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Foreign exchange exposure: is 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; An important task of the financial manager is to measure and manage foreign exchange exposure; Foreign exchange exposure can be measured in several ways.
Transaction exposure: measures changes in the value of outstanding financial obligations incurred prior to a change in exchange rates but not due to be settled until after the exchange rates change; Thus, this type of exposure deals with changes in cash flows that result from existing contractual obligations; Transaction exposure and operating exposure exist because of unexpected changes in future cash flows; But transaction exposure is concerned with future cash flows already contracted for, while operating exposure focuses on expected (not yet contracted for) future cash flows that might change because a change in exchange rates has altered international competitiveness; Transaction exposure measures gains or losses that arise from the settlement of existing financial obligations whose terms are stated in a foreign currency; Examples include: Purchasing or selling on credit goods or services when prices are stated in foreign currencies; Borrowing or lending funds when repayment is to be made in a foreign currency; Being a party to an unperformed forward contract; Otherwise acquiring assets or incurring liabilities denominated in foreign currencies
Translation exposure: also called accounting exposure, is 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.
Operating exposure: also called economic exposure, competitive exposure, or strategic exposure, measures the change in the present value of the firm resulting from any change in future operating cash flows of the firm caused by an unexpected change in exchange rates.
Hedge: MNEs possess a multitude of cash flows that are sensitive to changes in exchange rates, interest rates, and commodity prices; These three financial price risks are the subject of the growing field of financial risk management; Many firms attempt to manage their currency exposures through hedging; Hedging is the taking of a position, acquiring either a cash flow, an asset, or a contract (including a forward contract) that will rise (fall) in value and offset a fall (rise) in the value of an existing position; While hedging can protect the owner of an asset from a loss, it also eliminates any gain from an increase in the value of the asset hedged against; The value of a firm is the present value of all expected future cash flows; Expected but not certain; Currency risk is the variance in expected cash flows arising from unexpected exchange rate changes; A firm that hedges these exposures reduces some of the variance in the value of its future expected cash flows.
Foreign Exchange Transaction: Foreign exchange transaction exposure can be managed by contractual, operating, and financial hedges; The main contractual hedges employ the forward, money, futures, and options markets.
Translation exposure: also called accounting exposure, arises because financial statements of foreign subsidiaries (which are stated in foreign currency) must be restated in the parent’s reporting currency for the firm to prepare consolidated financial statements; The accounting process of translation, involves converting these foreign subsidiaries financial statements into US dollar-denominated statements; potential increase or decrease in the parent’s net worth and reported net income caused by a change in exchange rates since the last translation; while the main purpose of translation is to prepare consolidated statements, management uses translated statements to assess performance (facilitates comparisons across subsidiaries)
Current Rate Method: Most prevalent method today; Assets and liabilities – at the current exchange rate ; Income statement items – at the exchange rate on the dates they were recorded or an appropriately weighted average exchange rate for the period; Dividends (distributions) – at the exchange rate on payment date ; Common stock and paid-in capital – at historical exchange rate; Gains or losses caused by translation adjustments are not included in the consolidated net income; Reported separately and accumulated in a separate equity reserve account (on the B/S) with a title such as cumulative translation adjustment (CTA); Advantage: the gain or loss on translation does not pass through the income statement reducing variability of reported earnings
Temporal Method: Monetary Assets and Liabilities – at current exchange rate; Nonmonetary Assets – at historical exchange rate; I/S items – at the average exchange rate for the period; Dividends (distributions) – at the exchange rate on payment date; Common stock and paid-in capital – at historical exchange rate; Disadvantage: gain or loss on translation is carried directly to current consolidated income increasing variability of consolidated earnings
Managing Translation Exposure: The main technique to minimize translation exposure is called a balance sheet hedge; Requires an equal amount of exposed foreign currency assets and liabilities on a firm’s consolidated balance sheet
Operating exposure: also called economic exposure, competitive exposure, or 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; Operating exposure analysis assesses the impact of changing exchange rates on a firm’s own operations over coming months and years and on its competitive position vis-à-vis other firms.
