FOREIGN CURRENCY RISK EVALUATION
With Firm XYZ’s proposed expansion into three new foreign markets there will be several problems that arise. A risk assessment will need to be completed and presented to the board. The following is a risk assessment, with relevant subsequent mitigation measures in the area of foreign currency.
Types of Risk
There are primarily three types of risk that the firm XYZ faces with the expansion abroad. These are the accounting exposure, transaction exposure and the operating exposure. Accounting exposure, is defined as the exposure that a company faces due to the reduction of its value; as a result of foreign exchange differences between the ...view middle of the document...
With this strategy, the gain that was realized with the devaluation of the liabilities, now offsets the loss in value of assets due to foreign exchange rate. As such, there is no loss of gain as far as the foreign exchange rate applies. The balance sheet hedging method is contingent on the costs of borrowing in the foreign country. The company can use forward foreign exchange contracts for balance sheet hedging. By using the contracts, the company is aided company in offsetting any future losses as a result of the change in foreign exchange rates.
Another method to mitigate exposure is contractual hedges. Commonly used for transaction exposure; contractual hedges work by allowing the company to enter into contract with the suppliers, for example, that all costs will be paid at a certain foreign exchange rate. Therefore, the company is shielded from any increase in costs that can be caused as a result of changes in the foreign exchange rate. Absent the contract, costs can rise continually due to the exchange rate.
Under these methods, one can use either the current-rate method or the temporal-rate method. The current-rate method is used when the reporting currency and functioning currency are different. It is preferred when the foreign subsidiaries are relatively autonomous. This does not require that the parent company keep managing their affairs. There are numerous advantages with this method. The main advantage is the removal of variability on net earnings as a result of accounting losses or gains. The other advantage is that the relative sections of balance sheet accounts do not change. Even with these, there is one primary disadvantage. This method uses historical costs, which violates the principle of accounting. In regards to XYZ, it has been determined that the subsidiaries are not autonomous. The exposure for the company is therefore elevated. In these circumstances, it has been proposed by scholars such as Hull (2012) that the temporal rate method be applied. Under the temporal rate method, the...