An overview of FX Exposure Risk:

Assessment and Management

June 2015
1. Introduction
This report presents an overview of various types of foreign currency exposure, their impact on the financial
statements, and management. Foreign currency exposure is a financial risk posed by an exposure to
unanticipated changes in the exchange rate between two currencies.

Foreign Exchange risk arises when a company holds assets or liabilities in foreign currencies and affects the
earnings and capital of the entity due to the –undesired and unanticipated– fluctuations in the exchange rates.

Foreign currency exposure is equal to the variance between the functional (or measurement or domestic)
currency and the foreign currency.

Types of FX Exposure:

The term exposure refers to the extent to which a firm is affected by exchange rate changes. Exposure
determines the potential magnitude of the risks that accompany currency fluctuations. A distinction is
commonly drawn between accounting exposure, which refers to the changes in financial statements that occur
due to currency changes, and economic exposure, which refers to real economic changes. Accounting
exposure may or may not have economic consequences. Economic exposure, in turn, is commonly divided into
two categories:

Operating exposure is the economic exposure created when the operations of a firm generate foreign-
currency-denominated cash flows.

Transaction exposure is the economic exposure created when contractual obligations are denominated in
foreign currencies.

The primary difference between operating and transaction exposure is that with transaction exposure the
amount of the currency flows is known in advance. For this reason, the methods firms may use to manage
each type of exposure will differ.

The table below illustrates in a snapshot the different types of exposures across time and their implications:

Transaction or
Contractual Exposure

Outstanding obligations

Translation or Economic or Operating

Accounting Exposure Exposure

Accounting statements Future cash flows

Time
e Point in time when
Exchange Rate incident occurs
2. Translation Exposure
Translation or Accounting Exposure is the sensitivity of the real domestic currency value of Net Assets
(Assets minus Liabilities) appearing in the financial statements to unanticipated changes in exchange rates.
Thus, translation exposure affects the balance sheet and the income statement.

According to IAS 21, the results and financial position of an entity 1 are translated into a different
presentation currency using the following procedures:

i. Assets and liabilities for each balance sheet presented (including comparatives) are translated at
the closing rate at the date of that balance sheet. 2
ii. Income and expenses for each income statement (including comparatives) are translated at
exchange rates at the dates of the transactions; and
iii. All resulting exchange differences are recognized in other comprehensive income 3.

Item Rate How to present Differences

Assets (including goodwill)
Closing rate
and liabilities In Other Comprehensive income
Historical rate (OCI)
Income and expenses
(average) as a separate component of Equity
Share capital Not specified in IAS

Example 1.1
An entity commenced business on January 1, 2013, with an opening share capital of $2 million. The
income statement and closing balance sheet follow:

Income Statement for the year ended December 31, 2013 (in million USD)
Revenue 32
Cost of sales (10)
Gross profit 22
Distribution costs (8)
Administrative expenses (2)
Profit before tax 12
Tax expense (4)
Profit for period 8

1 Under the condition that the functional currency is not the currency of a hyperinflationary economy.
2
This would include any goodwill arising on the acquisition of a foreign operation and any fair value adjustments
to the carrying amounts of assets and liabilities arising on the acquisition of that foreign operation are treated as
part of the assets and liabilities of the foreign operation.
3
According to IAS 1, Other comprehensive income comprises items of income and expense (including
reclassification adjustments) that are not recognized in profit or loss as required or permitted by other IFRSs.
The components of other comprehensive income include:
a) changes in revaluation surplus (see IAS 16 Property, Plant and Equipment and IAS 38 Intangible Assets);
b) actuarial gains and losses on defined benefit plans recognized in accordance with paragraph 93A of IAS 19
Employee Benefits;
c) gains and losses arising from translating the financial statements of a foreign operation (see
IAS 21 The Effects of Changes in Foreign Exchange Rates);
d) gains and losses on re-measuring available-for-sale financial assets (see IAS 39 Financial Instruments:
Recognition and Measurement);
e) the effective portion of gains and losses on hedging instruments in a cash flow hedge (see IAS 39).
 Balance Sheet as of December 31, 2013 (in million USD)
Share capital 2
Retained earnings 8
Equity 10
Trade payables 4
Total equity and liabilities 14
Land (non-depreciable) acquired Dec 31, 2013 8
Inventories 4
Trade receivables 2
Total assets 14