Diversifying operations:means diversifying the firm’s sales, location of production facilities, and raw material sources; If a firm is diversified, management is prepositioned to both recognize disequilibrium when it occurs and react competitively; Recognizing a temporary change in worldwide competitive conditions permits management to make changes in operating strategies
Diversifying: the financing base means raising funds in more than one capital market and in more than one currency; If a firm is diversified, management is prepositioned to take advantage of temporary deviations from the International Fisher effect
Operating and transaction exposures can be partially managed by adopting operating or financing policies that offset anticipated currency exposures Five commonly employed proactive policies are: Matching currency cash flows; Risk-sharing agreements; Back-to-back or parallel loans; Cross-currency swaps; Contractual approaches
Matching Currency Cash Flows:offset an anticipated continuous long exposure to a particular currency by acquiring debt denominated in that currency; This policy results in a continuous receipt of payment and a continuous outflow in the same currency
Natural hedge: occurs through the conduct of regular operations (e.g. suppliers)
Risk-sharing: is a contractual arrangement in which the buyer and seller agree to “share” or split currency movement impacts on payments
back-to-back loan: also referred to as a parallel loan or credit swap, occurs when two firms in different countries arrange to borrow each other’s currency for a specific period of time; It is difficult for a firm to find a partner (counterparty) for the currency amount and timing desired; One of the parties may fail to return the borrowed funds at the designated maturity – although this risk is minimized because each party has 100% collateral (denominated in a different currency)
Currency Swap: a firm and a swap dealer agree to exchange an equivalent amount of two different currencies for a specified period of time; Two firms borrow funds in the markets and currencies in which they are well known
Some MNEs now attempt to hedge their operating exposure with contractual hedges
Taking long-term currency option positions hedges designed to offset lost earnings from adverse changes in exchange rates; Merck has purchased over-the-counter (OTC) long-term put options on foreign currencies versus the U.S. dollar as insurance against potential lost earnings from exchange rate changes; The ability to hedge depends on; Predictability of the firm’s future cash flows; Predictability of the firm’s competitor responses to exchange rate changes
Multinational Tax Management: Tax planning for MNE operations is extremely complex but a vital aspect of international business; MNEs must understand not only the intricacies of their own operations worldwide, but also the different structures and interpretations of tax liabilities across countries; The primary objective is the minimization of the firm’s worldwide tax burden
Tax Principle- National Tax Environments: Nations typically structure their tax systems along one of two basic approaches (The worldwide approach; The territorial approach); The worldwide approach levies taxes on the income earned by firms that are incorporated in the host country, regardless of where the income was earned (domestically or abroad); A MNE earning income both at home and abroad would therefore find its worldwide income taxed by its home country tax authorities
Territorial Approach: focuses on the income earned by the firms within the legal jurisdiction of the host country, not on the country of firm incorporation; Results in a major gap in coverage if resident firms earn income outside the country but are not taxed by the country in which the profits are earned
Tax Deferral: parent companies defer claiming additional income taxes on that foreign source income until it is remitted to the parent firm
Tax Treaties: provide a means of reducing double taxation; Bilateral, with the two signatories specifying what rates are applicable to which types of income; Result in reduced withholding tax rates
Income Tax: primary source of revenue in many countries
Withholding Tax: passive income (dividends, royalties, interest) earned by a non-resident are normally subject to a withholding tax; Government wishes a minimum payment for earning income within their tax jurisdiction knowing that party won’t file a tax return in the host country
Value Added Tax: type of sales tax collected at each stage of production or sale of consumption goods in proportion to the value added during that stage
Other National Taxes: with different importance from country to country; Turnover tax (tax on purchase/sale of securities); Tax on undistributed profits (a higher income tax rate on retained earnings of firms); Property and inheritance tax
Foreign tax credit (FTC): To prevent double taxation of the same income, many countries grant FTC for income taxes paid to the host country; Vary widely by country; A tax credit is a direct reduction of taxes that would otherwise be due; It is not a deductible expense because it does not reduce the taxable income
Transfer Pricing: the pricing of goods, services, and technology transferred to a foreign subsidiary from an affiliated company is the first and foremost method of transferring funds out of a foreign subsidiary; These costs enter directly into the cost of goods sold component of the subsidiary’s income statement
Fund positioning effect: A parent wishing to transfer funds can charge higher prices to its subsidiary to the degree that government regulations allow: A high transfer price allows funds to be accumulated in the selling country
Income tax effect: A major consideration in setting a transfer price is the income tax effect; Minimize taxable income in a country with a high-income tax rate; Maximize taxable income in a country with a low-income tax rate
Tax Haven: Many MNEs have foreign subsidiaries that act as tax havens for corporate funds awaiting reinvestment or repatriation; Tax-haven subsidiaries, categorically referred to as international offshore financial centers, are partially a result of tax-deferral features on earned foreign income allowed by some of the parent countries. Tax-haven subsidiaries are typically established in a country that meet the following requirements; A low tax on foreign investment or sales income earned by resident corporations and a low dividend withholding tax on dividends paid to the parent firm; A stable currency to permit easy conversion of funds into and out of the local currency; The facilities to support financial services; for example, good communications, professional qualified office workers, and reputable banking services; A stable government that encourages the establishment of foreign-owned financial and service facilities within its border