.7640/₤ = $ 1,729,411.77
   To determine the total future value (in 90 days) cost of the money market hedge one should include the WACC.
   
    

4. Option hedge: purchasing a call option.

Calculation:

1. To determine the cost of the call option premium one should multiply the principal amount by both the premium and the current spot rate.

₤1,000,000 * 1.5% * $1.7640/₤ = $26,460

1. 2. This cost will be paid up front, regardless of whether the call option is exercised or not. Therefore, one should include the WACC to determine the actual cost. Thus, call option premium is:
      

1. 3. The total call option cost is the principal multiplied by the at the money (ATM) strike price plus the call option premium. (ATM = $1.75/₤)

→ (₤1,000,000 * $1.75/₤) + $27,254 = $1,777,254

Eventually the CFO must make a decision based on:

1. The risk tolerance of the company

2. His or her own view or expectation of the direction of the exchange rate.

Types of hedges:

• Natural hedge: an off-setting operating cash flow, a payable arising from the conduct of business.

• Financial hedge: an offsetting debt obligation (e.g. loan) or some type of financial derivative (e.g. interest rate swap).

Chapter E: The concepts of operating exposure

Foreign exchange exposure: a measure of the potential for a firm’s profitability, net cash flow, and market value to change because of a change in exchange rates.

Cash flows of a company:

• Operating cash flows: cash flows related to the business activities (payments for use of facilities and equipment, the use of technology, etc.).

• Financial cash flows: cash flows related to the financing of the company (loans, and stockholder equity).

Types of foreign exchange exposure:

• Transaction exposure

• Operating exposure (economic exposure, competitive exposure, strategic exposure): measures any change in the present value of a firm resulting from changes in future operating cash flows caused by an unexpected change in exchange rates.

• Accounting exposure

Characteristics of operating exposure:

• Measuring the operating exposure of a firm requires forecasting and analyzing all the firm’s future individual transaction exposures together with the future exposures of all the firm’s competitors and potential competitors worldwide.

• Operating exposure is unpredictable → unable to hedge.

• Example of operating exposure: p. 138-142.

Managing operating exposure

Key: quickly recognize a disequilibrium in parity conditions and respond to it.

Diversification strategy

• Diversifying operations: diversifying sales, location of production facilities, and raw material sources.

• Diversifying financing base: raise funds in more than one capital market and in more than one currency.

Note: these strategies are not an option for domestic firms as they are unable to diversify their operations or finance sources quickly across the globe (no previous presence), as a response to a disequilibrium in parity conditions.

Hard currency: a currency that is expected to be stable in the future.

Soft currency: a currency which is expected to fluctuate erratically.

Proactive management of operating exposure

Operating and transaction exposures can be partially managed by adopting operating or financing policies that offset anticipated foreign exchange exposures. Six most common proactive policies:

1. Matching currency cash flows: acquire debt denominated in the currency in which the company also has account receivables through the use of a hedge. Exhibit 12.4, p. 146.

• Natural hedge: an off-setting operating cash flow. The foreign currency cash inflow matched with cash outflow (same amount and timing)

• Example: in order to hedge accounts receivable in Canadian $, seek for potential suppliers of raw materials in Canada → accounts payable in Canadian $ too.

• Currency switching: pay foreign companies in the currency in which the company also has accounts receivable.

2. Risk-sharing agreements: a contractual arrangement in which the buyer and seller agree to “share” or split currency movement impacts on payments between them. Aim is to reduce the impact on both parties of volatile and unpredictable exchange rate movements.

3. Back-to-back loans (parallel loan, credit swap): two companies in separate countries arrange to borrow each other’s currency for a specific period of time. They return the borrowed currencies at an agreed terminal date. It is a method for parent-subsidiary cross-border financing without incurring direct currency exposure. Exhibit 12.5, p. 148.

Disadvantages:

• Difficult to find a partner (counterparty) for the currency, amount and timing desired.

• Risk exists that one of the parties will fail to return the borrowed funds at the designated maturity.

4. Currency swaps: a back-to-black loan that does not appear on the firm’s balance sheet. Two firms and a swap dealer agree to exchange an equivalent amount of two different currencies for a specified period of time. The swap dealer acts as a middleman in setting up the agreement. If funds are more expensive in one country than another, a free may be used to compensate for the interest differential. A cross-currency swap is shown in exhibit 12.6, p. 150.

• Swap: a foreign exchange agreement between two parties to exchange a given amount of one currency for another and, after a period of time, to give back the original amounts swapped.

5. Leads and lags: to accelerate or decelerate the timing of payments that must be made or received in foreign currencies.

• To lead: to pay early.

