Managing Foreign Currency Risk in Business

Managing Foreign Currency Risk in Business

Real appreciation/depreciation of the Irish Punt, US Dollar, French Franc, Japanese Yen and Deutsche Mark

The real exchange rate is the nominal exchange rate adjusted for changes in the relative purchasing power of each currency (Shapiro, 1999). This concept can be linked to the theory of Purchasing Power Parity (PPP), first introduced by Gustav Cassel in 1918 and defined as:

e (home)/e (foreign) = p (home)/p (foreign) (formula 1)

e = spot rate

p = Inflation

In absolute terms, it states that currencies should have the same purchasing power all over the world. Transportation costs, tariffs, quotas, restrictions and product differentiation are ignored though.

The relative version of PPP states that the exchange rate between home and foreign currency will adjust to reflect changes in price levels of the two countries. So, if inflation in the US is 5% and 3% in the UK, then sterling must rise by 2% in order to equalise the dollar price of goods in the two countries.

Vice versa, when calculating real appreciation or depreciation, it is necessary to adjust for inflation rates. Therefore, real appreciation or depreciation of a currency is that adjusted for inflation and is calculated using the following formula:

e(real) = e(nominal)*[p(foreign)/p(home)] (formula 2)

Similarly, the real interest rate must be adjusted to reflect inflation. The real interest rate, according to the Fisher effect, measures the exchange rate between current and future purchasing power. Together with (expected) inflation, it represents the nominal rate. This can be approximated by the equation r = a + i, where r is the nominal rate, i is the rate of inflation, and a is the real rate of interest.

Based on these calculations, it clearly emerges that the US$ is overvalued by about 36% since the exchange rate differential is greater than the relative inflation between the USA and Ireland.

We can thus assume that if PPP holds, the controller has a convincing argument with regards to his fears of the US$ weakening against the punt. But it is widely accepted that PPP generally does not hold for major currencies bought for investment purposes such as the US$, and that if it does hold, it will only do so over the long term (Shapiro, 1999).

Please see overleaf for calculations.

2. Universal Circuits' currency exposure

Should the controller be concerned about the dollar's exchange rate?

Due to the US$ being the Irish's subsidiary functional currency, the controller should be concerned about the Punt/$ exchange rate. Although all the customers (independent sales representatives, US sales force and foreign sales affiliate) are billed in US$, with a direct effect to limit translation, transaction and economic exposure, the Irish subsidiary still incurs many Irish punt costs. Such costs are unmatched by any punt revenues and are thus subject to different types of exposures as it will be explained later.

From the case (p. 255), we know that labour and locally sourced supplies account for 30% of direct cost of sales and that operating and other expenses are incurred in effect exclusively in Irish punt. Putting these figures into context by using exhibit 5 (p. 261), it is possible to calculate that the costs incurred in Irish punt amount to 51.4% (i.e.: 30% of cost of sales = 14.4% + operating expenses of 34% = 48.4% + other expenses of 3% = 51.4%) of total costs.

Thus if the uprising trend of the US$ reverses, the effect will be that more US$ will have to be purchased on the foreign exchange market by the Irish subsidiary in order to service its punt costs. The company therefore has a very large economic exposure (the change in the NPV of future cash flows of the firm as a result of unanticipated changes in real exchange rates) to the dollar that cannot be hedged using currency futures or FRAs because such instruments are not long-term enough. Alternatively dynamic hedging could be used to limit the adverse impact of economic exposure. The only feasible solution to limit economic exposure would be to match punt costs with punt revenues.

As most of Universal Circuit's costs are punt costs (i.e.: wages and general expenses), the Irish subsidiary might see its total costs rise if the US$ weakens against the punt and other main European currencies. Every month, the subsidiary has to pay for wages, other general expenses and materials sourced from outside the US by buying punt, DM and FF for example. The danger here is that if between the time the company has incurred the costs and the time it has to pay for them, the US$ drops in value against any of these currencies then the bills will dramatically increase in US$ value (transaction exposure).

What nature of currency exchange exposure does the Irish subsidiary face?

There are three types of currency exchange exposures: translation (or accounting) exposure, transaction exposure, and economic exposure.

Translation exposure

Translation exposure arises from the need to convert the financial statements of foreign operations from the local currencies involved to the home currency (Shapiro, 1999). Whenever the exchange rate changes, assets, liabilities, revenues, expenses, gains or losses have to be restated.

For Universal Circuits' Irish subsidiary, whose functional currency is the dollar and whose accounting standard is FASB No.52, any changes of the Irish Punt will directly appear on the income statement as a gain or loss before interest and tax (the cumulative translation adjustment applies to the parent, not the foreign subsidiary), as the difference between translated net income before and retained earnings after currency gains. Currency gains are likely to be high for the Irish subsidiary, but with foreign debt of $13.7 (Yen, FF, DM) this is not evident on the financial statements.

Transaction exposure

Transaction exposure stems from the possibility of incurring future exchange gains or losses on transactions already entered into and denominated in a foreign currency (Shapiro, 1999). This applies, for instance, where the exchange rate changes between submitting an order and the actual settlement date. This exposure largely overlaps with translation exposure, although items such as inventories and fixed assets are excluded,