Foreign Currency Translation according to IAS 21 and IAS 39 in Consolidated Financial Statements considering intragroup Foreign Currency Hedging Strategies

Acknowledgements

I would like to acknowledge all those who helped make this paper a reality.

Prof. Dr. Dirk Hachmeister, who supervised my thesis. I am grateful for your

cooperation and continuing guidance.

Ernst & Young, Santiago de Chile, especially Mr. Marek Borowski, who supplied me with the information and documentation I needed. Without Marek’s help, it would have been impossible to develop the case study that forms part of this paper. Thanks for putting aside your busy schedule to answer all my questions.

Frauke May, who proofread this paper. I appreciate your help.

A personal note of gratitude goes to my parents. Thank you for having given me the opportunity to go to university and for your support on all levels along the way. This thesis is dedicated to you.

Ganz besonders danke ich meinen Eltern dafür, daß sie mir die Möglichkeit gegeben haben zu studieren und mich während meiner gesamten Studienzeit stets unterstützt haben. Ihnen ist diese Diplomarbeit gewidmet.

I

Table of Contents Page

  Acknowledgements  I

  Abbreviations  V

  List of Tables  VII

1  Introduction  1

2  Management of Foreign Currency Risks  5

2.1  Currency Exposures  5

2.1.1  General Remarks  5

2.1.2  Translation Exposure  6

2.1.3  Transaction Exposure  6

2.1.4  Economic Exposure  8

2.2  Instruments of Foreign Currency Risk Management  9

2.2.1  General Remarks  9

2.2.2  Managing Translation Exposure  10

2.2.3  Managing Transaction Exposure  13

2.2.4  Managing Economic Exposure  16

3  Foreign Currency Translation according to IAS 21 (revised 2004 )  19

3.1  General Remarks  19

3.2  The Concept of the Functional Currency  20

3.2.1  Background  20

3.2.2  Factors determining the Functional Currency  22

3.3  Translating Foreign Currency Transactions into the Functional Currency  25

3.3.1  Monetary Items  25

3.3.2  Non-Monetary Items  27

3.3.3  Net Investments in Foreign Operations  29

3.3.4  Recognition of Exchange Differences  32

3.3.5  Accounting for Hedges of a net Investment in a Foreign Operation  35

II

3.4  The Presentation Currency  38

3.4.1  Allowed Presentation Currencies  38

3.4.2  Translation from the Functional Currency into the Presentation  

  Currency  39

3.4.3  Translation of Foreign Operations  40

3.4.4  Recognition of Exchange Differences  43

3.4.4.1  Exchange Differences in Separate Financials Statements  43

3.4.4.2  Exchange Differences in Consolidated Financial  

  Statements using a Foreign Currency Hedge  46

3.4.4.3  Exchange Differences arising from Intragroup Monetary  

Items…………………………………………………………   51

4  Foreign Currency Hedge Accounting according to IAS 39 in multinational groups  53

4.1  Introducing Hedge Accounting under IFRS  53

4.1.1  Overview  53

4.1.2  Derivative Financial Instruments  54

4.1.3  Hedges for Foreign Currency Risk  55

4.1.4  Qualifying Instruments for Hedge Accounting  56

4.1.5  Effectiveness Criteria  57

4.1.6  Hedging of Net Positions  59

4.2  Accounting for Fair Value Hedges  61

4.3  Accounting for Cash Flow Hedges  64

4.4  Exposure Draft ED 7 “Cash Flow Hedge Accounting of Forecast Intragroup  

  Transactions  68

4.4.1  Planned Amendments of IAS 39 (revised 2003 )  68

4.4.2  Reasons for the planned Amendments of IAS 39  69

4.4.3  Review on the proposed Amendments  71

5  Summaries  72

III

Appendix A: Case Study: Intragroup Foreign Currency Hedging shown on the Example of the Consolidated Financial Statements of a Chilean Company……..…. A-1 A.1 Information for the Reader………………………………...…………………… A-1

A.2 The Company……………………...………………………………………...…. A-1

A.3 Significant Accounting Policies of the Company related to Hedge Accounting

A.4 Overview over Chilean Accounting Rule BT64………...................................... A-2 A.5 Hedging Strategies and Functional Currencies……………………..………….. A-3 A.6 Net Investment Hedges…………………………...………………...………….. A-4 A.7 Differences between Chilean GAAP and IFRS…………………...……...……. A-10 A.8 Disposal of a Subsidiary………………...…………………………...…………. A-13 A.9 Further Hedging Activities concerning Foreign Currency Risks…………......... A-14 A.10 Assets and Liabilities denominated in Foreign Currencies…...…………...….. A-16 A.11 Conclusion………………………………………………………………...…... A-22