• Firms that hold soft currency or have debts in a hard currency will lead → using the soft currency to pay the hard currency debts as soon as possible.

• To lag: to pay late.

• Firms that hold hard currency or have debts in a soft currency will lag → paying debts late, hoping that less of the hard currency will be needed.

Note: leading and lagging between related firms (intra-company) is more feasible than between independent firms (intercompany) because they presumably embrace a common set of goals for a consolidated group.

6. Re-invoicing center: involves a separate corporate subsidiary that serves as a middleman between the parent in one location and all foreign subsidiaries in other countries. Manufacturing subsidiaries sell goods to distribution subsidiaries of the same firm but in a different country through selling to a re-invoicing center. However, the physical movement of goods is direct from the manufacturing subsidiary to the distribution subsidiary. Thus, the re-invoici8ng center handles paperwork but has no inventory. Therefore, all operating units deal in only in their own currency and all transaction exposure lies with the re-invoicing center. The re-invoicing center resells at cost plus a small commission for their service. Exhibit 12.7, p. 152.

Advantages:

• Managing foreign exchange exposure

• Guaranteeing the exchange rate for future orders

• Managing intra-subsidiary cash flows

Disadvantages:

• High costs (inter alia initial setup cost)

Ability of firms to hedge the ‘unhedgeable’ depends on:

1. The predictability of the firm’s future cash flows.

2. The predictability of the firm’s competitor’s responses to exchange rate changes.

Chapter F: The concepts of translation exposure

Translation exposure (accounting exposure): occurs when foreign subsidiaries financial statements are converted into home-currency-denominated statements in order to create a consolidated financial statement.

Functional currency: the dominant currency used by a foreign subsidiary in its day-to-day operations.

Note: the geographic location of a foreign subsidiary and its functional currency may be different.

Exposed asset: an asset whose value drops with the depreciation of the functional currency and rises with an appreciation of that currency.

Net exposed assets: exposed assets minus exposed liabilities.

Two different exchange rates used in translation:

1. Current exchange rate (C): the rate in effect on the balance sheet date.

2. Historical exchange rate (H)

Two basic methods employed in translation:

1. Current rate method: most prevalent nowadays, involves translation.

• Assets and liabilities are translated at the current rate of exchange.

• Equity items (common stock + retained earnings) are translated at historical rates.

• Dividends paid are translated at the exchange rate in effect on the date of payment.

• Income statement items (including depreciation and COGS) are translated at 1) the actual exchange rate on the dates the various revenues, expenses, gains, and losses were incurred, or 2) at an appropriately weighted average exchange rate for the period.

Gains or losses caused by translation adjustments are not included in the calculation of consolidated net income. Translation gains or losses are reported separately and accumulated in a separate equity reserve account which is titled cumulative translation adjustment (CTA).

Advantage: the gain or loss on translation does not pass through the income statement but goes directly to a reserve account → reducing variability of reported earnings.

2. Temporal method: involves re-measuring.

• Assets are translated at both current and historical exchange rates, depending on the timing of the item’s creation.

• Monetary assets and liabilities are translated at current exchange rates.

• Non-monetary assets and liabilities are translated at historical rates.

• Equity items are translated at historical rates.

• Dividends paid are translated at the exchange rate in effect on the date of payment.

• Income statement items are translated at the average exchange rate for the period. Exception: depreciation and COGS (directly associated with non-monetary assets or liabilities) → use historical rate.

Gains or losses resulting from re-measurement are carried directly to current consolidated income via translation gain (loss) (increased variability of consolidated earnings).

Advantage: foreign non-monetary assets are carried at their original cost in the parent’s consolidated statement.

An example of the current rate method and the temporal method is evident on page 166-171.

BALANCESHEET

Types of foreign subsidiaries:

1. Integrated foreign entity: operates as an extension of the parent, with cash flows and business lines that are highly interrelated. They are typically re-measured using the temporal method.

2. Self-sustaining foreign entity: operates in the local economic environment independent of the parent company. They are translated at the current rate method.

Balance sheet hedge: the main technique to minimize translation exposure. It requires an equal amount of exposed foreign currency assets and liabilities on a firm’s consolidated balance sheet. An example is shown on page 172-174, including exhibit 13.7, p. 173.

Monetary balance: net translation exposure of zero that can only be achieved through the temporal method.

A balance sheet hedge is justified when:

1. The foreign subsidiary is about to be liquidated → value of its CTA would be realized.

2. The firm has debt covenants or bank agreements that stat the firm’s debt/equity ratios will be maintained within specific limits.

3. Management is evaluated on the basis of certain income statement and balance sheet measures that are affected by translation losses or gains.

4. The foreign subsidiary is operating in a hyperinflationary environment.