The Hedge Relationship Between Transaction and Translation Exposures

John Bird, Bank of America Global Corporate and Investment Bank - 14 January 2004

Foreign exchange risk on the translation of foreign earnings is a principal concern for a large number of US MNCs. However, as US accounting policy does not allow a favorable accounting treatment for the direct hedging of these exposures, it is important that the hedging of transactional exposures be structured to mitigate and not add to the translation risk on foreign earnings. This article examines the range of relationships between transaction and earnings translation risks, and shows that targeting the proper components of transaction risk can have a favorable effect on earnings translation risk.

Types of Risk

Accounting policy separates exposures relating to changes in the values of known cash flows or transactions with exposures relating to the valuation of forecasted flows denominated in a foreign currency. However, for the purposes of this paper, we will combine exposures already represented on the balance sheet with anticipated exposures and collectively refer to these as transaction exposures. Further, we will assume that transaction exposure refers to value changes in relation to cash flows (both recorded and forecast) that are denominated in currencies other than the functional currency of the subsidiary. For example, a euro-receivable on the books of a euro-functional subsidiary is not an exposure for that subsidiary.

We will examine the impact of the hedging of transaction exposures on earnings translation risk. We define earnings translation risk as the exposure to re-measurement into US dollars of a foreign subsidiary's local currency-denominated earnings. However for USD-functional subsidiaries (that do not have foreign-functional profits), we will show the impact of transaction hedging on the net foreign currency receivable position.

Dollar-Functional Subsidiary

In many respects, the hedging of transaction exposures for a USD-functional subsidiary represents the most simplistic case in terms of the interaction between exposure types. Table 1 displays a basic balance sheet and income statement for a USD-functional subsidiary, with consolidated entity income as well. As will be the case with all of our examples, we will assume that the subsidiaries are located in Europe (within the euro-zone), with the consolidated entity reporting in US dollars. Also our examples will highlight exposures from the point of view of the subsidiary along with consolidated income. Finally, to further simplify our examples, we'll assume that the EUR/USD level is at parity.

In our first example, US dollar receivables and payables are not considered exposures for this subsidiary, even though they are denominated in a currency that is not the normal currency for financial transactions within Europe. On the other hand, euro-denominated receivables and payables are considered exposures for this entity (as they are denominated in a currency other than the unit's functional currency). Finally, the subsidiary's earnings are denominated in USD (the unit's functional currency) as are the earnings of the consolidated entity.

As we are focusing on the linkage between transaction exposures and foreign earnings, we need to describe the dynamics of foreign earnings risk for this USD-functional unit. This unit will not report earnings on a euro-basis. However, this unit's net EUR-receivable/payable position will affect consolidated entity income in the same way as the EUR-denominated income of a EUR-functional entity would affect consolidated entity income. For each reporting period, foreign-denominated A/R and A/P are revalued at the current exchange rate with changes affecting current period income. So a decline in the currency (relative to the functional currency) of a foreign-denominated receivable will have an adverse impact on income (both for the unit and on a consolidated basis) even though the USD-functional entity will not be reporting non- USD earnings.

Table 2 displays the impact of hedging EUR-receivables/payables on a net EUR-position from a consolidated point of view. As stated earlier, the impact on foreign income of transaction hedging for a USD-functional entity is relatively straight forward. As is shown in the upper left-hand cell of the table (cell [1,1]), the hedging of euro receivables will tend to decrease the risk of a net-euro-receivable position (a proxy for EUR revenue). This combination represents the best case for US MNCs in relation to foreign earnings hedging: a USD-functional subsidiary can hedge the foreign receivable exposure which will have a mitigating impact on the risk of the consolidated company's foreign-denominated earnings (or in the case of a USD-functional entity, the net foreign receivable position) while obtaining favorable hedge accounting.

