Chapter 11
Financial Risk Management
Discussion Questions
1. Enterprise risk management assesses individual risks in the context of a firm’s business strategy. Risks
are viewed from a portfolio perspective with risks of various business functions, e.g., FX risk, interest rate risk, political risk and the like, being coordinated by a senior financial manager responsible for keeping top management apprised of critical risks that could interfere with the accomplishment of a firm’s
strategic objectives and devising risk optimization strategies. The variables that management accountants must track include factors both external and internal to the firm and varies from company to company.
2. Market risk refers to the risk of loss due to unexpected changes in the prices of currencies, interest rates,
commodities, and equities. It is not confined to price changes. Market risk also includes liquidity risk, market discontinuities, credit risk, regulatory risk, tax risk, and accounting risk. An example of a foreign exchange risk is a situation where an exporter invoices a credit sale to a foreign importer in foreign currency and foreign currency devalues prior to payment.
3. An FX risk management program includes the following processes:
a. Forecasting the expected movement in the relation between the yuan and your domestic
currency.
b. Measuring on a periodic basis your firm’s exposure to fluctuations in the value of the yuan. c. Designing protection strategies that will minimize losses should the yuan revalue.
d. Establishing internal controls to measure your performance in hedging the risk of loss from
changes in the value of the yuan.
4. Translation exposure measures the impact of exchange rate changes on the domestic currency equivalents
of a firm s foreign currency assets and liabilities. It is primarily concerned with currency restatement. Transaction exposure measures the cash flow impact of fluctuating currency values on the settlement of commercial transactions denominated in foreign currencies. Transaction exposure is concerned with a currency conversion (exchange) process. Economic exposure attempts to measure the impact of changing exchange rates on the future revenues, costs, and sales volume of a multinational entity. It is concerned with the temporal effects of exchange rate changes.
Although FAS No. 52 attempts to mitigate concern with translation gains and losses (accounting exposure), it does not totally eliminate it. Companies choosing the U.S. dollar as their functional currency will still use the temporal translation method and report translation gains and losses in period income. Companies designating the local currency as the functional currency will find their asset exposures increased as inventories and fixed assets are translated using current exchange rates. While such translation gains and losses bypass income, the adverse effects of currency fluctuations on a company’s consolidated equity will still exist. This is especially likely where loan covenant and other contractual provisions specify minimum debt-to-equity ratios. This suggests that the issue of accounting versus economic exposure is far from settled.
5. The chapter lists 10 specific methods to reduce a firm’s exposure to foreign exchange risk in a
devaluation-prone country. These techniques, and possible cost-benefit trade-offs, are summarized in the following table.
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Trade-Offs
a. Reduced exposure versus higher business and
financial risk due to possible \
b. Remitting excess cash back b. Same as item a.to the parent company. c. Accelerate the collection c. Reduced exposure versus of local currency receivables possible reduction in sales d. Defer payment of local d. Reduced exposure versus currency payables impaired local credit rating e. Speed up payment of e. Reduced exposure versus foreign currency payables foregone earnings on a
relatively cheap credit source
f. Invest local currency cash f. Reduced exposure versus balances in inventories and higher transaction costs other assets less prone to and possible mis- devaluation loss allocation of corporate
resources
g. Invest in strong currency g. Reduced exposure versus foreign assets higher transaction costs
and possible government interference (e.g. exchange controls)
h. Raise selling prices h. Reduced exposure versus
potential erosion of
market share i. Invoice exports in hard i. Reduced exposure versus currencies possible reduction in
sales abroad
j. Currency swaps j. Reduced translation exposure versus increased
transaction exposure if parent assesses the exposed affiliate an
interest charge in hard
currency
6. A multicurrency transactions exposure report differs from a multicurrency translation exposure report in a
number of ways. First, the transactions exposure report has a cash flow orientation instead of a static balance sheet orientation. It includes off balance sheet items that are executory in nature. Finally, a multicurrency transaction exposure report has a local currency orientation, whereas a multicurrency translation exposure report has a parent currency orientation. 7. Derivative instruments are formal agreements that transfer financial risk from one party to another. The
value of a derivative is derived from its reference to a basic underlying instrument or variable such as a foreign currency receivable or a quantum of foreign exchange. Thus the value of a forward exchange contract is related to the change in the foreign exchange rate times the notional amount being hedged. An important accounting issue is whether derivatives should receive the same accounting treatment as the basic instruments to which they relate. Specifically, should a derivative instrument hedging a foreign currency asset appear in the financial statements as a foreign currency liability? If so, should its valuation base be identical to basic instruments? Do cash flows associated with derivative instruments have the
Methods
a. Minimize cash balances in devaluation-prone country
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same economic meaning as those associated with basic instruments? How should gains and losses associated with derivative instruments be reflected in the income statement? Can and should risks attaching to these financial instruments be recognized and measured?
