Chapter 11Financial Risk ManagementDiscussion Questions1.Enterprise risk management assesses individual risks in the context of a firm’s business strategy. Risksare 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’sstrategic 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 domesticcurrency.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 fromchanges in the value of the yuan.4.Translation exposure measures the impact of exchange rate changes on the domestic currency equivalentsof 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 acurrency 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 adevaluation-prone country. These techniques, and possible cost-benefit trade-offs, are summarized in the following table.Methods Trade-Offsa. Minimize cash balances in a. Reduced exposure versusdevaluation-prone country higher business andfinancial risk due to possible "cash-outs."b. Remitting excess cash back b. Same as item a.to the parent company.c. Accelerate the collection c. Reduced exposure versusof local currency receivables possible reduction in salesd. Defer payment of local d. Reduced exposure versuscurrency payables impaired local credit ratinge. Speed up payment of e. Reduced exposure versusforeign currency payables foregone earnings on arelatively cheap creditsourcef. Invest local currency cash f. Reduced exposure versusbalances in inventories and higher transaction costsother assets less prone to and possible mis-devaluation loss allocation of corporateresourcesg. Invest in strong currency g. Reduced exposure versusforeign assets higher transaction costsand possible governmentinterference (e.g.exchange controls)h. Raise selling prices h. Reduced exposure versuspotential erosion ofmarket sharei. Invoice exports in hard i. Reduced exposure versuscurrencies possible reduction insales abroadj. Currency swaps j. Reduced translationexposure versus increasedtransaction exposure ifparent assesses theexposed affiliate aninterest charge in hardcurrency6. A multicurrency transactions exposure report differs from a multicurrency translation exposure report in anumber 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. Thevalue 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 thesame 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, hasborrowed 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 orforeign 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 fore ign currencycommitments. 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 income11.In theory, the term highly effective means that gains or losses on hedging instruments should be shouldexactly 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 reporte d earnings.12.The notion of an opportunity cost refers to the return associated with your next best opportunity. In thearea 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.Exercises1.Students usually gloss over diagrams without thinking them through. This exercise forces them to thinkthrough 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 intoquantifiable 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 wasdenominated 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 ofa 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 manager ial accounting issues from the user’sperspective. 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/nonmonetaryExposed assets(PHP):Cash 500,000 500,000 500,000Accounts receivable 1,000,000 1,000,000 1,000,000 Inventories(LCM) 900,000 900,000Fixed assets 1,100,000 -- --Total 3,500,000 2,400,000 1,500,000 Exposed liabilities:Short-term payables 400,000 400,000 400,000Long-term debt 800,000 --- 800,000Total 1,200,000 400,000 1,200,000Positive/(negative) exposure 2,300,000 2,000,000 300,000 Positive exposure X $0.03 $69,000 $60,000 $9,000Positive exposure X $0.02 46,000 40,000 6,000 FX gain/(loss) $(23,000) $(20,000) $(3,000)5.ILS $ £$ EquivalentExposed Assets:Cash & due from banks 100,000 50,000 (40,000) 20,000Loans 200,000 ---- ---- 100,000Fixed assets ---- 30,000 ---- 30,000Exposed Liabilities:Deposits 40,000 ---- 15,000 50,000Owners equity ---- 100,000 ---- 100,000Net exposed assets 260,000 (20,000) (55,000) NIL(liabilities)ILS $ £$ EquivalentExposed Assets:Cash & due from banks 100,000 50,000 (40,000) 