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Real appreciation / depreciation of the Irish Punt, US Dollar, French Franc, Japanese Yen and Deutsche Mark The real exchange rate is the nominal exchange rate adjusted for changes in the relative purchasing power of each currency (Shapiro, 1999). This concept can be linked to the theory of Purchasing Power Parity (PPP), first introduced by Gustav Cassel in 1918 and defined as: e (home) /e (foreign) = p (home) /p (foreign) (formula 1) e = spot rate p = Inflation In absolute terms, it states that currencies should have the same purchasing power all over the world. Transportation costs, tariffs, quotas, restrictions and product differentiation are ignored though. The relative version of PPP states that the exchange rate between home and foreign currency will adjust to reflect changes in price levels of the two countries. So, if inflation in the US is 5 % and 3 % in the UK, then sterling must rise by 2 % in order to equality the dollar price of goods in the two countries. Vice versa, when calculating real appreciation or depreciation, it is necessary to adjust for inflation rates.
Therefore, real appreciation or depreciation of a currency is that adjusted for inflation and is calculated using the following formula: e (real) = e (nominal) [p (foreign) /p (home) ] (formula 2) Similarly, the real interest rate must be adjusted to reflect inflation. The real interest rate, according to the Fisher effect, measures the exchange rate between current and future purchasing power. Together with (expected) inflation, it represents the nominal rate. This can be approximated by the equation r = a + i, where r is the nominal rate, i is the rate of inflation, and a is the real rate of interest.
Based on these calculations, it clearly emerges that the US$ is overvalued by about 36 % since the exchange rate differential is greater than the relative inflation between the USA and Ireland. We can thus assume that if PPP holds, the controller has a convincing argument with regards to his fears of the US$ weakening against the punt. But it is widely accepted that PPP generally does not hold for major currencies bought for investment purposes such as the US$, and that if it does hold, it will only do so over the long term (Shapiro, 1999). Please see overleaf for calculations. 2. Universal Circuits currency exposure Should the controller be concerned about the dollars exchange rate? Due to the US$ being the Irish's subsidiary functional currency, the controller should be concerned about the Punt/$ exchange rate.
Although all the customers (independent sales representatives, US sales force and foreign sales affiliate) are billed in US$, with a direct effect to limit translation, transaction and economic exposure, the Irish subsidiary still incurs many Irish punt costs. Such costs are unmatched by any punt revenues and are thus subject to different types of exposures as it will be explained later. From the case (p. 255), we know that labour and locally sourced supplies account for 30 % of direct cost of sales and that operating and other expenses are incurred in effect exclusively in Irish punt. Putting these figures into context by using exhibit 5 (p. 261), it is possible to calculate that the costs incurred in Irish punt amount to 51. 4 % (i.
e. : 30 % of cost of sales = 14. 4 % + operating expenses of 34 % = 48. 4 % + other expenses of 3 % = 51. 4 %) of total costs. Thus if the uprising trend of the US$ reverses, the effect will be that more US$ will have to be purchased on the foreign exchange market by the Irish subsidiary in order to service its punt costs. The company therefore has a very large economic exposure (the change in the NPV of future cash flows of the firm as a result of unanticipated changes in real exchange rates) to the dollar that cannot be hedged using currency futures or Fra's because such instruments are not long-term enough. Alternatively dynamic hedging could be used to limit the adverse impact of economic exposure. The only feasible solution to limit economic exposure would be to match punt costs with punt revenues. As most of Universal Circuits costs are punt costs (i.
e. : wages and general expenses), the Irish subsidiary might see its total costs rise if the US$ weakens against the punt and other main European currencies. Every month, the subsidiary has to pay for wages, other general expenses and materials sourced from outside the US by buying punt, DM and FF for example. The danger here is that if between the time the company has incurred the costs and the time it has to pay for them, the US$ drops in value against any of these currencies then the bills will dramatically increase in US$ value (transaction exposure). What nature of currency exchange exposure does the Irish subsidiary face?
