The translation of foreign subsidiaries concerns the consolidated group balance sheet. However, this does not affect the real “economic” value or exposure of the subsidiary. Economic risk focuses on how exchange rate moves change the real economic value of the corporation, focusing on the present value of future operating cash flows and how this changes in line with exchange rate changes. More specifically, the economic risk of a corporation reflects the effect of exchange rate changes on items such as export and domestic sales, and the cost of domestic and imported inputs. As with translation risk, calculating economic risk is complex, but clearly necessary to be able to assess how exchange rate changes can affect the present value of foreign subsidiaries. Economic risk is usually applied to the present value of future operating cash flows of a corporation’s foreign subsidiaries. However, it can also be applied to the parent company’s operations and how the present value of those change in line with exchange rate changes. Summarizing this part, transaction risk deals with the effect of exchange rate moves on transactional exposure such as accounts receivable/payable or dividends. Translation risk focuses on how exchange rate moves can affect foreign subsidiary valuation and therefore the valuation of the consolidated group balance sheet. Finally, economic risk deals with the effect of exchange rate changes to the present value of future operating cash flows, focusing on the “currency of determination” of revenues and operating expenses. Here it is important to differentiate between the currency in which cash flows are denominated and the currency that may determine the nature and size of those cash flows. The two are not necessarily the same. To complicate the issue further, there is the small matter of the parent company’s currency, which is used to consolidate the financial statements. If a parent company has foreign currency-denominated debt, this is recorded in the parent company’s currency, but the value of its legal obligation remains in the currency denomination of the debt. In sum, transaction risk is just the tip of the iceberg!
Of necessity, the reality of currency risk is very case-specific. That said, there has been an attempt by the academic and economic communities to apply the traditional exchange rate models to the corporate world for the purpose of demonstrating how exchange rates impact a corporation. More specifically, the models typically used for this purpose have been those of PPP, the international Fisher effect and the unbiased forward rate theory, which we looked at in earlier posts. To recap:
PPP (or the law of one price) suggests that price differentials of the same good in different countries require an exchange rate adjustment to offset them.
The international Fisher effect suggests that the expected change in the exchange rate is equal to the interest rate differential.
The unbiased forward rate theory suggests that the forward exchange rate is equal to the expected exchange rate.
Generally, these theories are grounded in the efficient market hypothesis and therefore flawed at best. Over the long term, these traditional “rules” of exchange rate theory suggest that competition and arbitrage should neutralize the effect of exchange rate changes on returns and on the valuation of the corporation. Equally, locking into the forward rate should, according to the unbiased forward rate theory, offer the same return as remaining exposed to currency risk, as this theory suggests that the distribution of probability should be equal on either side of the forward rate.
The unfortunate thing about such models, however worthy the attempt, is that they do not and cannot deal with the practical realities of managing currency risk. What academics regard as “temporary deviations” from where the model suggests the exchange rate should be can be sufficient and substantial enough to cause painful and intolerable deterioration to both the P&L and the balance sheet.
To conclude this part, a corporation should define and seek to quantify the types of currency risk to which it is exposed in order then to be able to go about creating a strategy for managing that currency risk.
Translation risk is slightly more complex and is the result of the consolidation of parent company and foreign subsidiary financial statements. This consolidation means that exchange rate impact on the balance sheet of the foreign subsidiaries is transmitted or translated to the parent company’s balance. Translation risk is thus balance sheet currency risk. While most large multinational corporations actively manage their transaction currency risk, many are less aware of the potential dangers of translation risk.
The actual translation process in consolidating financial statements is done either at the average exchange rate of the period or at the exchange rate at the period end, depending on the specific accounting regulations affecting the parent company. As a direct result, the consolidated results will vary as either the average or the end-of-period exchange rate varies. Thus, all foreign currency-denominated profit is exposed to translation currency risk as exchange rates vary. In addition, the foreign currency value of foreign subsidiaries is also consolidated on the parent company’s balance sheet, and that value will vary accordingly. Translation risk for a foreign subsidiary is usually measured by the net assets (assets less liabilities) that are exposed to potential exchange rate moves.
Problems can occur with regard to translation risk if a corporation has subsidiaries whose accounting books are local currency-denominated. For consolidation purposes, these books must of course be translated into the currency of the parent company, but at what exchange rate? Income statements are usually translated at the average exchange rate over the period. However, deciding at what exchange rate to translate the balance sheet is slightly more tricky. There are generally three methods used by major multinational corporations for translating balance sheet risk, varying in how they separate assets and liabilities between those that need to be translated at the “current” exchange rate at the time of consolidation and those that are translated at the historical exchange rate:
The all current (closing rate) method
The monetary/non-monetary method
The temporal method
As the name might suggest, the all current (closing rate) method translates all foreign currency exposures at the closing exchange rate of the period concerned. Under this method, translation risk relates to net assets or shareholder funds. This has become the most popular method of translating balance exposure of foreign subsidiaries, both in the US and worldwide. On the other hand, the monetary/non-monetary method translates monetary items such as assets, liabilities and capital at the closing rate and non-monetary items at the historical rate. Finally, the temporal method breaks balance sheet items down in terms of whether they are firstly stated at replacement cost, realizable value, market value or expected future value, or secondly stated at historic cost. For the first group, these are translated at the closing exchange rate of the period concerned, for the second, at the historical exchange rate.
The US accounting standard FAS 52 and the UK’s SSAP 20 apply to translation risk. Under FAS 52, the translation of foreign currency revenues and costs is made at the average exchange rate of the period. FAS 52 generally uses the all current method for translation purposes, though it does have several important provisions, notably regarding the treatment of currency hedging contracts. Under SSAP 20, the corporation can use either the current or average rate. Generally, there has been a shift among multinational corporations towards using the average rather than the closing rate because this is seen as a truer reflection of the translation risk faced by the corporation during the period.
Translation risk is a crucial issue for corporations. Later in this blog, we will look at methods of hedging it. For now, it is important to get an idea of how it can affect the company’s overall value.
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