Part 2: Management of Translation Exposure |English| #InternationalFinance| M. Com|MBA

Summary

This video delves into translation exposure, a financial risk faced by multinational corporations (MNCs) due to currency fluctuations during financial statement consolidation. It explains the concept, types of exposure, and introduces four translation methods: current/non-current, monetary/non-monetary, current rate, and temporal. The video concludes with strategies for hedging translation exposure, including balance sheet hedging and derivative hedging, to mitigate risks associated with exchange rate changes.

Takeaways

• 🌐 Translation exposure is the financial risk faced by multinational corporations (MNCs) due to changes in exchange rates when consolidating financial statements of subsidiaries in different countries.
• 💼 The value of a subsidiary's holdings needs to be converted into the home country's currency, which can be affected by exchange rate fluctuations, also known as accounting exposure.
• 🏢 An example is given where an Austrian subsidiary of an American company purchases a building, and the change in exchange rate affects the value recorded in the parent company's financial statements.
• 📈 There are various methods to translate financial statements, including current/non-current method, monetary/non-monetary method, current rate method, and temporal method.
• 💰 The current/non-current method differentiates between current assets/liabilities (translated at current exchange rates) and non-current assets/liabilities (translated at historical rates).
• 💵 Monetary assets and liabilities, which have a fixed amount of money, are translated at the current exchange rate, while non-monetary assets are translated at the historical rate.
• 🔄 The current rate method translates all items except for the stock of capital at the current exchange rate, with the capital being translated at the historical rate.
• 📊 The temporal method is similar to the monetary/non-monetary method but has different treatment for inventory, which is typically translated at the historical rate unless it's valued at market value.
• 🛡️ Two hedging strategies are discussed: balance sheet hedge, which aligns assets and liabilities to prevent mismatches, and derivative hedge, which uses financial instruments like forwards, options, and swaps.
• 📚 The presenter encourages viewers to check out previous videos for more detailed information on types of foreign exchange exposure and hedging strategies.

Q & A

What is translation exposure?

Translation exposure is the financial exposure faced by multinational corporations (MNCs) that operate in various subsidiaries from different countries. It occurs when financial statements are consolidated from subsidiaries to the parent company and the exchange rate changes, affecting the value of the financial statements.

How does translation exposure affect the financial statements of a company?

Translation exposure affects the financial statements of a company by causing changes in the value of the holdings of each subsidiary when they are converted into the currency of the home country due to fluctuations in the exchange rate.

What is the difference between current and non-current translation methods?

In the current translation method, current assets and liabilities are converted at the exchange rate prevailing on the balance sheet date, while non-current assets and liabilities are converted at the historical exchange rate.

Can you provide an example to illustrate the current and non-current translation method?

Yes, if a subsidiary purchases a building worth one lakh Euro on September 1, 2021, with an exchange rate of 1.20 (Euro to USD), it would be recorded as $120,000. If the financial statements are consolidated on March 31, 2022, with an exchange rate of 1.15, the building would then be recorded as $115,000.

What are monetary and non-monetary assets in the context of translation exposure?

Monetary assets are fixed amounts of money, such as cash and accounts receivable, which do not change with exchange rates. Non-monetary assets are assets like machinery and buildings whose values can fluctuate with market value.

How does the current rate method differ from the monetary and non-monetary method?

The current rate method values all assets and liabilities at the current exchange rate, except for the stock of capital, which is valued at the historical rate. In contrast, the monetary and non-monetary method values monetary accounts at the current rate and non-monetary accounts at the historical rate.

What is the temporal method of translation?

The temporal method is similar to the monetary and non-monetary method, but it differs in how it treats inventory. Inventory is generally taken at the historical rate unless it is measured at market value, in which case it is converted at the current exchange rate.

What strategies can be used to hedge against translation exposure?

Two common hedging strategies against translation exposure are balance sheet hedging and derivative hedging. Balance sheet hedging involves matching assets and liabilities to prevent mismatches in final values due to exchange rate changes. Derivative hedging uses financial instruments like forwards, options, and swaps to mitigate risk.