8. Student responses should proceed along the following lines. Pele Corporation, a Brazilian firm, has
borrowed a certain sum of British pounds at 9 percent and is worried that the pound will appreciate relative to the real prior to maturity. To hedge this currency risk, it arranges with a bank to swap the pounds borrowed for an equivalent amount of reals for 3 years bearing the same rate of interest. During the 3-year period, it will make periodic interest payments to the bank in reals, and in return, receive periodic interest payments in pounds. At the end of the 3-year period, it will re-exchange the real principal for pounds at the original exchange rate.
9. A futures contract is a commitment to purchase or deliver a specified quantity of a financial instrument or
foreign currency at a future date at a price set when the contract is made. It differs from a forward contract in several respects. A futures contract is standardized in terms of size and delivery date whereas a forward contract is tailored to a customer’s needs. Futures contracts are freely traded on organized exchanges. In contrast, there is no secondary market for forward contracts as they are private agreements between two parties. Futures contracts are carried at market values with gains or losses taken immediately to income, whereas profits on a forward contract are realized only at the delivery date. Finally, a party to a futures contract must meet periodic margin requirements. In a forward contract, margins are set once, on the date of the initial transaction.
10. Fair value hedges are hedges of a firm’s foreign currency assets and liabilities and firm foreign currency
commitments. Cash flow hedges are hedges of forecasted transactions such as a future sale or purchase. Net investment hedges are hedges of an exposed balance sheet asset or liability position. For qualifying fair value hedges, all changes in the fair value of the derivative and the underlying item that is being hedged are recognized in earnings. For qualifying cash flow hedges, the change in the fair value of the derivative is recognized in Other Comprehensive Income and recognized in earnings when the hedged cash flows affect earnings. For qualifying hedges of a net investment, changes in the fair value of the derivative are recorded in comprehensive income
11. In theory, the term highly effective means that gains or losses on hedging instruments should be should
exactly offset gains or losses on the item being hedged. In practice, it means that gains or losses on the derivative substantially offset the changes in the value or cash flow of the hedged item. Measurement of this attribute is important. If a hedging instrument does not meet the highly effective test, the hedge is terminated and deferred gains or losses on the derivative are recognized immediately in current earnings. This, in turn, introduces volatility into a firm’s reported earnings.
12. The notion of an opportunity cost refers to the return associated with your next best opportunity. In the
area of FX risk management, it entails comparing a given risk management strategy with an appropriate standard of comparison. This provides an objective means of assessing the effectiveness of a given risk reduction program. For example, when FX risk management programs are centralized at corporate headquarters, appropriate benchmarks against which to compare the success of corporate risk protection would be programs that local managers could have implemented on their own. Exercises
1. Students usually gloss over diagrams without thinking them through. This exercise forces them to think
through each step of the diagram and allows them to better internalize the risk management cycle. Responses might follow the following pattern: Step 1 involves operationalizing a firms strategies into
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quantifiable objectives and then identifying developments both external and internal risks that could affect the achievement of these objectives. These risks are measured by the firm’s accountants and quantified in terms of their potential impact on the firm. For example, the firm may have as its strategic objective an increase of 5% of market share in a given country per year given assumptions about the rate of economic growth in that country. The chance that this growth rate may fall short of 5% and the impact of this shortfall for projected sales in that country would be quantified. Response formulation would involve identifying protection strategies to minimize the hit to sales of projected GNP shortfalls such as promotion campaigns to maintain sales or use of alternative sourcing venues to lower sales prices. This strategy would be implemented if projected GNP started to slow beyond a certain cutoff point. The impact of this protection strategy would then be quantified in terms of actual sales relative to forecast sales taking into account the costs of protection. The information contained in risk management performance reports would then be communicated to top management who would be in a position to reaffirm or alter strategic objectives and/or risk identification processes.