Bibliography..…………………………………………………………………………....... VIII

IV

Abbreviations Abbreviation Meaning Explanation

Acc. Accumulated Arg$ Argentine Peso BB Der Betriebsberater German Professional Journal

BFuP Zeitschrift für betriebs-wirtschaftliche German Professional Journal

Forschung und Praxis

BT Buletin técnico Chilean Accounting Rule

Ch$ Chilean Peso Col$ Colombian Peso Cp. Compare DB Der Betrieb German Professional Journal Diss. Dissertation

DRS

Deutscher Rechnungslegungsstandard German Accounting Standard DStR Deutsches Steuerrecht German Professional Journal € Euro e.g. For example ED Exposure Draft Ed. Editor Eds Editors Etc. Et cetera Ex. Diff. Exchange Differences FAS Financial Accounting Standard GAAP Generally Accepted Accounting Principles HGB Handelsgesetzbuch German Commercial Code

IAS International Accounting Standard IASB International Accounting Standards Board

V

Abbreviation Meaning Explanation i.e. Id est; that is IFRS International Financial Reporting Standard IGC Implementation Guidance Commettee KoR Zeitschrift für kapitalmarkt-orientierte German Professional Journal

Rechnungslegung Mn. Maginal Number Pounds British Pound Sterling Reales Brasilean Reals S.A. Sociedad anónima Incorporated Company SEC US Securities and Exchange Commission Soles Peruvian Soles SFAS Statement of Financial Accounting Standard SIC Standard Interpretation Committee of the

IASB Sub. Subsidiary

SVS Superintendencia de Valores y Seguros ThCh$ Thousands of Chilean Peso UF Unidad de Fomento Chilean inflation-indexed, peso-

US United States US$ US-Dollar German Professional Journal

WPg Die Wirtschaftsprüfung ZfBF Zeitschrift für betriebs-wirtschaftliche German Professional Journal

Forschung

ZfgK Zeitschrift für das gesamte Kreditwesen German Professional Journal

VI

  List of Tables  

Table Title  Page  

  Balance sheet as of the 31 st December 2003 in US  44

Table 1   

  Balance sheet as of the 31 st December 2003 in euros  44

Table 2   

  Balance sheet as of the 31 st December 2004 in US  45

Table 3   

  Balance sheet as of the 31 st December 2004 in euros  45

Table 4   

  Consolidation bookings as of the 31 st of December 2003  47

Table 5   

  Consolidation bookings as of the 31 st of December 2004  50

Table 6   

Table 7  Investments in related companies A  5

Table 8  Exchange differences transferred to equity A  7

Table 9  Details for other reserves in shareholder’s equity A  7

Table 10  Detail for net cumulative foreign currency translation  

  adjustment A  8

Table 11  Equity changes due to foreign currency exchange differences  

  related to each Subsidiary A  9

Table 12  Detail of hedge ratios for net investment  

  hedges A  10

Table 13  Exchange Differences transferred to equity for individual and  

  consolidated level A  12

Table 14  Detail of forwards and swaps used for hedging A  14

Table 15  Detail adjustment related to derivative contracts A  15

Table 16a  Current Assets denominated in foreign currencies as of the  

31  st of December 2003 A  17

Table 16b  Current Assets denominated in foreign currencies as of the  

31  st of December 2003 , continued A  18

Table 17a  Current liabilities denominated in foreign currencies as of  

  the 31 st of December 2003 A  19

Table 17b  Current liabilities denominated in foreign currencies as of  

  the 31 st of December 2003 , continued A  20

Table 18  Long-term liabilities denominated in foreign currencies as of  

  the 31 st of December 2003 A  21

VII

1 Introduction

Globalization is not just a buzzword. It is reality. Big multinational companies as well as small and medium sized companies operate in many foreign markets by importing and exporting goods or by having production plants in countries other than the home country. Acquisitions or mergers of companies that are located in other countries are daily business and shareholders of companies are located all over the world. While companies’ activities are international, the currencies in which business contracts are contracted and settled are still a national affair. Hence, due to international activities, companies hold many items that are denominated in foreign currencies. 1

Fluctuating exchange rates may influence the companies economic situation, for example, provided that the order situation and the management are good, a company that pays two thirds of its bills in euros and generates two thirds of its revenues in US-dollars (US$) could, given constant exchanges rates, earn a profit. However, if the US$ becomes weaker against the euro during the fiscal year, the same company would possibly operate in the red, despite a good business situation. Thus, due to fluctuating exchange rates, companies face risks. These risks have to be systematized to be able to develop techniques, which can diminish risks arising from fluctuating exchange rates. To protect themselves against these kinds of risks or to limit them, companies have various possibilities; mainly these possibilities involve the use of financial instruments. Limitation or protection against risks arising from fluctuating exchange rates is known as foreign currency hedging.