Why is it important for companies to manage their translation exposure?

Managing translation exposure is important because it helps companies to predict and control the financial impact of exchange rate fluctuations on their consolidated financial statements, thereby reducing financial risk and uncertainty.

How can a company's decision to hedge its translation exposure affect its financial performance?

Hedging translation exposure can stabilize a company's financial performance by reducing the volatility caused by exchange rate fluctuations. However, it may also involve costs and can sometimes limit potential gains if exchange rates move favorably.

What is the role of derivatives in managing translation exposure?

Derivatives play a crucial role in managing translation exposure by providing a means to offset potential losses due to exchange rate changes. They allow companies to lock in exchange rates, thus reducing the risk associated with currency fluctuations.

Outlines

00:00

🌐 Introduction to Translation Exposure

The video begins with a discussion on translation exposure, a financial risk faced by multinational corporations (MNCs) with subsidiaries in different countries. When consolidating financial statements, fluctuations in exchange rates can affect the value of these statements, leading to translation exposure. The presenter clarifies that this exposure is also known as accounting exposure. An example is provided where an Austrian subsidiary of an American company purchases a building, and the change in exchange rate from the time of purchase to the time of financial consolidation affects the recorded value of the asset in USD.

05:03

📈 Methods of Translation and Hedge Strategies

The video script explains different methods for translating financial statements: the current/non-current method, the monetary/non-monetary method, the current rate method, and the temporal method. Each method has specific rules for converting assets and liabilities at either the current exchange rate or the historical rate. The script also discusses designing hedging strategies, such as balance sheet hedging to match assets and liabilities and derivative hedging using financial instruments like forwards and options. The presenter encourages viewers to check out previous videos for more details on these strategies and concludes by asking viewers to like, share, and subscribe if they found the content helpful.

Keywords

💡Translation Exposure

Translation exposure refers to the potential financial impact on a multinational corporation (MNC) due to changes in exchange rates when consolidating financial statements of its foreign subsidiaries. In the video, the presenter explains that when an MNC has subsidiaries in different countries, fluctuations in exchange rates can affect the value of the subsidiaries' assets and liabilities when converted into the parent company's currency. An example given is an Austrian subsidiary of an American company that purchases a building in Euros, which is then converted to US dollars at different rates over time.

💡Consolidation

Consolidation in the context of the video is the process of combining the financial statements of a parent company and its subsidiaries into a single set of financial statements. This process is crucial for understanding the overall financial health of an MNC. During consolidation, translation exposure comes into play as all foreign currency transactions must be converted into the reporting currency, potentially affecting the consolidated financials.

💡Exchange Rate

The exchange rate is the rate at which one currency can be exchanged for another. It plays a critical role in the video's discussion of translation exposure, as changes in these rates directly affect the value of foreign assets and liabilities when they are translated into the home currency for consolidation. The presenter uses the fluctuation of the Euro to US Dollar exchange rate as an example to illustrate this concept.

💡Hedge Strategy

A hedge strategy, as discussed in the video, is a financial strategy used to reduce or eliminate the risk of loss from adverse movements in exchange rates. The presenter outlines two main types of hedging strategies: balance sheet hedge and derivative hedge. These strategies are essential for MNCs to manage their exposure to currency fluctuations and protect their financial stability.

💡Current and Non-Current Method

The current and non-current method is one of the methods for translating financial statements discussed in the video. Current assets and liabilities are translated at the current exchange rate, while non-current assets and liabilities are translated at the historical exchange rate. This method reflects the idea that short-term financial flows are more sensitive to current exchange rates, whereas long-term assets and liabilities are less affected by short-term fluctuations.

💡Monetary and Non-Monetary Method

This method distinguishes between monetary and non-monetary items when translating financial statements. Monetary items, such as cash and accounts receivable, are fixed in amount and are translated at the current exchange rate. Non-monetary items, such as property and equipment, are translated at the historical rate. The video uses this method to illustrate how different types of assets and liabilities are affected differently by exchange rate changes.