Two of the other cells in Table 2 display a less favorable story (cells [1,2] and [2,1]). If a company hedges its EUR receivable but is in a net EUR-payable position, the hedging would add to the risk of the net-euro-payable (cell [2,1]). Similarly, if a company hedges a EUR-payable but has a net EUR-receivable position, the hedge would also add to the net-receivable risk position. These may sound like unlikely situations, as both require the hedging of exposures that do not foot to a net exposure position for the subsidiary, but the numbers on our simplistic balance sheet which foot to the income number will not always be the case. Longer-term assets and liabilities can have an impact on the net currency position of the consolidated company as they may shift the overall corporate position from a net long currency position to a net short currency position[1]. Cell (2,1) displays the risk of a situation that is quite common: that the hedging of foreign-denominated receivables will add to the income statement risk of a USD-functional subsidiary operating at a loss. Many new foreign subsidiaries operate at a loss for the first few years of their existence, with this example displaying that hedge policies created for positive-income units may harmfully affect this unit's risk position. The purpose of these cases (and, in fact, this paper) is to reinforce the need to analyze all of the exposures in relation to the company's overall position to make certain that the overall corporate exposure is being favorably impacted.

EUR-Functional Subsidiary, USD Exposures

Table 3 displays a basic balance sheet and income statement for a EUR-functional subsidiary along with consolidated entity income. Besides euro-balances, this entity also has USD-denominated balance sheet items. The number of differences outnumber the similarities between these financial statements and the ones for the USD-functional entity. For this EUR-functional entity, the USD-denominated balances represent exposures for this subsidiary while the EUR-denominated assets and liabilities do not. For the income statement, euro-denominated profit is reflected on the unit income statement while profit is stated in USD-terms on the consolidated income statement.

For this example, FX risk relating to the subsidiary's euro-denominated profit is the principal currency exposure that the consolidated entity is concerned with. The hedging of this exposure would not receive a favorable accounting treatment for either the parent (as profit hedging does not receive favorable accounting) or for the subsidiary (as EUR-denominated profit is not an exposure for the subsidiary).

Table 4 displays the impact of hedging USD-receivables/payables on the subsidiary's euro-denominated profit. For this example, the upper left-hand cell of the table (cell [1,1]) displays that hedging a USD-receivable would add to the risk of the consolidated entity's euro profits (that reside on the books of the subsidiary) despite the fact that these hedges could receive favorable hedge accounting. This balance sheet hedge would entail the selling of USD/buying of EUR which would add to the long EUR position of the consolidated company (their euro-denominated profit). The table displays that the hedging of the subsidiary's USD payable exposure would be required to hedge the company's long euro-profit position. The two lower cells ([2,1] and [2,2]) display the effect of balance hedges on a short euro-earnings profile (an operating loss on the subsidiary's books).

This example should reinforce the point that the subsidiary's risk profile needs to be taken into account if reducing consolidated entity risk is the overall goal, as hedging the subsidiary's risk can have a detrimental impact on the risk to the consolidated entity. The fact that these subsidiary hedges can receive favorable hedge accounting does not make their overall corporate impact any more palatable.

EUR-Functional Subsidiary, GBP Exposures

Payables and receivables that are not denominated in either the functional currency of the subsidiary or the functional currency of the parent provide a third distinct example. Our third example is of a euro-functional subsidiary that has GBP-denominated receivables and payables, yet whose financial statements are consolidated into a USD-entity. For this entity, the GBP-denominated receivables and payables constitute their exposures and, as with the previous examples, the primary concern of the consolidated entity is the translation risk of their non-USD-denominated profit. However, the net GBP-receivable also constitutes an exposure; one similar in nature to the EUR-receivable in the first example where a net receivable balance affected the consolidated entity in the same way that foreign earnings affect the consolidated entity.