Not any kind of hedging activity really limits risks. Depending on the kind of risk that shall be hedged, the respective hedging instruments and strategies have to be implemented. Fluctuating exchange rates result in several kinds of risks and thus, hedging foreign currency risks requires the use of several instruments and hedging strategies. Hence, the kinds of risks have to be identified before hedging strategies are developed. As this paper focuses accounting aspects of foreign currency translation and -hedging, hedging strategies are not discussed here. ² Some hedging strategies suggest or require the use of currency options as the hedging

¹ Cp. Arbeitskreis „Rechnungslegungsvorschriften der EG-Kommission“ (1993), P. 746; Lachnit/Ammann (1998), P. 751.

² For implementation of hedging strategies cp. Chang/Wong (2003), P. 555-574; Hautsch/Inkmann (2003), P. 173-198.

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instrument. The valuation of options requires comprehensive knowledge of capital market theory and option-pricing models. Hedges using options as the hedging instruments cannot be discussed here, as option pricing is not an accounting problem. 3

For financial reporting purposes, all these items have to be translated to a single currency, for example, the currency of a company’s home country. Various translation methods have been created in the last years, but the main question when doing so is which exchange rate shall be used for the translation process. ⁴ Items could be translated into another currency by using the exchange rate of the transaction date, by using the exchange rate of the reporting-day (e.g. the balance sheet day), by using average exchange rates or any other kind of exchange rates. This leads to the question, whether currency translation shall be a process of translating one currency into another, or if it also is a method to remesurement. To answer this question, it has to be found out, which economical effects (on cash flow, income, balance sheet etc.) items that are denominated in foreign currency have on the company.

When translating an item using different exchange rates, exchange differences arise. These exchange differences could be treated in different ways. They could either be recognized in the income statement, although gains or losses arising from items denominated in foreign currencies might not be realized yet, or exchange differences could initially be realized in equity and be transferred to profit or loss when they are realized. As well as in the case mentioned above, the economical effects have to be regarded to make sure, that exchange differences are treated in a way, which insures fair presentation and decision usefulness of financial statements. 5

Most groups include foreign subsidiaries in their financial statements. Thus, all financial statements have to be translated into one currency single currency in order to create consolidated financial statements, which contain useful information for the readers. Just if all of the group’s items that are included in the consolidated financial statement are presented in the same currency, items are

³ For option pricing and option pricing models cp., for example, Hiller (1996), P. 112-192; Linkwitz (1992), P. 80-120; Mehl (1991), P. 64-153; Lombard/Marteau (1990), P. 45-62.

⁴ An overview of translation methods is provided by Langenbucher (1998), Mn. 1028-1076; Busse von Colbe/Ordelheide (1993), P. 133-146; Wiley et. al. (2003), P. 830-832; Küting/Weber (2001), P. 154-176; Lachnit/Ammann (1998), P. 754-759.

⁵ Fair presentation is requiered by IAS 1.10.

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presented on a reasonable base (i.e. the same currency). Translating financial statements from one currency into another can result in profits or losses, which affect the group’s net income, or the groups equity may change, depending on the fact, how arising exchange differences are treated. The net income and/or the equity of a company are important values for the capital markets and influence the company’s market capitalization, the price it has to pay for loan capital etc. In order to make financial statements of companies comparable, the International Accounting Standards Board (IASB) issued International Accounting Standard (IAS) 21 “The Effects of Changes in Foreign Exchange Rates”, which provides accounting rules for the currency translation of business transactions denominated in foreign currencies and the translation of financial statements. As a company’s income might be affected by currency translation processes, income taxes are affected. As the recognition of exchange differences for the calculation of income tax might differ from the treatment required by accounting-standards, the recognition of deferred taxes might be necessary. ⁶ However, tax effects are not discussed in this paper because its focus is set on currency translation and hedge accounting.