💡Current Rate Method

The current rate method is a simplified approach to translating financial statements where all items, except for the stock of capital, are translated at the current exchange rate. This method assumes that most assets and liabilities are affected by current exchange rates, with the exception of equity, which is translated at the historical rate. The video uses this method to show a straightforward way of dealing with currency translation.

💡Temporal Method

The temporal method is a translation approach that treats inventory differently from the current rate method. While inventory is generally translated at the historical rate, if inventory is measured at market value, it is translated at the current rate. This method reflects the idea that the value of inventory can change based on market conditions, which are influenced by current exchange rates.

💡Balance Sheet Hedge

A balance sheet hedge, as mentioned in the video, is a strategy that involves matching assets and liabilities in the same currency to reduce the risk of adverse exchange rate movements. By aligning the currencies of assets and liabilities, MNCs can minimize the impact of translation exposure on their financial statements.

💡Derivative Hedge

A derivative hedge is a strategy that uses financial derivatives, such as forwards, options, and swaps, to hedge against currency risk. As discussed in the video, MNCs can use these financial instruments to lock in exchange rates, thus protecting themselves from unfavorable currency fluctuations. This strategy is part of a broader approach to managing translation exposure.

Highlights

Translation exposure is the financial exposure faced by MNCs operating in various countries.

Translation exposure arises when consolidating financial statements of subsidiaries in different currencies.

The value of holdings of each subsidiary needs to be converted into the home country's currency.

Translation exposure is also known as accounting exposure.

An example of translation exposure involves an Austrian subsidiary of an American company purchasing a building in Euros.

The fluctuation in exchange rate affects the recorded value of the building in the parent company's currency.

There are various methods of translation: current/non-current, monetary/non-monetary, current rate, and temporal methods.

Current assets and liabilities are converted at the current exchange rate.

Non-current assets and liabilities are converted at the historical exchange rate.

Monetary assets and liabilities are fixed amounts that do not change with exchange rates.

Non-monetary assets fluctuate with market value and are converted at the historical rate.

The current rate method involves converting all items except stock capital at the current exchange rate.

The temporal method treats inventory differently based on whether it is recorded at historical or market value.

Designing a hedging strategy involves balance sheet hedging and derivative hedging.

Balance sheet hedging involves matching assets and liabilities to prevent mismatches in final values.

Derivative hedging can use forwards, options, or swaps to mitigate exposure.

The video provides a comprehensive overview of translation exposure and its management strategies.