There are three types of currency exchange exposures: translation (or accounting) exposure, transaction exposure, and economic exposure. Translation exposure Translation exposure arises from the need to convert the financial statements of foreign operations from the local currencies involved to the home currency (Shapiro, 1999). Whenever the exchange rate changes, assets, liabilities, revenues, expenses, gains or losses have to be restated. For Universal Circuits Irish subsidiary, whose functional currency is the dollar and whose accounting standard is FASB No. 52, any changes of the Irish Punt will directly appear on the income statement as a gain or loss before interest and tax (the cumulative translation adjustment applies to the parent, not the foreign subsidiary), as the difference between translated net income before and retained earnings after currency gains.
Currency gains are likely to be high for the Irish subsidiary, but with foreign debt of $ 13. 7 (Yen, FF, DM) this is not evident on the financial statements. Transaction exposure Transaction exposure stems from the possibility of incurring future exchange gains or losses on transactions already entered into and denominated in a foreign currency (Shapiro, 1999). This applies, for instance, where the exchange rate changes between submitting an order and the actual settlement date. This exposure largely overlaps with translation exposure, although items such as inventories and fixed assets are excluded, while contracts for future sales or purchases are excluded in the translation exposure. In Universal Circuits case, transaction exposure is considered relatively low, with sales invoiced in dollars and average debtor days of 55 days. Economic exposure This exposure is by far the most serious of all currency exchange exposures because it is the most difficult to preview, estimate or remedy.
It consists of operating exposure the extent to which currency fluctuations can alter a companys future operating cash flows (Shapiro, 2000) and transaction exposure. In other words, economic exposure is the risk of a change in the value of a firm (measured by the present value of its expected cash flows) associated with a change in exchange rates. As the term suggests, economic exposure is linked to macroeconomic risks: a changing exchange rate often follows changes in interest rate and inflation (as suggested by the parity conditions). This risk also affects businesses solely operating in one country. In accounting terms, economic exposure cannot be minimised through retrospective accounting techniques because the real effect of currency changes is on a firms future cash flows. Research by Due (1978) suggests that firms try to counter currency devaluations by minimising balance-sheet exposure (e.
g. reducing working capital). This can however limit a firms ability to act or to take advantage of devaluations in other respects. Universal Circuits is evidently exposed to economic exposure.
Its (relative) prices will affect its competitive position across the world, and prices depend on costs, making flexibility in production (e. g. the possibility to shift production from one country to another), and the product composition in terms of input mix (imported vs. exported components) prevalent. Functional currency why the dollar and not the punt? In 1981, the Statement of Financial Accounting Standards No. 52 (FASB- 52) replaced the old FASB- 8.
The new standard also set rules as to how to treat foreign currencies: firms must use the current rate method to translate foreign-currency denominated assets and liabilities into dollars, which means all foreign currency revenues and expenses must be translated at the rate of the date incurred or at a weighted average exchange rate for the period. This has two advantages: one, translation gains and losses bypass the income statement, as they are listed on the balance sheet as cumulative translation adjustments. Second, there is a distinction between reporting currency and functional currency. Functional currency is the currency of the primary economic environment in which the affiliate generates and expends cash.
Generally, when the foreign affiliates operations are a direct and integral component or extension of the parent companys operations, the functional currency would be that of the parents home country (Shapiro, 1999). Since Universal Circuits operations are split between the US and Ireland (see organisation chart) and since these are directly linked, it is appropriate that the Irish subsidiary should have the dollar as functional currency. In addition, if all the bills and costs were made / incurred in punts, then the subsidiary would expose itself not only to a greater level of economic and transaction exposures, but also to greater translation exposure. That means that at the end of the accounting year when the subsidiary's profits are consolidated with its US parent, profits might appear much smaller in US$ terms if the US$ strengthened against the Irish punt. 3. Should the Punt be bought forward?
In the light of a possible weakening of the dollar, the Irish controller should have approval for buying the punt forward. Still, it is necessary to consider costs and alternatives. It should be examined prior to approval whether a money market hedge would be more favourable than a forward hedge or whether other hedging techniques such as the following funds adjustments should be applied: Increase levels of local currency cash and marketable securities Relax credit (reduce local currency receivables) Speed up collection of hard-currency receivables Reduce imports of hard-currency goods Reduce local borrowing Speed up payment of accounts payable Delay dividend and fee remittances to parent and other subsidiaries Delay payment of inter subsidiary accounts payable Speed up collection...
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