In order to limit or even to eliminate the risks companies face due to fluctuating exchange rates they implement foreign currency hedges. In the majority of the cases, financial instruments are used as the hedging instruments. The accounting of financial instruments is a very complex topic, because their value may be influenced by various determinants and their “character” (i.e. whether they have to be regarded as an asset or a liability, or if they have to be recognized in the balance sheet at all) is not, in the majority of the cases, a trivial question. Furthermore, some financial instruments may, due to their leverage effect, dramatically effect a company’s financial and liquidity situation. The risks and awards of financial instruments have to be shown in the financial statements to make the reader able to judge the company’s (risk-) situation. The accounting of financial instruments in general and the accounting of hedging relationships is within the scope of IAS 39 “Financial Instruments: Recognition and Measurement”, which was issued to make sure that companies use the same accounting base for the accounting of financial instruments and for the accounting of hedging relationships. Specific accounting rules for hedge accounting have to

⁶ Cp. IAS 12 „Income Taxes“.

3

be established, because using hedges may request other accounting procedures to ensure fair presentation of the financial statements.

Especially multinational groups broadly use foreign currency hedging to limit or even to eliminate the currency risk they face in their consolidated financial statements. With a continually increasing international activity of most companies, questions of currency translation processes and hedging activities become more and more important.

In this paper, several possibilities of installing hedges and their accounting are demonstrated in examples. These examples are mainly easy-structured to make easy understanding possible and to show and to explain several effects isolated. A comprehensive real case study is also included in this thesis. In this case study, the before mentioned and explained hedging and accounting possibilities are shown on the real example of a big Chilean company. As not to impede the reading flow and in order to give the case study a compact format without needing theoretical explanations, this part is provided in appendix A.

4

2 Management of Foreign Currency Risks

2.1 Currency Exposures

2.1.1 General Remarks

Internationally operating companies face the risk of fluctuating exchange rates of foreign currencies. This risk is defined as the uncertainty of volatility of the economic value of a company, arising from economic and financial exposures ⁷ . However, a currency is not at risk because its devaluation is likely. The important point is that devaluations mostly are not certain. If they were certain, there would be no risk at all. 8

A company may, for example, sell products to a customer who is located in a different country or a company may purchase raw material or other types of equipment from suppliers located in a country outside the company’s local market. In addition, the company’s financial activities may result in a foreign currency risk when, for example, a company acquires loan capital in other countries or when a company grants credits to customers in other countries. As a matter of course, the risk just arises if the underlying contracts are denominated in a foreign currency, i.e. an importing company agrees that the supplier bills in his local currency and vice versa.

Hence, foreign currency risks affect most activities of a company that do not take place in the company’s local market. ⁹ The extend of foreign currency risk depends on many factors, such as rate of revenues realized in other countries, capital structure, origin of raw materials, the number of the groups’ entities operating in other countries etc. Thus, the extend of foreign risk will vary from company to company and also the items effected may vary. ¹⁰ The different items affected are known as exposures. To develop instruments for analyzing and managing the foreign currency risks, the exposures are divided into three groups: the translation exposure, the transaction exposure, and the economic exposure. ¹¹ However, it is important to mention, that the three groups overlap to some degree. ¹² Anyway, it

⁷ Cp. Hollem (2002), P. 112.

⁸ Cp. Adler/Dumas (1984), P. 42.

⁹ Cp. Mayrhofer (1992), P. 11.

¹⁰ Cp. Pausenberger/Glaum (1993), P.767.

¹¹ Cp. Franke (1989) , Mn. 2201-2005.

¹² Cp. Jones/Jones (1987), P. 10.

5

makes sense forming those groups to recognize where, and to which extend the exposures occur. Risks arising from exposures are mostly measured by models as the value-at-risk-concept. This model makes it possible to calculate the probability that a certain amount of loss is not exceeded. 13

2.1.2 Translation Exposure

Translation exposures arise from including entities in financial statements, which prepare their financial statements in a currency other than the currency of the reporting company. Hence, only multinational companies that prepare consolidated financial statements face translation exposures. ¹⁴ To include foreign entities in the financial statements of the reporting company, the financial statements of the foreign entities have to be currency translated, which may result in unrealized profits or losses recognized directly as profit or loss or in other comprehensive income. ¹⁵ As those unrealized profits and losses are just a result of the translation process when using closing-rates instead of rates of the transaction date, there is no influence of translation exposures to cash flows. 16

Furthermore, the concept of translation exposure is retro perspective and therefore does not support planning of risk reducing instruments for future cash flows. It has been argued that the translation exposure neither affects cash flows, nor supports the risk-reducing-planning processes and therefore it can be ignored for practical purposes. 17

2.1.3 Transaction Exposure

Transaction exposure always arises, when the date of conclusion of a contract and the future payment date are different and any payment fixed by the contract is denominated in a foreign currency. A company whose local currency is the euro, for example, sells a machine to a customer in the United States. The selling contract, denominated in a fixed US$ selling price is signed on 1 ^st of October with payment on 31 ^st of December.

