Entity Level - Currency Exchange Risk

Question 1

Currency Exchange Risk

Answer 1

Entities that engage in international economic activity face this; 3 types

Transaction risk - Possible unfavorable impact of transactions, denominated in foreign currency, based on changes in currency exchange rate (receivables or payables in foreign currency)

• Can mitigate by using same currency; leading/lagging payments and collections; hedging - using offsetting/contra transactions to offset gain on one and loss on other

Translation risk - Possible unfavorable

• Occurs when domestic entity has foreign operation that prepares its financials in foreign currency.

Some accounts are translated using current (spot) exchange rate

-Can mitigate by reducing assets and liabilities converted using spot exchange rate; create offsetting assets and liabilities so gain if offset on loss; borrow in foreign currency in amount approximating net assets so gain/loss offset

Economic risk - Possibility that exchange rate may alter FUTURE

• Can mitigate by shifting sources of revenues and expenses to different places with different currencies

Question 2

Foreign currency hedging

Answer 2

Hedging accomplished through forward contracts;

Forward exchange contract is a contract to buy or sell a specified amount of foreign currency at a specified future date at a specified (forward) rate. TRANSACTION MUST OCCUR

Foreign currency option contract - a contract that gives the right the option to buy or sell a specified amount of a foreign currency for a specified Tim at a specified rate. UP TO OPTION HOLDER

Question 3

Transfer Price

Answer 3

Amount at which goods and services exchanged between affiliated entities; by manipulating transfer prices firms can manipulate taxes (therefore profits)

Question 4

Factors affecting Transfer Pricing

Answer 4

1) Management’s objective in setting transfer prices

2) Legal requirements governing transfer prices between countries

Question 5

Determining transfer price

Answer 5

1) cost based - Transfer price a function of the cost to the selling unit to produce a good or provide a service
2) market - Transfer price is based on the price of the good or service in the market
3) negotiated - Negotiated agreement between buying and selling

In addition to its role in determining the total profit of firms with multinational operations, transfer pricing also affects the profit reported by the individual affiliated units. Because unit profit is typically used to evaluate the unit’s management, individual unit managers may prefer a transfer price that is different from the price that maximizes total profit to the consolidated entities. Therefore, the transfer pricing methodology used by multinational firms is important, not only to profit determination, but also to performance throughout the multinational entity.