 The functional currency is the dollar, but the entity wishes to present its financial statements
using the euro as its presentation currency.
 The entity translates the opening share capital at the closing rate.
 The exchange rates in the examined period were:

$1 =
January 1, 2013 €1
December 31, 2013 €2
Average rate €1.5

In order to translate the financial statements from the functional currency to the presentation one,
according to the procedures indicated earlier, we have:

Income Statement for the year ended December 31, 2013

Calculations
(in million EUR)
Revenue 48 =32 x 1.5
Cost of sales (15) =(10) x 1.5
Gross profit 33
Distribution costs (12) =(8) x 1.5
Administrative expenses (3) =(2) x 1.5
Profit before tax 18
Tax expense (6) =(4) x 1.5
Profit for period 12

Balance Sheet as of December 31, 2013 (in million EUR) Calculations

Share capital 4 =2 x 2
Retained earnings 12 from income
statement above
Translation gain (loss) 4 =16 – 12 (see
also
below)
Equity 20
Trade payables 8 =4 x 2
Total equity and liabilities 28

Land (non-depreciable) acquired Dec 31, 2013 16 =8 x 2

Inventories 8 =4x 2
Trade receivables 4 =2 x2
Total assets 28
Calculation of translation gain (loss): If translated into euros, the retained earnings would be €16 million
($8 million x 2 ⁄ ). As the income statement has been translated using the average rate, the profit is €12
million, creating a difference of €4 million. Note that this exchange difference is shown as component of
equity and is not recognized in profit or loss.

3. Transaction Exposure
Transaction exposure reflects the impact of settling outstanding obligations entered before into a change
in the exchange rate, but settled after the change. Exposure would include all payables and receivables
which appear on the balance sheet, as well as off-balance sheet items which represent commitments
already entered into, which will create future receivables and payables. Unlike translation gains (losses)
which require only a bookkeeping adjustment, transaction gains (losses) are realized as soon as the
exchange rate changes.

There are four main types of transactions from which contractual exposure arises:
 Borrowing or lending funds when repayment is to be made in a foreign currency.
 Purchasing or selling on credit goods or services when prices are stated in foreign currencies.
 Being a party to an unperformed foreign exchange forward contract.
 Otherwise acquiring assets or incurring liabilities denominated in foreign currencies.

According to IAS 21, a foreign currency transaction should be recorded initially at the rate of exchange at
the date of the transaction (use of averages is permitted if they are a reasonable approximation of actual).

At each subsequent balance sheet date:

 Foreign currency monetary4 amounts should be reported using the closing rate.
 Non-monetary5 items carried at historical cost should be reported using the exchange rate at the date
of the transaction.
 Non-monetary items carried at fair value should be reported at the rate that existed when the fair
values were determined.

Exchange differences arising when monetary items are settled or when monetary items are translated at
rates different from those at which were translated when initially recognized or in previous financial
statements, are reported in profit or loss in the period.

However, exchange differences arising on a monetary item that forms part of a reporting entity’s net
investment in a foreign operation shall be recognized in profit or loss in the separate financial statements of
the reporting entity or the individual financial statements of the foreign operation, as appropriate. In the
financial statements that include the foreign operation and the reporting entity (e.g. consolidated financial
statements when the foreign operation is a subsidiary), such exchange differences shall be recognized
initially in other comprehensive income and reclassified from equity to profit or loss on disposal of the net
investment.

When a gain or loss on a non-monetary item is recognized in other comprehensive income, any exchange
component of that gain or loss shall be recognized in other comprehensive income. Conversely, when a
gain or loss on a non-monetary item is recognized in profit or loss, any exchange component of that gain or
loss shall be recognized in profit or loss.