¹³ Cp. Duhr/Wüstemann (2003), P. 2502.

¹⁴ Cp. Linares (1999),P. 48.

¹⁵ Cp. Chapter 3 of this paper.

¹⁶ Cp. Pausenberger/Glaum (1993), P. 769.

¹⁷ Cp. Buckley (1986), P. 132.

6

The European company faces the risk of fluctuating €-US$ exchange rates, because sales-revenues measured in euros change with fluctuating exchange rate, which means the future cash flow in euros is insecure. Transaction exposure not only arises from selling or buying processes, but also always arises whenever future cash flows appear in a foreign currency. ¹⁸ Therefore, loans and receivables denominated in a foreign currency also face transaction exposure.

Thus, whenever there is a time difference of contract date and payment date, and payments are settled in a foreign currency, transaction exposure occurs. In contrast to the translation exposure, future cash flows and profits and loses are directly affected. ¹⁹ Thus, transaction exposure is also known as cash flow exposure. 20

Apart from those committed exposures, transaction exposure is also made up by exposure arising from contingent businesses. ²¹ Assume that a European company calculates the price for a power plant, which will be build in the United States. The base for the calculation of the selling price (which the US customer will pay in US$) may be today’s exchange rate or an estimated exchange rate. Neither the exact price, nor the payment date are fixed yet and it is very likely that the exchange will differ from the exchange rate, which was the base for the price calculation. Thus, the arising exposure is known as contingent exposure. However, only regarding translation exposures and transaction exposures disregards other exposures that may occur in the future. The concept of transaction exposure only deals with foreign currency cash flows arising from already committed contracts or contracts that are likely to be committed in the near future, but transactions, that are neither committed yet, nor will be committed in the near future may also be influenced by currency risk. ²² Therefore, the concept of economic exposure has been developed.

¹⁸ Cp. Manichetti (1993), P. 65.

¹⁹ Cp. Pausenberger/Glaum (1993), P. 770.

²⁰ Cp. Shapiro (2003), P. 339.

²¹ Cp. Linares (1999), P. 58.

²² Cp. Pausenberger/Glaum (1993), P. 772.

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2.1.4 Economic Exposure

The market value of a company can be considered as the sum of discounted future free cash flows ²³ and - as mentioned above - foreign currency risks influence cash flows measured in the local currency. The concept of economic exposure deals with the influences of future changes on the market value of the company by considering changes in future cash flows, which arise from fluctuating exchange rates. Hence, the marked value of the company faces economic exposure. Unlike the concept of transaction exposure and translation exposure, the economic exposure regards current impacts as well as future impacts of exchange rate movements. 24

The market value of a company (measured in local currency) is not only influenced by the change of the exchange rates but also by the cash flow structures, which have an important influence. The exposure of a company that funds most parts of its cash flows in foreign currencies will be higher than the exposure of a company, which primarily funds its cash flows in the local currency. Furthermore, exposures depend on the number of different currencies, which form part of the cash flow.

As transaction exposure regards currency effects on cash flows, it could be considered to be subset of the economic exposure, ²⁵ though the effects of transaction exposures are insignificant compared to the effects of economic exposure, because of the unlimited lifetime of the company, which is assumed in this model. The concepts should be regarded separately, because they have conduct to different objectives. Whereas the transaction exposure deals with very detailed and short term facts, the economic exposure is used for less detailed issues, which make it necessary to use different instruments of risk analyzing and risk management.

Cash flows are made up by selling prices, selling quantities and costs and all of those determinants face foreign currency risk. For an exporting company, a devaluating foreign currency may not only lead to declining selling prices (measured in local currency) but also in declining selling quantities, because the relative prices have changed. ²⁶ Hence, economic exposure not just arises from the

²³ Cp. Hachmeister (2000), P. 3; Rappaport (1994), P. 54.

²⁴ Cp. Jones/Jones (1987), P. 13.

²⁵ Cp. Mayrhofer (1992), P. 18f.

²⁶ Cp. Allen (1997), P.20.

