Badly need help in explaining this topic about MANAGING TRANSLATION EXPOSURE. It would be much appreciated if the explanation is as simple as possible. ESPECIALLY THE EXAMPLES PROVIDED BELOW.

MANAGING TRANSLATION EXPOSURE

Translation exposure occurs when an MNC translates each subsidiary’s financial data to its home currency for consolidated financial statements. Even if translation exposure does not affect cash flows, it is a concern of many MNCs because it can reduce an MNC’s consolidated earnings and thereby cause a decline in its stock price. Thus, some MNCs may consider hedging their translation exposure.

Use of Forward Contracts to Hedge Translation Exposure

MNCs can use forward contracts or futures contracts to hedge translation exposure. Specifically, they can sell the currency forward that their foreign subsidiaries receive as earnings. In this way, they create a cash outflow in the currency to offset the earnings received in that currency.

Limitations of Hedging Translation Exposure

1. Inaccurate Earnings Forecasts - A subsidiary’s forecasted earnings for the end of the year are not guaranteed. In the previous example involving Columbus, Inc., British earnings were projected to be £20 million. If the actual earnings turned out to be much higher, and if the pound weakens during the year, the translation loss would likely exceed the gain generated from the forward contract strategy.

2. Inadequate Forward Contracts for Some Currencies - A second limitation is that forward contracts are not available for all currencies. Thus, an MNC with subsidiaries in some smaller countries may not be able to obtain forward contracts for the currencies of concern.

3. Accounting Distortions - A third limitation is that the forward rate gain or loss reflects the difference between the forward rate and the future spot rate, whereas the translation gain or loss is caused by the change in the average exchange rate over the period in which the earnings are generated. In addition, the translation losses are not tax deductible, whereas gains on forward contracts used to hedge translation exposure are taxed.

4. Increased Transaction Exposure - The fourth and most critical limitation with a hedging strategy such as using a forward contract on translation exposure is that the MNC may be increasing its transaction exposure. For example, consider a situation in which the subsidiary’s currency appreciates during the fiscal year, resulting in a translation gain. If the MNC enacts a hedge strategy at the start of the fiscal year, this strategy will generate a transaction loss that will somewhat offset the translation gain.

Some MNCs may not be comfortable with this offsetting effect. The translation gain is simply a paper gain; that is, the reported dollar value of earnings is higher due to the subsidiary currency’s appreciation. If the subsidiary reinvests the earnings, however, the parent does not receive any more income due to this appreciation. The MNC parent’s net cash flow is not affected. Conversely, the loss resulting from a hedge strategy is a real loss; that is, the net cash flow to the parent will be reduced due to this loss. Thus, in this situation, the MNC reduces its translation exposure at the expense of increasing its transaction exposure.

Answer rating: 100% (QA)

Managing translation exposure is a concern for many multinational corporations MNCs This is because ... View the full answer