Other Standards require some gains and losses to be recognized in other comprehensive income. For
example, IAS 16 requires some gains and losses arising on a revaluation of property, plant and equipment

4 Monetary items are units of currency held and assets and liabilities to be received or paid in a fixed or
determinable number of units of currency. Examples of monetary items are: Trade receivables and payables;
Cash dividends recognized as a liability; Investments in debt securities; Deferred taxes; Pension and other
employee benefits to be paid in cash; Provisions that are to be settled in cash.
5
Non-monetary items are all items that are not monetary items, i.e. non-monetary items do not have the right
to receive or an obligation to deliver a fixed or determinable amount of units of currency. Examples of non-
monetary items are: Prepaid amounts for goods or services; Deferred income; Investments in equity
instruments; Inventories and other fixed assets; Goodwill, patents, trademarks and other intangible assets.
to be recognized in other comprehensive income. When such an asset is measured in a foreign currency,
IAS 21 requires the revalued amount to be translated using the rate at the date the value is determined,
resulting in an exchange difference that is also recognized in other comprehensive income.

Item Rate How to present Differences

Monetary items Closing rate In profit or loss
Non-monetary items with the exception of:
Historical rate
at historical cost Net investment in the foreign operation
Non-monetary items Rate at the date when fair value
P&L OCI
at fair value was measured

Example 2.1
ABC Corp. has its headquarters in USA and has a 100%-owned subsidiary in EU; ABC Europe. The
functional currency of the subsidiary is the euro and the currency of the parent is US dollars. In Y-E
2013, the subsidiary’s balance sheet was:

Balance Sheet as of December 31, 2013 (in €)

Cash 1,600,000 Accounts payable 800,000
Accounts receivable 3,200,000 S-T bank loan 1,600,000
Inventories 2,400,000 L-T debt 1,600,000
Net plant and equipment 4,800,000 Common stock 1,600,000
Retained earnings 6,200,000
Total 12,000,000 Total 12,000,000
Moreover, we have the following info:

 Inventories on hand were purchased during the immediately prior quarter when the average
exchange rate was €1= $1.218.
 Net plant and equipment were acquired at a past rate of €1= $1.276.
 The exchange rate was €1= $1.2 on December 31, 2013.

If the exchange rate drops by 16.67% to €1= $1, the gains (losses) will be:

In Euros Item Exchange rate ($/€) In US Dollars

Assets
Cash $1,600,000 Monetary 1.2000 $1,920,000
Accounts receivable 3,200,000 Monetary 1.2000 3,840,000
Non-
Inventories 2,400,000 1.2180 Not Exposed
monetary
Non-
Net plant and equipment 4,800,000 1.2760 Not Exposed
monetary
Total exposed assets (A) $5,760,000

Liabilities
Accounts payable $800,000 Monetary 1.2000 $960,000
S-T bank loan 1,600,000 Monetary 1.2000 1,920,000
L-T debt 1,600,000 Monetary 1.2000 1,920,000
Total exposed liabilities (L) $4,800,000

Net exposed assets (A) - (L) $960,000

(x) Amount of currency depreciation (from 1.2 $/€ to 1.0 $/€) -16.67%
Exchange gains (losses) -$160,000
The loss of $160,000 will be presented in the income statement affecting the net income.

Example 2.2 : Currency transaction that is settled during the same accounting period

XYZ Limited, whose functional currency is €, buys raw materials invoiced at $10,000 on January 1,
2013. This is a credit transaction. Exchange rate is: €1= $1.47.

XYZ Limited records this transaction as follows:

Dr. Purchases €6,803

Cr. Creditors €6,803

To record transaction for US $10,000 at exchange rate of €1 = $1.47.

Now suppose that the entity pays to the creditors $10,000 on March 1, 2013. Exchange rate is: € 1=
$1.52.

Dr. Creditors €6,803

Cr. Bank €6,579

Cr. Exchange gain €224

To record payment of US $10,000 at exchange rate €1 = $1.52.

Exchange gain/loss is credited/charged to profit or loss.

Example 2.3 : Mark to market valuation of outstanding monetary item on the reporting date

XYZ Limited, whose functional currency is €, buys raw materials invoiced at $10,000 on April 1, 2013.
This is a credit transaction. Exchange rate is: €1= $1.58.

XYZ Limited records this transaction as follows:

Dr. Purchases €6,329

Cr. Creditors €6,329

To record transaction for US $10,000 at exchange rate of €1 = $1.58.

