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Thursday, 18th April 2024
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Hedging translation exposure management Back  
Des Leavy and Jayne Bull debate whether translation exposures are relevant from a risk management perspective. This article focuses not on hedging foreign exchange exposures on transactions but on the more difficult topic of translation exposure management arising from accounting conventions - both on the balance sheet and in the profit and loss account.
Translation exposures arise from accounting conventions rather than cash movements and can be subdivided into those arising in the balance sheet and those arising in the profit and loss account. A company must have either assets, liabilities or a trading branch or subsidiary in a foreign currency for it to be affected by translation exposures. If a company’s base currency strengthens against other currencies in which it has assets or trading profits, then the base currency equivalent of those assets or profits is diminished. Changes in the value of overseas assets are generally reflected in an adjustment to the bank debt figure on the consolidated balance sheet.

There is a great deal of debate about whether translation exposure is relevant from a risk management perspective. Those who consider it doesn’t matter would argue the effect is simply on book values and not on cash flow. On the other hand those who consider it does matter highlight the effect it can have on debt and reserves, and thus on gearing and, in turn, on compliance with covenants. It is however, worth noting two important points about translation exposure:
• They arise solely from the accounting consolidation process and do not involve any cash flows
• Managing them will change the company’s cash flow
In considering whether and / or how to manage them companies ask themselves the same question as in any other business decision: what are the objectives? The following, highlights some of the common issues that companies face when they go through this process, and they would fall into one of two categories; those that would hedge and those that wouldn’t.

To Hedge…
• A company that is predominantly domestic, but with a small overseas operation may conclude that currency exposure in the earnings and / or the net assets of the business should be eliminated as far as possible
• The net asset value is an accounting entry that should be hedged
• In the event of a continuing trend in exchange rates in one direction, an extreme translation hedging policy of either zero hedging or 100 per cent hedging could benefit one group of Shareholders in favour of another
• Protection against currency devaluation
• To ensure that profits are not rendered unpredictable
• Minimisation of year to year fluctuations

Or not to Hedge…
• A company that has a major overseas subsidiary or is geographically diverse may take the view that shareholders want the geographic and currency exposure and as such it would be wrong to hedge it away
• The balance sheet value of an asset is questionable. The value may be based on historical costs and may have been affected by factors such as revaluations, provisions, goodwill accounting and so on
• Where the hedge takes on the form of a liability created to match the asset in the same currency, this can lead to a change in the reported cash position. i.e. there is a reduction in the real cash position to hedge an exposure that does not result in a cash outflow
• Hedging would limit bank facilities
• Hedging would increase treasury administration
Whether or not a company chooses to hedge it’s translation exposure or not, it should do so on the basis of clear policy objectives. Those companies that hedge do so with close consideration of a number of key factors such as:
• Size of exposure
• Stability of the currencies
• Ability to forecast
• Treasury management expertise
• Access to hedging instruments
• Shareholders
There is a wider choice of products now available to companies that wish to hedge translation exposure and these are currently being used successfully in a global market context. In this constantly changing market place, and with volatility as prevalent as it was pre-Euro, Irish companies might find the greater choice beneficial to their businesses.

Shareholder Value
Shareholder value should be considered when treating translation exposure.
• Portfolio diversity could be altered - shareholders who deliberately invest in companies to expose themselves to a range of currencies to spread their risk.
• In the event of a continuing trend in exchange rates in one direction an extreme translation hedging policy (from no hedge to 100 per cent hedged) could benefit one group of Shareholders in favour of another.
For the reasons suggested above it is not unusual for a company that is considering a major translation hedge that would have a significant impact on shareholder value to consult its main institutional shareholders before putting a hedge in place.

This article was compiled by Jayne Bull and Des Leavy of Ulster Bank Financial Services. Jayne Bull is head of business development and Des Leavy is associate director of corporate services.

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