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Chapter 10 Transaction and Translation Exposure * These lecture notes include material Copyrighted by Pearson Prentice Hall. Learning Objectives n Distinguish between the three major foreign exchange exposures experienced by firms n Analyze the pros and cons of hedging foreign exchange transaction exposure n Examine the alternatives available to a firm for managing a large and significant transaction exposure n Evaluate the institutional practices and concerns of foreign exchange risk management Learning Objectives n Demonstrate how translation practices result in a foreign exchange exposure for the multinational enterprise n Explain the meaning behind the designation of a foreign subsidiarys functional currency n Illustrate both the theoretical and practical differences between the two primary methods of translating foreign currency denominated financial statements into the currency reporting of the parent company n Compare translation exposure with operating expense n Analyze the costs and benefits of managing translation exposure Foreign Exchange Exposure n Foreign exchange exposure is a measure of the impact of changes in exchange rates on a firms profitability , net cash flow , and market value These three components (profits, cash flow and market value) are the key financial elements of how we view the relative success or failure of a firm While finance theories tell us that cash flows matter and accounting does not, we know that currency- related gains and losses can have destructive impacts on reported earnings which are fundamental to the markets opinion of that company Foreign Exchange Exposure n Types of foreign exchange exposure 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 rate changes Translation Exposure also called accounting exposure , is the potential for accounting derived changes in owners equity to occur because of the need to translate financial statements of foreign subsidiaries into a single reporting currency for consolidated financial statements Foreign Exchange Exposure Operating Exposure also called economic exposure, measures the change in the present value of the firm resulting from any change in expected future operating cash flows caused by an unexpected change in exchange rates Hedging n Hedging protects the owner of an asset (future stream of cash flows) from loss n However, it also eliminates any gain from an increase in the value of the asset hedged against n Since the value of a firm is the net present value of all expected future cash flows, it is important to realize that variances in these future cash flows will affect the value of the firm and that at least some components of risk (currency risk) can be hedged against Hedging - the Pros & Cons n Opponents of hedging give the following reasons: Shareholders are more capable of diversifying risk ... View Full Document

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