Table 6 displays the impact of GBP-denominated transaction hedging on euro profit as well as on the net GBP-revenue position. The upper four cells display that, if the subsidiary hedges the net GBP balance sheet position, it will also be decreasing the risk on its net GBP-payable/receivable position (the former a balance sheet exposure with the later viewed as a proxy for GBP profitability). The lower four cells display that the hedging of the GBP-denominated transaction exposure affects the risk on the functional-currency profits of the subsidiary (when viewed from the parent) in the same way as the USD-denominated transaction exposure affects the EUR-profits in our second example. As with the EUR-functional entity with USD exposures, the hedging of GBP receivables (cell [3,1]) in this example adds to FX risk relating to local currency profitability, when viewed from the consolidated entity. The same increase in risk can be seen from the combination of balance sheet exposure and income statement risk can be observed in cell (4,2). While cells (3,2) and (4,1) show the opposite result, where the hedging of these specific balance sheet risks decrease the consolidated entity non-USD earnings exposure.

The comparison of the upper and lower groupings of cells (especially cells [1,1] and [3,1]) displays an interesting result. Namely, that the hedging of a long GBP position for euros, from a consolidated point of view, means exchanging a GBP exposure for a EUR exposure – not eliminating an exposure (when viewed on a consolidated basis). While the GBP-denominated “income” is reduced, the exposure relating to the euro-denominated earnings is increased. And the result of reducing the GBP exposure while increasing the EUR-denominated profit exposure holds for other cells as well.

These more complicated exposure interrelationships displayed in this three-currency example underline the importance of studying the full impact of hedge policies. While the earlier examples displayed that specific transaction hedging could have an unintended impact on earnings translation risk, this example displays that the hedging of more complicated transaction exposure positions require a greater analytic effort to avoid unintended consequences. These more complicated interrelationships make the determination of a clear overall risk management goal more important as well; as the satisfaction of subsidiary goals can have an unintended and unfavorable impact on consolidated entity risk.

Closing

This discussion has focused on the effect of transaction exposure hedging on earnings translation risk. Our primary assumption was that our consolidated entity was principally concerned with earnings translation risk. However, there are factors that might cause a company to be more concerned with transaction risk than with earnings translation risk, or with a combination of the two. The results of our 2000/2001 customer survey[2] display that while more than 90% of companies hedge transaction exposure, only 30% percent hedge their translation exposure.

One of the reasons that we hear from companies regarding why they focus more on transaction exposures than earnings translation exposure is that transaction exposures constitute risks to cash flow, where earnings translation risks do not. Another reason that many companies emphasize transaction exposures, as mentioned at the outset of this piece, is that transaction hedging can easily be structured to receive favorable accounting treatment while earnings translation hedging cannot.

The counter-argument is that foreign earnings translation risk is the principal risk that investors and equity analysts are concerned with. So, at a minimum, companies should consider both transaction and translation risks if not primarily focus on earnings translation risk. The logic behind this argument is that investors are interested in earnings, and especially by reported earnings. Effective hedging of foreign earnings should diminish the impact and/or the likelihood of adverse currency changes on foreign earnings. We studied the impact of earnings volatility due to FX changes on market capitalization and showed that missed earnings forecasts (due in this case to FX movements) can have a significant market impact.[3]

Through our consulting work we have spoken with a large number of companies that recognize the importance of reducing or eliminating earning translation risk. Some of these companies choose non-derivative structures to hedge these exposures while others use the selective hedging of transaction exposures to reduce their earning translation risk. Unfortunately, there are limitations dependent on the subsidiary structure to the use of selective transaction hedging as a control for earnings translation risk. Overall, understanding the linkages between transaction and earnings translation exposure in relation to the corporate subsidiary structure is a necessary first step towards the determination of the applicability and attractiveness of this strategy.

Endnotes

1. Monograph 23, Spring 1994, Functional Currency and Financial Statements by A. Miyamoto describes financial statement reporting for USD and foreign currency functional entities.
2. Yee, V., Corporate America: FX Risk Management 2000/2001, Journal of Risk Analysis, Monograph 158, Spring 2001.
3. Bird, J. and Yee, V., Currency Fluctuations, Earnings Announcements, and Market Capitalization, Journal of Risk Analysis, Monograph 162, Spring 2001.

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