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direct effect of translating foreign currencies in local currency, but also from resulting competition effects. ²⁷ Thus, all companies face economic exposure, although they only fund cash flows in their local currency. Due to varying exchange rates, imported products become (relatively) cheaper which also threatens the company’s position in its local market. This may result in declining selling quantities accompanied by declining cash flows. When measuring the economic exposure, various determinants have to be identified, considered and assumed. ²⁸ Among these are, for example, the effects of fluctuating exchange rates on inflation, the company’s production costs, possibilities to alter sales prices, the impact on the volume due to price level adjustments, future exchange rates, acts of central banks to influence exchange rates etc. 29

The aim of the concept of economic exposure is identifying determinants, which affect the market value of a company. In theory, it is appropriate to be the base of all management decisions, because it considers influences to the main target, namely the market value of the company, i.e. its shareholder value. ³⁰ On the other hand, it can be questioned, if the concept is useful for practical purposes due to its complexity. If using it as a base for decisions, it has to be regarded that some determinants are estimated and others cannot even be considered because their estimation is impossible. Using this model may help recognizing risks and may provide guidance for avoiding them, but it does not show the total exposure the company faces, because a model including all determinants would be too complex to be handled.

2.2 Instruments of Foreign Currency Risk Management

2.2.1 General Remarks

As shown above, companies face risks arising from items denominated in foreign currencies. Reducing risks resulting from foreign currency items means reducing risks in general, which effect the income and/or liquidity situations. Therefore, companies should take a close look at their foreign currency risk management.

²⁷ Cp. Shapiro (2002), P. 205-208.

²⁸ Cp. Linares (1999), P. 50.

²⁹ Cp. Jones/Jones (1987), P. 14.

³⁰ Cp. Pausenberger/Glaum (1993), P. 774.

9

Shareholders are also interested in an efficient risk management, because - if done well - it adds value to the company. 31

Foreign currency exposures are managed by means of hedging, which means establishing a offsetting currency position, so as to lock in a value measured in the local currency for the currency exposure and thereby eliminating the risk posed by currency fluctuations. ³² Thus, risk management programs provide stability to earnings and budgets (measured in local currency) without additional risk. ³³ A variety of hedging instruments are available for managing exposures, but before they are used, companies have to decide, which kind of exposures shall be hedged and to which extend

To give guidance to employees who are responsible for currency hedging, companies shall formulate corporate objectives for currency hedges and provide guidance for resolving potential conflicts in objectives, as, for example, minimizing transaction exposure could increase translation exposure and vice versa. Furthermore, the objectives should be examined on their influence to shareholder value. 34

If those objectives and the guidance are not established accurately, hedging activities may lead to the obverse effect and lead to dramatic losses, as it has already happened to several companies. ³⁵ To avoid risks arising from hedging activities, exposures have to be identified and the related hedging strategy has to be established. For the above mentioned exposure concepts, various hedging strategies were developed and a short overview will be provided in the following chapters.

2.2.2 Managing Translation Exposure

Essentially, the target of managing activities dealing with translation risk is increasing hard currency assets and decreasing soft currency assets, and simultaneously, decreasing hard currency liabilities and increasing soft currency

³¹ Cp. Hagelin (2003), P. 55.

³² Cp. Shapiro (2003), P. 340.

³³ Cp. Hollem (2002), P. 113.

³⁴ Cp. Shapiro (2003), P.340.

³⁵ For example: Metallgesellschaft, Procter&Gamble, UBS, Barings. However, it has to be mentioned, that these companies held a vast amount of financial instruments not for hedging purposes but because they hoped for gains arising from trading activities involving financial instruments.

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liabilities ³⁶ . If the devaluation of a currency is likely, the basic hedging process will be as follows: delay accounts payable, convert foreign currency cash into local currency cash, change local currency borrowings to foreign currency borrowings etc. But those activities are not necessarily valuable, because the market may already have recognized the devaluation, and therefore the recognition is already reflected in the exchange rates and hedging costs. Only if the company’s anticipations differ from the market’s, hedging can lead to reduced translation exposures. Furthermore, the effects that the translation exposure has on transaction exposure shall be recognized to ensure an efficient hedging strategy. ³⁷ This is because the concept of translation exposures disregards influences on cash flows and may only result in unrealized profits and losses, whereas the concept of transaction exposure regards influences on cash flows and realized profits and losses. Hedging unrealized gains and losses does not make sense, if the influence of the hedging activities on realized gains and losses is disregarded, because that would mean that effects on the liquidity situations would not be regarded. The mentioned techniques can be accomplished by means of cash flow adjustment techniques, which means that effects of fluctuation exchange rates on cash flows are controlled by the company. In order to reduce translation exposure. This can be done by altering either the amounts of currencies of planned cash flow of the parent or its foreign operations. 38

If the local currency of the parent is about to devaluate, exports will be priced in foreign currencies, whereas (if possible and accepted by the supplier) imports will be priced in local currency. Cash denominated in local currency can be invested in securities denominated in foreign currencies and local accounts receivables can be sold against foreign currency (e.g. by using factoring). Multinational groups may move assets and liabilities denominated in local currency to foreign operations, transfer prices can be adjusted, payment of dividends can be accelerated etc.