2. Foreign exchange risk a devaluation of the foreign currency in which an account receivable was
denominated would cause the domestic currency cash flows to decrease. This would cause current assets to decrease. Alternatively, a revaluation of the foreign currency would cause the account receivable and current assets to increase. Interest rate risk an increase in market rates of interest would cause the price of a short-term fixed-rate debt instrument being held as a marketable security to decrease. This, in turn, would cause current assets to decrease. A decrease in interest rates would have the opposite effect.
Commodity price risk an increase in the price of copper would cause the cost of copper purchases and the resultant unexpired cost of inventories in the current asset section of the balance sheet to increase. A fall in copper prices would have the opposite effect. Equity price risk a fall in stock prices would depress the carrying value of marketable securities (current assets), and conversely.
3. The purpose of this exercise is to force students to look at managerial accounting issues from the user’s
perspective. Students may suggest additional information sources with respect to inflation differentials, balance of trade and balance of payments statistics, international monetary reserves, forward exchange quotations, the behavior of related currencies, and interest rate differentials. We recommend that this exercise be assigned to small groups to encourage teamwork. At the time this exercise was prepared, professional forecasters were predicting a rate of 10.5 ecrus to theU.S. dollar.
Some groups may contend that exchange markets are efficient and that exchange rate changes are simply random events. Again, they must be prepared to convince management of their case, or at a minimum, identify the consequences of not attempting exchange rate forecasts.
4. Current rate Current/Noncurrent Monetary/nonmonetary
Exposed assets(PHP): Cash 500,000 500,000 500,000 Accounts receivable 1,000,000 1,000,000 1,000,000 Inventories(LCM) 900,000 900,000 Fixed assets 1,100,000 -- -- Total 3,500,000 2,400,000 1,500,000
Exposed liabilities: Short-term payables 400,000 400,000 400,000 Long-term debt 800,000 --- 800,000 Total 1,200,000 400,000 1,200,000
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Positive/(negative) exposure 2,300,000 2,000,000 300,000
Positive exposure X $0.03 $69,000 $60,000 $9,000 Positive exposure X $0.02 46,000 40,000 6,000 FX gain/(loss) $(23,000) $(20,000) $(3,000) 5.
Exposed Assets:
Cash & due from banks Loans Fixed assets
Exposed Liabilities: Deposits Owners equity Net exposed assets (liabilities)
Exposed Assets:
Cash & due from banks Loans Fixed assets
Exposed Liabilities: Deposits Owners equity Net exposed assets (liabilities) 6.
Cash & due from banks Loans Fixed assets Deposits
Owners equity
ILS
100,000 200,000 ---- 40,000 ---- 260,000 ILS
100,000 200,000 ---- 40,000 ---- 260,000
ILS
100,000 200,000 ---- 40,000 ----
$
￡
$ Equivalent 50,000 (40,000) 20,000
---- ---- 100,000 30,000 ----
30,000
---- 15,000 50,000
100,000 ---- 100,000 (20,000) (55,000) NIL $
￡
$ Equivalent 50,000 (40,000) 20,000 ---- ---- 100,000 30,000 ---- 30,000 ---- 15,000 50,000 100,000 ---- 100,000 (20,000)
(55,000)
NIL
Trial Balance Before
$ ￡
$ Equivalent
50,000 (40,000) 20,000 ---- ---- 100,000 30,000 ---- 30,000
----
15,000 50,000 100,000
----
100,000
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国际会计第七版英文版课后答案（第十一章）