Transcripts

hi guys welcome to my channel I hope you

guys are doing well

so in today's video we will be

discussing about translation exposure

in this we'll be covering about the

meaning methods of translation and

designing a hedge strategy right so

before we begin with I have already made

a video on the all the types of Foreign

Exchange exposure that is translation

exposure economic exposure and the

transaction exposure please go and check

that video I will provide you the video

in the description box all right

so let's just begin with what is the

translation exposure this is basically

the financial exposure that is being

faced by the mncs that operate in

various subsidiaries from different

countries say like India

or in Australia Europe so on and so

forth right so whenever the financial

statements are being Consolidated of the

subsidiaries

okay to the parent company then the

translation exposure comes into the

picture so let's understand the meaning

firms Consolidated financial statements

can be affected by changes in the

exchange rate right

so in the previous video I have already

explained you with the help of an

example supposedly there is a company

mncs that operates in U.S right it is a

parent company it has various

subsidiaries we are taking into

consideration the three subsidiaries say

one operating in UK one in Africa and

one in India right so whenever the

financial statements are being made of

these subsidiaries these will be in

their own home currency right however

when the final accounts will be made the

consolidation of the financial

statements will be done of the parent

company the all the financial statements

will be converted into the parent

company currency right so whatever is a

fluctuation in the exchange rate is

known as the translation exposure I hope

I have already cleared you this thing

right

so in this what happens is if the parent

company is situated in a country with a

different currency the value of the

Holdings of each subsidiary needs to be

converted into the currency of the Home

Country right this exposure is no also

known as the accounting exposure

so let's just take an example there is

an Austrian subsidiary of American

company what it does it it purchases a

building worth one lakh Euro on first of

September 2021

right on that date that is first

September the exchange rate that is Euro

euro to US dollar was 1.20

so they have recorded their building

that is in uh 120 000 uh dollars they

have already recorded in their books

however when the total the compilation

of these financial statements was done

the subsidiaries account was merged into

the consolidation on 31st March 2022 the

exchange rate went to

1.15 dollars

so now it has to be recorded into one

lakh fifteen thousand dollars in their

books right

now we have various methods of

translation first is it current or

non-current method then we have monetary

non-monetary current rate method and

temporal method we'll study all these

one by one first is the current and

non-current Method right we have current

assets we have non-current assets I hope

you know the meaning of current and

non-current you're going to comment this

in the comment section

right so whatever the current assets or

liabilities are there we take into

consideration there

there are converted into the

exchange rate that prevails on the date

of balance sheet right however for the

non-current assets or liability these

are being converted into historical rate

now if I say that my historical exchange

rate is 1.20 and the current rate is

1.15 now let's see how will we will

convert it

I told you that in current and

non-current Method what do we do all the

current

assets or liability are taken at current

rate whatever the exchange rate is

prevailing we take into consideration so

the uh sundry creditors right cash in

hand sanitary debtors these all have

been taken as a part of current

prevailing exchange rate

however others that is non-current long

term debt will be non-current capital

and then your buildings this has been

taken at the Historical rate right any

confusion till now please comment in the

comment section

then we have the monetary or

non-monetary method okay so what are

monetary assets basically monetary

assets or liability they have the fixed

amount of money that does not change for

example cash the amount of cash will be

the same the debtors whatever is a

liability from the debtors they are

going to pay you the same amount that

will not change with the exchange rates

the creditors and Loans right whatever

is fixed is known as the monetary assets

however whatever the value of the assets

such as Machinery buildings capitals

which fluctuates with the market value

is known as the non-monetary method thus

we can say that all the monetary

accounts are being converted at the

current rate of exchange whereas

non-monetary accounts are converted at

the Historical rate right

let's take an example

the example is the same that the

historical exchange rate is 1.12 and the

current rate is at 1.15

so we've already started that all the

monetary values will be taken at the

current rate and non-monetary at the

Historical rate so over here we can see

monetary is the current creditors

right then we have is the long term debt

cash in hand and Sundry debtors whereas

non-monetary will be the value the

market value of which it keeps on

changing capital and building has been

taken on the historical rate

next method is the current rate method

this is the simplest of all that you

take everything on the current rate of

exchange

except for the stock of capital right

except for stock of capital everything

has to be taken on the current rate of

exchange

over here what have we done we have

taken everything on the current rate

except for the capital that will be on

the historical rate easy

last method is the temporal method this

method is same as monetary and

non-monetary except for its treatment

about the inventory

now over here you guys need to note over

here is that value of the invert

inventory is generally taken at

historical rate but if in the books the

inventory is measured or taken on market

value then it is being converted into

the current rate right if I say that we

have taken the inventory of the books in

the books it has been recorded at 1000

Euro then the value of conversion will

be at the Historical rate

however if the prevailing if it is

prevailing on the market value then only

you take the current

exchange rate that is prevailing right

last is the designing of the hedging

strategy over here we have two

strategies basically first is the

balance sheet head and another one is

the derivative hedge in balance sheet

what do we do there are various items in

balance sheet we have liabilities and we

have the assets right so if there is any

mismatch

the assets and liabilities are actually

hedged so that they do not mismatch in

their final value

and about the derivative hedge what can

be the derivatives your forwards

then

options

swaps

right we've already discussed about the

derivatives hedge in the previous

lecture so you guys can go and check out

that in detail

so that is it for today guys I hope you

have learned something if yes then

please do like share and subscribe to my

channel thank you and have a nice day