By doing this, the translation exposure can be reduced, because the number of items (assets denominated in a devaluating currency) that face translation exposure was reduced. The following example illustrates the hedging effect of an intragroup transaction:

³⁶ Cp. Shapiro (2003), P. 349.

³⁷ Cp. Luz/Scharpf (2000), P. 118.

³⁸ Cp. Shapiro (2003), P. 350.

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A German parent company owns land in the United States that has been purchased on 2 ^nd of January 2003 for US$1,000,000 (payment in US$) at an exchange rate of €1.00=US$1.00, so that the book value in the parent’s financial statement is €1,000,000(=US$1,000,000). The land is necessary for the production process of the German parent’s subsidiary, which is located in the US. ³⁹ The company expects the US$ to devaluate, so on the same day, it sells the land for US$1,000,000 (payment in US$) to its subsidiary in the United States, to avoid translation exposure. Also on the same day, the parent company changes the received cash for the sale into euros and therefore receives €1,000,000 in cash (disregarding transaction costs).

The expected devaluation of the US$ has taken place, so that on the 31 ^st of December the exchange rate is US$1.00=€0.80.

If the transaction would not have taken place, the parent would have had to depreciate the land to an amount of €800,000 (=US$1,000,000 purchase costs multiplied by the exchange rate as of the 31 ^st of December 2003). By immediately selling the asset, which is denominated in a devaluating currency, the translation exposure has been eliminated, because foreign currency has been changed into local currency at the exchange rate of the day, when the initial transaction took place .

The example also illustrates that cash-flows are not influenced. Even if the transaction had not taken place and the value of the land had had to be depreciated, cash flows would not have changed. Just unrealized losses had had to be recognized. Hence, hedging strategies dealing with translation exposure, only regard accounting effects. However, it is rational to manage translation exposure, as they influence the reported income, which may influence bankruptcy and other costs such as taxes, credit costs etc.

To manage the influences of fluctuating exchange rates on cash flows, hedging instruments that deal with transaction risks have to be used.

³⁹ Therefore the land is classified as fixed asset. Furthermore it is assumed that the land cannot be sold to a third party. Due to tax-reasons, the US-subsidiary did not immediately buy the land itself.

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2.2.3 Managing Transaction Exposure

Generally, currency risks can be hedged by operative activities (such as transferring the creation of value to other countries, changing suppliers etc.), or financial activities (such as using financial instruments for hedging). ⁴⁰ The aim of hedging through operative activities is changing the structure of currency movements. Therefore, those activities can only be realized long term. ⁴¹ When currency movements are structural, the resulting exposures have to be regarded as economic exposure, because there are no committed items yet. The related instruments will be discussed in chapter 2.2.4.

Thus, there are no short term possibilities to hedge risks arising from transaction exposure by using operative activities. So if such hedge shall be installed, financial instruments have to be used. Financial instruments can only be used to reduce risks arising from items that face transaction exposure. For example, a forward contract locks in the exchange rate for any transaction denominated in a foreign currency anticipated on a specific future date, which eliminates risks arising from fluctuating exchange rates.

In general, transaction exposure can be eliminated by entering a foreign currency transaction whose cash flows exactly offset the cash flows of the transaction exposure. ⁴² Apart from forward contracts, this effect can be achieved by using price adjustment clauses in selling contracts, currency options, and borrowing and lending in the foreign currency.

Accordingly, all types of contracts could be committed in the company’s local currency, which will be difficult, as foreign suppliers and customers face currency risk themselves, and they may not be able or willing to do so. Trying to avoid transaction exposure by shifting it to suppliers or customers respectively is known as risk shifting. Transaction exposure does not disappear, it is just shifted to another party. If the customer agrees to paying in the supplier’s local currency, it is the customer who faces the currency risk, which makes risk shifting a zero-sum game. 43

Currency risks arising from payables that are denominated in foreign currencies can be eliminated by accelerating (leading) payments. ⁴⁴ But if a devaluation of the

⁴⁰ Cp. Duhr/Wüstemann (2003), P. 2502.

