International Accounting, 6/e Frederick D.S. Choi Gary K.

Meek

Chapter 11: Financial Risk Management

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Learning Objectives

What does risk management entail? What are the various types of market risks that international financial managers encounter? Identify four tasks involved in managing foreign exchange risk. How does translation exposure differ from transaction exposure? What is a financial derivative and how is it measured? Identify three types of foreign currency hedges and their accounting treatments recommended by IAS 39 and FAS 133.
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Enterprise Risk Management

Evaluates risk in the context of a firms business strategy External risk factors to consider:

Macroeconomic factors Exchange rate behavior Political intelligence Competitive environment Revenue concentration Inflation rates Immigration regulations Physical security Data security Technological obsolescence Financial reporting risks Liquidity and leverage Commodity price changes Equity price changes Liquidity Credit exposure Regulatory compliance Tax exposure Accounting risk
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Internal risk factors

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Why Manage Financial Risks?

Stabilize expected cash flows Facilitate concentration on primary business risk Align interests of shareholders and bondholders Maximize returns on pension fund investments Limit exposure of firms clients to financial risks

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Accounting Dimension of FX Risk Management

Identify potential FX risk. Quantify tradeoffs associated with alternative riskresponse strategies. Measure a firms FX exposure. Account for specific hedge products. Evaluate effectiveness of hedging programs.
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Translation Exposure

Translation exposure: measures impact of FX changes on domestic currency equivalents of foreign currency assets and liabilities.

Current rate translation method

Exposure = total assets minus total liabilities Exposure = monetary assets (including nonmonetary assets measured at current values) minus monetary liabilities Exposure = monetary assets minus monetary liabilities

Temporal method

Monetary-nonmonetary method

Current-noncurrent method

Exposure = current assets minus current liabilities

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Translation Exposure (contin)

Multiple currency translation exposure report

Enables a parent company to aggregate its translation exposure reports for all foreign subsidiaries. Company can analyze its worldwide translation exposure by currency.

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Transaction Exposure

Measures exchange gains and losses that arise from the settlement of foreign currency sales, purchases, borrowing, or lending transactions.

Multicurrency transaction exposure report

Enables parent company to monitor its global transaction exposure by currency.

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Transaction Exposure (contin)

Involves assessing corporate strengths and weaknesses as a basis for strategy formulation

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Economic Exposure

Translation and transaction exposure are static concepts. Economic exposure is future-oriented and examines the impact of exchange rate changes on the future performance and cash flows of the firm.

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Hedging Strategies

Balance sheet hedges: adjusts the levels and currency of a firms exposed assets and liabilities. Operational hedges: adjusts variables, such as selling prices and currency of denomination, that impact foreign currency sales and expenses.

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Hedging Strategies (contin)

Contractual hedges: uses financial instruments to hedge a firms exposed assets and liabilities. Most financial instruments used for hedging are derivatives in that their values are derived from some underlying instrument. Types of financial instruments:

FX forward contract: an agreement to deliver or receive a specified amount of foreign currency in exchange for domestic currency on a fixed future date at a fixed rate. Financial futures: a commitment to purchase or deliver a specified amount of foreign at a future date at a set price. These instruments are traded on an organized exchange. Currency option: gives the buyer the right to buy or sell a currency from the seller at a specified price on or before a specified expiration date. Currency swap: a current and future exchange of two different currencies at predetermined rates.
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Accounting Treatments per IAS 39 and FAS 133

Financial derivatives are marked to market with unrealized gains or losses taken to income. Exceptions are granted if management documents:

the item being hedged exposes the firm to a market risk. the firms hedging strategy. the instruments to be employed as a hedge. the rationale as to why the hedge will be effective.
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Accounting Treatments per IAS 39 and FAS 133 (contin)

For fair value hedges (i.e., hedges of recognized foreign currency assets and liabilities):

Unrealized gains and losses on marking the derivative to market are included in current income. Changes in the value of the foreign currency asset or liability being hedged are also recognized in current income. Unrealized gains or losses on the derivative are initially recognized as an element of comprehensive income. These gains or losses are subsequently recognized in earnings when the forecasted transaction affects earnings.
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For cash flow hedges:

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Accounting Treatments per IAS 39 and FAS 133 (contin)

For hedges of a foreign currency net investment (i.e., translation exposure on a foreign subsidiary):

Unrealized gains or losses on the derivative are included in comprehensive income. These gains or losses are recognized in earnings when the foreign subsidiary is sold or liquidated.

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Other Chapter Exhibits

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Other Chapter Exhibits (contin)

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Other Chapter Exhibits (contin)

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Other Chapter Exhibits (contin)

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Other Chapter Exhibits (contin)

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Exhibit 11-11 (contin)

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Other Chapter Exhibits (contin)

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Other Chapter Exhibits (contin)

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Other Chapter Exhibits (contin)

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Other Chapter Exhibits (contin)

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Exhibit 11-17 (contin)

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Exhibit 11-17 (contin)

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Exhibit 11-17 (contin)

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