Page 61 - FINAL CFA II SLIDES JUNE 2019 DAY 5.2

READING 16: MULTINATIONAL OPERATIONS

Exposure to Changing Exchange Rates
Under the current rate method, exposure is defined as the net asset position of MODULE 16.4: CURRENT RATE METHOD
the subsidiary (net asset position is when assets exceed liabilities).

As under the current rate method, all of the assets and liabilities are translated at the current rate, it is the net assets, that is, the
subsidiary’s equity, that are exposed to changing exchange rates. So, if the subsidiary has a net asset exposure and the local currency is
appreciating, a gain is recognized. Conversely, a net asset exposure in a depreciating environment will result in a loss.

NOTE:

Most firms can’t survive very long when their liabilities exceed their assets.

Under the temporal method, as the nonmonetary assets and liabilities are remeasured at historical rates, only the monetary assets and
liabilities are exposed to changing exchange rates. Therefore, under the this method, exposure is defined as the subsidiary’s net monetary
asset or net monetary liability position. A firm has net monetary assets if its monetary assets exceed its monetary liabilities. If the monetary
liabilities exceed the monetary assets, the firm has a net monetary liability exposure.

Since very few assets are considered to be monetary (mainly cash and receivables), most firms have net monetary liability exposures. If the
parent has a net monetary liability exposure when the foreign currency is appreciating, the result is a loss. Conversely, a net monetary
liability exposure coupled with a depreciating currency will result in a gain.

Under the temporal method, firms can eliminate their exposure to changing exchange rates by balancing monetary assets and monetary
liabilities. When balanced, no gain or loss is recognized. For example, imagine that a U.S. multinational firm has a net monetary liability
exposure of €1 million. In this case, a loss will occur if the euro appreciates relative to the dollar. To eliminate the exposure, the firm could
sell euro denominated nonmonetary assets, such as fixed assets or inventory, and use the proceeds to reduce the monetary liabilities.
Eliminating exposure under the current rate method is more difficult because it is necessary to balance total assets and total liabilities.
Balancing assets and liabilities would eliminate shareholders’ equity.