20,000Loans 200,000 ---- ---- 100,000Fixed assets ---- 30,000 ---- 30,000Exposed Liabilities:Deposits 40,000 ---- 15,000 50,000Owners equity ---- 100,000 ---- 100,000Net exposed assets 260,000 (20,000) (55,000) NIL(liabilities)6.Trial Balance BeforeILS $ £$ EquivalentCash & due from banks 100,000 50,000 (40,000) 20,000Loans 200,000 ---- ---- 100,000Fixed assets ---- 30,000 ---- 30,000Deposits 40,000 ---- 15,000 50,000 Owners equity ---- 100,000 ---- 100,000Trial Balance After(£/$/ILS = 1/2/8)ILS $ £$ EquivalentCash & due from banks 100,000 50,000 (40,000) (5,000)Loans 200,000 ---- ---- 50,000Fixed assets ---- 30,000 ---- 30,000Deposits 40,000 ---- 15,000 40,000 Owners equity ---- 100,000 ---- 100,000Translation loss $(65,000)7. One recommendation might be to reduce positive exposures by engaging in balance sheet hedging, that is, by remitting excess cash back to the corporate parent, reducing the affiliate bank’s outstanding loans, or increasing its deposits in Israeli shekels.. The trade-offs here are potentially negative effects on operations, such as not satisfying loan demand against hedging translation gains and losses. Another option is to increase the pricing of bank services in Israel to provide a profit margin that can offset any FX losses. Again, the effects of such actions on competitive positioning could far exceed the benefits of hedging. A third option is to buy a forward or currency swap to hedge the exposure. Trade-offs include the out-of-pocket cost of the exchange contract versus the reported losses avoided.1.If the U.S. dollar is the functional currency, the translation gain upon consolidation is aggregated with thetransaction loss on the foreign currency borrowing and disclosed as one line item in the consolidated income statement. This figure is determined as follows:Translation gain = Positive exposure X change in exchange rate= NZD3,000,000 x $.10= $300,000Transaction loss =NZD loan balance X change in exchange rate= NZD1,000,000 x $.10= $ (100,000)Aggregate exchange adjustment = $300,000 + $ (100,000)= $200,000If the New Zealand dollar is the functional currency, the translation gain upon consolidation bypasses income and appears as a separate component in consolidated equity. It is offset by the translation loss on the New Zealand dollar borrowing.9.4/1 CD (¥32,500,000 ÷ ¥120) $250,000Cash $250,000(Purchase of CD)Chips (¥32,500,000 ÷ ¥120) $270,833Cash (¥3,250,000 ÷ ¥120) $ 27,083A/P (¥29,250,000 ÷ ¥120) 243,750(To record credit purchase)7/1 CD (¥30,000,000 ÷ [¥120 - ¥110]) $ 22,727FX gain $ 22,727(To record gain on CD investment)Purchases (¥29,250,000 ÷ [¥120 - ¥110]) 22,159Accts. Payable 22,159(To record increase in purchases and related liability accounts owing to yen appreciation) 7/1 Cash (¥30,000,000 ÷ ¥110) $278,182Interest income (¥30,000,000 X .08 X ¼) ÷ ¥110] $ 5,455CD 272,727(To record maturation of CD)Interest expense [(¥29,250,000 x.08 x 3/12) ÷ ¥110) 5,318Accts. payable (¥29,250,000 ÷ ¥110) 265,909Cash 271,227(To record settlement of purchase transaction)10. Journal entries:6/1 CHF Contract receivable $133,333Deferred premium 3,334$ Contract payable $136,667(To record contract with the foreign currency dealer to exchange $136,667 for CHF 166,667)6/30 CHF Contract receivable 1,667Transaction gain 1,667(To record transaction gain from increased dollar equivalent of forward contract receivable; $.81 - $.80 x SWF 166,667)6/30 Premium expense 1,111Deferred premium 1,111(To amortize deferred premium for 1 month)9/1 SWCHF Contract receivable 3,333Transaction gain 3,333(To record additional transaction gain by adjusting forward contract to the new current rate; $.83 - $.81 x CHF 166,667)9/1 Premium expense 2,223Deferred premium 2,223(Amortization of deferred premium balance)9/1 $ Contract payable 136,667Cash 136,667 Foreign currency 138,333CHF Contract receivable 138,333(To record delivery of $136,667 to foreign currency dealer in exchange for CHF166,667 with a dollar equivalent of $138,334 (=CHF166,667 x $.83). The Swiss francs will, in turn be used to pay for the chocolate supplies).11. Calculations:If the premium on the forward contract is considered an operating expense, and the conditions for hedge treatment are met, i.e., management designates the