Now suppose that the entity did not settle the creditors of $10,000 on June 30, 2013, which is the
second quarter reporting date. At June 30, 2013, the exchange rate is €1= $1.52.

XYZ Limited has to value the amount due to the creditors, which is a monetary item, by applying
the closing exchange rate of the reporting date.

Dr. Exchange fluctuation loss €250 (= €6,579 - €6,329)

Cr. Creditors €250

We derive the creditor new exposure at $10,000/1.52 = €6,579.

To record exchange rate fluctuation on June 30, 2013: ($10,000/1.58) = €6,329

Exchange fluctuation gain/loss is credited/charged to profit or loss.

Management of economic- transaction exposure
Transaction exposure is an economic exposure due to contractual obligations denominated in a
foreign currency. When the contract produces foreign currency inflow, the company is said to be long
in the currency. When the contract requires a foreign currency outflow, the company is said to be
short in the currency. Managing transaction exposure is the process of generating currency inflows
and outflows that moderate the long or short position a company faces in foreign currency. The term
hedging in this context typically refers to actions that eliminate the exposure entirely.

The simplest tools for hedging involve the use of forward markets and money markets. There are a
number of other mechanisms that vary in cost and effectiveness. One important point is that large
multinational firms may be in better positions to hedge against exposure and do so at a lower cost
since they have control over many cash flows denominated in many currencies.

4. Economic Exposure
Economic or Operating Exposure is the sensitivity of a company’s future cash flows, foreign
investments, and earnings to unanticipated changes in exchange rates and is long-term in nature.
Economic exposure encompasses the immediate and potential impact of unexpected exchange rates
changes on the cash flow generated and consequently, on the earning power of the company as a
whole beyond the accounting period when these changes occurred.

Operating exposure occurs as a result of foreign-currency-denominated operations. These operations

can take many forms and the consequences of such exposure are dramatic. A foreign operation that
is a complete subsidiary (manufacturing, purchasing, and selling in the foreign country) will create
exposure only for the amount of future profits. For a company that manufactures domestically but
sells overseas, the whole revenue stream is exposed. Conversely, for a company with foreign
production but domestic sales, the whole cost stream is exposed.

Interestingly, even a firm whose operations are entirely domestic will have operating exposure to the
extent that its domestic competitors have foreign-currency-denominated operations.

Economic Strategic Competitive

Exposure Exposure Exposure

In theory, economic exposure can arise only from unexpected changes in exchange rates. Expected
changes would be factored in by the financial markets and would be reflected in inflation and interest
rate differentials between the country of the parent company and the country of the affiliates in
accordance with the Purchasing Power Parity (PPP) and the International Fisher Effect. If financial
markets are not efficient to permit these adjustments to be made, the impact of expected exchange
rate changes would have been already reflected in the expected cash flows generated by the
affiliates and on the market value of the parent company.

Example 3.1

ABC Corp. has its headquarters in USA and has a 100%-owned subsidiary in EU; ABC Europe.
Economic risk arises from the unexpected change in the value of euro, which is the currency of
economic consequence for the European subsidiary. An unexpected depreciation or appreciation in
the value of the euro alters both the competitiveness of the subsidiary and the financial results which
are consolidated with the parent company.

For ABC Europe we have the following information:

 It uses European material and labor;

 All sales are invoiced in euros and the average collection period is 90 days;
 Inventory is equal to 25% of annual direct costs;
 Depreciation on plant and equipment is €600,000 per year.
 Plant and equipment, common stock and long-term debt were acquired at a past rate of €1=
$1,276;
 Corporate income tax is equal to 34%;
 ABC Europe can expand or contract production volume without any significant change in per-unit
direct costs or in overall general and administrative expenses;
 The cost of capital is 20%.

We assume that exchange rate was €1= $1.2 on December 31, 2013 and on January 1, 2014 it drops
to €1= $1.