⁴¹ Cp. Blok/Ronner (2001), P. 24.

⁴² Cp. Shapiro (2003), P. 352.

⁴³ Cp. Shapiro (2002), P. 281.

⁴⁴ Cp. Pausenberger/Glaum (1993), P. 778.

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foreign currency is expected, it is better to delay payments to realize a gain arising from fluctuating exchange rates. Thus, this method should not be used without having estimated future exchange rates before. Hence, if a company assumes that a foreign currency will devaluate, it will delay (lag) the payment of a foreign currency denominated account payable. This method is known as leading and lagging. 45

As mentioned above ⁴⁶ those items, whose payment dates and amounts are fixed, face transaction exposure, so that it is possible to calculate the amounts of transaction exposures. Normally companies have both, exposures on asset items and exposures on liability items and by netting them, a net-exposure arises. ⁴⁷ A US company, for example, may have €1,000,000 liabilities, because it bought raw material from a French supplier and it may have €1,100,000 accounts receivables from selling products to German customers. Assuming that payments are due on the same (or almost the same) date, the company just faces a transaction exposure arising of the net exposure of €100,000. Just this amount faces currency risk. In general, exposure netting involves offsetting exposures in one currency with exposures in the same or a different currency, when exchange rates are expected to move in a way that losses (gains) on the first position, will be offset by gains (losses) on the second position.

Especially multinational groups with various foreign operations have many possibilities to net items that face transaction exposure. ⁴⁸ Foreign operations might hold assets and liabilities denominated in various currencies. It is more effective to centralize all risk management and to hedge activities related to transaction exposure in one company, which is part of the group (e.g. the parent). By doing this, more items could be used for the netting because the cumulated value of assets and liabilities denominated in foreign currency in the entire group is higher. If items that face transaction exposure are netted within the group, the remaining net exposure is smaller than the cumulative net exposures of all operations of the group as long as every single operation hedged its own remaining net-exposure itself. Thus, in most groups net exposures are not hedged in single operations but are centralized in the parent, which hedges net exposures

⁴⁵ Cp. Shapiro (2003), P. 689.

⁴⁶ Cp. Chapter 2.1.3

⁴⁷ Cp. Linares (1999), P. 49.

⁴⁸ Cp. Zimmermann (1992), P. 702.

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with instruments of external capital markets, which is considered to be the most efficient solution. ⁴⁹ Eliminating risks arising from fluctuating exchange rates is one aim of the so called cash management that almost all multinational groups have implemented in the last few years. 50

Another possibility to eliminate currency risks arising from accounts receivables, which are denominated in a foreign currency is entering a loan agreement in the same amount and with same payment date as the account receivable. Assuming a US company sells medical equipment to a French hospital (the French customer insists on payment in euros) for €1,000,000 with delivery on the 1 ^st of October and payment due on the 1 ^st of December. On the delivery date, the US company enters into a 1,000,000-loan denominated in euros, which is due on the 1 ^st of December and changes the so received euros amount into US$ on the 1 ^st of October.

On the 1 ^st of December, the US company pays the euro loan with the received euro-payment. Hence, the currency risks was eliminated, because entering the loan agreement has the same effect, as if the French customer paid immediately. Currency Options are a further possibility to reduce currency risk. ⁵¹ When a company uses currency options to hedge currency risks, it may realize gains on fluctuation exchange rates, without running the risk of losses. The disadvantage is, that a option premium has to be paid, which always results in fixed expenditures, whereas other kind of hedging strategies do not necessarily require the use of instruments, which only have to be acquired for the hedging purpose. As mentioned above, the concept of transaction exposure only reflects a part of the total exposure a company faces. Thus, instruments that are supposed to eliminate transaction exposure are not able to reduce, let alone eliminate the whole total exposure. To avoid long term exposure, a strategic management of exchange rates is necessary. ⁵² This involves hedging with operating activities i.e. hedging with instruments related to the reduction of economic exposure.

⁴⁹ Cp. Duhr/Wüstemann (2003), P. 2503; Blok/Ronner (2001), P. 26.

⁵⁰ Cp. Ammelung/Kaeser (2003), P. 655. For more details concerning cash management, cp. ebenda.

⁵¹ For further details see: Shapiro (2003), P. 273-293.

⁵² Cp. Pausenberger/Glaum (1993), P. 780.

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