forward contract as a hedge, documents its risk management objective and strategy, identifies the hedging instrument, the item being hedged and the risk exposure, and that the forward is effective both prospectively and retrospectively in hedging the risk, the gain on the forward can be offset against the loss on the payable as follows:Amount paid to settle the account payable on the purchase $138,333Less Transaction gain on forward contract (5,000)Cost of purchase $133,333The $133,000 is what was originally anticipated, CHF166.667 X $0.80 = $133,333.12. Journal entries:The call option is intended to hedge an uncertain cash flow. Accordingly, gains or losses on the hedging instrument would bedisclosed in comprehensive income and reclassified into earnings in the period the sale actually takes place.June 1 Premium expense $28,125Cash $28,125($.018 X CHF 62,500 X 25)August 31 Cash $40,625Comprehensive income $40,625[($.416 - $.39) X CHF 62,500 X 25]Case 11-1Exposure Identification1. Infosys appears to have several exposures as enumerated below.Foreign Exchange RiskPage Value-Drivers88 Revenues/Selling and administrative expenses89 Cash flows from interest/dividend income96 Revenue recognition/LT leases97 Operating income/foreign currency transactions/FA98 Marketing/Overseas staff expenses99 Derivative values100 Lease obligations101 Investment returns102 Segment revenues/expenses103 Dividends to ADS holders142 Penalties on export obligations149 Valuing intangibles150 Export revenuesCommodity Price RiskPage Value-Drivers98 Power and fuel expenses145 Brand valuation147/48 Current cost disclosures149 Value of intangiblesEquity Price RiskPage Value Drivers87 Share capital98 Diluted eps100 Stock option compensation expense103 Convertible preferreds145 Cost of capital151 Economic value-addedInterest Rate RiskPage Value Drivers88 Interest expense89 Cash flows from security investments/interest income97 Gratuity/Superannuation/Provident obligations143 Employee compensation145 Cost of capital149 Value of intangibles.151 Economic value-addedInformation on the company’s risk management policies are contained on pages 108-109 of their annual report which were not reproduced in Chapter 1. We include the relevant information here. Infosys derives its revenues from 51 countries of which 78 percent were denominated in US dollars. To minimize both transaction and translation risk the company:1.Tries to match expenses in local currency with receipts in the same currency.es forward exchange contracts to cover apportion of outstanding receivables.3.Denominates contracts in non-US and non-EU regions in internationally tradable currencies to minimizeexposures to local currencies that may have non-tradability risks.Case 11-2Value At Risk: What Are Our Options?Students should be asked to play the role of the consultant, and will find it to be a contentious issue. Suggested remedies that have merit are:1. The FASB should permit deferral accounting for rolling options which would take the derivative gain or loss on each option to equity until the anticipated event occurs, as opposed to taking it immediately to income. This, however, might encourage companies to game the system, so students should also suggest ways to keep this from happening.2. Another tack would be to adhere to generally accepted accounting principles and record the gain or loss on the derivative in current income as it is marked to market, but to disclose which transactions were undertaken for hedge purposes. Management could also game the system here as speculative activities could be disclosed as hedge activities.3. Another option that students might suggest is to revert back to the earlier U.S. practice of keeping the option off balance sheet and providing supplementary disclosure of mark-to-market accounting. This might be confusing to lay readers, but it would enable analysts to better understand the components of reported earnings.It is clear from the annual report clipping that management will ignore accounting pronouncements when it is in their interest to do so. Analysts must be alert to situations where management departs from GAAP to better reflect the economics of what transpired as opposed to doing so to manage earnings.精品文档，知识共享！！！。