Three cases are examined:

1. Case 1: no change in costs, prices, sales volume;

2. Case 2: increase in sales volume only;
3. Case 3: increase in sales price only.

Balance Sheet as of December 31, 2013 (in €)

Cash 1,600,000 Accounts payable 800,000
Accounts receivable 3,200,000 S-T bank loan 1,600,000
Inventories 2,400,000 L-T debt 1,600,000
Net plant and equipment 4,800,000 Common stock 1,600,000
Retained earnings 6,200,000
Total 12,000,000 Total 12,000,000

Assumptions Base case Case 1 Case 2 Case 3

Exchange rate, $/€ 1.20 1.00 1.00 1.00
Sales volume (units) 1,000,000 1,000,000 2,000,000 1,000,000
Sales price per unit € 12.80 € 12.80 € 12.80 € 15.36
Direct cost per unit € 9.60 € 9.60 € 9.60 € 9.60
Annual cash flows before adjustments
Sales revenue € 12,800,000 € 12,800,000 € 25,600,000 € 15,360,000
Direct cost of goods sold 9,600,000 9,600,000 19,200,000 9,600,000
Cash operating expenses (fixed) 890,000 890,000 890,000 890,000
Depreciation 600,000 600,000 600,000 600,000
Pretax profit 1,710,000 1,710,000 4,910,000 4,270,000
Income tax expense 581,400 581,400 1,669,400 1,451,800
Profit after tax 1,128,600 1,128,600 3,240,600 2,818,200
+ Depreciation 600,000 600,000 600,000 600,000
Cash flow from operations (in €) € 1,728,600 € 1,728,600 € 3,840,600 € 3,418,200
Cash flow from operations (in $) $2,074,320 $1,728,600 $3,840,600 $3,418,200
Adjustments to working capital for 2014 and 2018 caused by changes in conditions
Accounts receivable € 3,200,000 € 3,200,000 € 6,400,0006 € 3,840,0007
Inventory € 2,400,000 € 2,400,000 € 4,800,0006 € 2,400,0008
Total € 5,600,000 € 5,600,000 € 11,200,000 € 6,240,000

6 Double sales volume requires double investment in accounts receivable and in inventory.
7
The increase in sales price per unit leads to increased investment in accounts receivable.
8
The investment in inventory remains the same since annual direct costs do not change.
Change from base conditions in
2014 (€) – €0 € 5,600,000 € 640,000
Change from base conditions in
2014 ($) – $0 $5,600,000 $640,000
Year Year-End cash-flows
2014 $2,074,320 $1,728,600 -$1,759,4009 $2,778,20010
2015 $2,074,320 $1,728,600 $3,840,600 $3,418,200
2016 $2,074,320 $1,728,600 $3,840,600 $3,418,200
2017 $2,074,320 $1,728,600 $3,840,600 $3,418,200
11
2018 $2,074,320 $1,728,600 $9,440,600 $4,058,20011
Year Change in Year-End cash-flows from Base conditions

2014 – -$345,720 -$3,833,720 $703,880

2015 – -$345,720 $1,766,280 $1,343,880
2016 – -$345,720 $1,766,280 $1,343,880
2017 – -$345,720 $1,766,280 $1,343,880
2018 – -$345,720 $7,366,280 $1,983,880
Present Value of incremental Year-End cash-flows
– -$1,033,914.43 $2,866,106.15 $3,742,892.16

Management of economic- operating exposure

One can use forward markets and money markets to partially hedge operating exposure, but the cost of
this may be exorbitant. Most often, a company employs strategic decisions regarding revenues (pricing
and marketing) and costs (production and input decisions) to manage operating exposure. No method
can be completely effective, but the extent of operating exposure in many countries requires that all
possible actions be taken and that every alternative be explored, including:

Revenue management:
A company must often select the market to which it offers a product or service. This means a company
can choose a country or market segment within a country. Managing operating exposure can be
accomplished by careful market selection. For example, a company can export to a stable country or sell
to a market within a country that is not very price-sensitive. In the latter case, the company can pass on
any costs from price movements to its customers.

When currency movements occur that negatively impact a firm’s overseas sales, a company must
choose between a loss of market share (keep the domestic value of sales the same by raising the
foreign price) or loss of profit margin (keep the foreign price the same but lower the domestic value of
sales). This is a choice that has important long-run implications for future cash flows. Conversely, when
currencies move in the favor of an exporter, the exporter must choose between profit skimming (higher
domestic margins) or market penetration (lower foreign price). Promotional decisions should be made in
light of expected or realized currency movements and, therefore, can complement market share
decisions.

