6. Foreign exchange risk Aa Aa Companies that compete in the global economy face

Question

6. Foreign exchange risk Aa Aa Companies that compete in the global economy face various types of risks-for example, foreign exchange risk. Three distinct categories of foreign exchange risk are transaction risk, economic risk, and translation risk Consider the following case: Emma works for a multinational conglomerate firm. The firm's business extends across different sectors, such as computers, consumer electronics, and automobiles. Her job is to monitor foreign exchange risk and recommend strategies for managing it. Situation Emma's company has a subsidiary in Canada. In its recent periodic financial statement, the subsidiary reported investments in marketable securities of 1 milion Canadian dollars (CAD). The company will add this amount to the consolidated balance sheet at the current spot rate, but the annual report is expected to be submitted to the SEC in 60 days Emma identifies the risk, classifies it, and recommends potential strategies. Based on your understanding of foreign exchange risk, complete the tasks involved in Emma's analysis Identify the risk Type of risk Strategies for managing the risk Economic exposure Transaction exposure Translation exposure O Issue 1 million CAD equity shares O Issue 1 million CAD long-term bonds O Accounting risk Operating risk Issue 1 million CAD short-term bonds

Explanation / Answer

Transaction Exposure: Firms engaged in international trade face the risk of currency exchange rate fluctuations post entering into an international financial obligation such as sales or purchase. Often hedged using money market, forwards and derivative instruments.

Economic Exposure: The risk faced by a firm's future cash flows owing to UNEXPECTED fluctuations in currency exchange rates. Since, these rate fluctuations are unexpected economic exposure is difficult to hedge as compared to the other two types of exposure.

Translation Exposure: The risk of currency exchange rate fluctuations altering the value of a firm's financial statement items such as equitues, liabilities, assets and income.This stems from recording portions of a firm's assets or debts or equities in a foreign currency and is thereby known as an Accounting Exposure.

The listing of the subsidiary's investments of 1 million CAD from marketable securities in Canadian Dollars is hence a Transaltion Exposure and an Accounting Risk. As investment in marketable securities is an increment in the subsidiary's asset, issuance of equity is an effective method of managing this risk as the equity issuance of 1 million CAD will also be recorded at the current spot rates (like the investment in marketable securities) thereby keeping Asset, Equity, Liability equation balanced. Long term debt is not needed as the SEC fillings are in the short term future (of 60 days) and short term debt might carry high interest expenses therby unecessarily denting the firm's income.

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