Finally, like choosing a country or market within a country, a firm may simply decide what products to
produce or sell in the first place and how many product lines to produce or sell within a given product
category.

9
Cash flow from operations – Change from base conditions = $3,840,000 – $5,600,000 = -$1,759,400.
10
Cash flow from operations – Change from base conditions = $3,418,200 – $640,000 = $2,778,200.
11
At the end of 2018, the cash outflows for working capital should be recaptured.
Cost management:
The major tools for managing costs in light of currency movements are to adjust input sources (a short-
term decision) and to decide on facility locations (a long-term decision).

Adjusting inputs is simply a matter of choosing to source inputs where they are cheaper. One can easily
trace the movement of companies from one country to another as they manufacture where labor is
relatively cheapest. The same logic applies to most inputs. Another possibility is to raise productivity
when difficulties arise. While it might seem that this should always be done, the decision can be
complicated. Increasing efficiency is costly. The cost may become small relative to the gains from
efficiency only when currencies move so as to create difficulties.

Locating plants, and making the related decision of selecting their number and size, should be done in
such a way that a firm can adjust to currency movements. Whereas a very large plant might be less
efficient, for example, smaller plants in a number of locations might allow better management of
currency exposure.

Financial management:
Financing costs are another input to the production decision over which a firm may have control. Thus, a
company may choose to finance its operations in the country it expects to generate revenues since the
inflows from sales can be used to pay the financing costs. Of course, financial cash flows are typically
contracted whereas operating cash flows may be highly variable. Furthermore, a firm may not always be
able to borrow in a local currency. Nevertheless, financial cash flows can certainly be used to some
extent to offset local currency exposure.

5. Concluding remarks
Accounting or Translation exposure reflects the changes in the dollar value of balance sheet items
resulting from fluctuations in the exchange rates of currencies.

Transaction exposure reflects the impact of settling all outstanding obligations (including off
balance-sheet receivables and payables) at a different exchange rate from the rate prevailing when
these obligations were made. The simplest tools for hedging involve the use of forward markets and
money markets.

Operating exposure is economic exposure that occurs because the firm has foreign currency-
denominated costs or revenues. In general, operating exposure does not include contracted cash
flows (transaction exposure). This makes management much more difficult since the amount of
future cash flows can only be approximated. Furthermore, these cash flows can include very long-
term cash flows for which the forward market may not exist and the money market may be very
costly (a schematic presentation of probable impact of depreciation of company’s local currency on
parent company’s cash flow is depicted at the end of the report). No method can be completely
effective, but the extent of operating exposure in many countries requires that all possible actions
be taken and that every alternative in terms of revenue, cost and financial management be
explored.
ANNEX: Schematic presentation of probable impact of depreciation of company’s local currency (Rubles) on parent company’s cash flow in US$

Likely Impact on
Parent Company's
Category
Cash Flow in U.S.
Dollars

Price and Volume

Increase (by less
Export Markets Increase
than depreciation
%)

Sales Revenue
Strong Import Price and Volume
Decrease Slightly
Competition Increase Slightly

Local Markets

Weak or No Import Price and Volume

Decrease
Competition Remain the Same

Low Import Increase

Decrease Slightly
Component Moderately

Production Costs Increase by

Percentage of
Low Substituality Decrease Sharply
Currency
Depreciation
High Import
Component
Increase
High Substituality Decrease Slightly
Moderately

Increase
Other Costs and Moderately
Working Capital (depending on % Decrease Slightly
Requirements increase in sales
and costs)

Decrease by
Precentage of
Depreciation Remain the same
Currency
Depreciation

Decrease by Less
Overall Cash Flow than Percentage of
Effect Currency
Depreciation
References:

Economic Exposure, Darden Business Publishing, University of Virginia, 2009

Various lecture notes on Global Corporate Finance, NYU Stern School of Business, 2012

Financial Management for the Multinational Firm, Fuad A. Abdullah, 1987

Interpretation and Application of International Financial Reporting Standards, Wiley, 2013

Multinational Business Finance, Eiteman, David K.; Stonehill, Arthur I.; Moffett, Michael H., Addison Wesley, 2009