Chapter 15 • International aspects of business finance
be commercially unsound. For example, it is not always easy to trade in the particular
countries of the business’s choice; businesses often have to make sales where they can.
Another aspect will be picked up later in this chapter.Currency swaps
A problem of borrowing funds in a foreign country is that exchange rate fluctuations
can alter the sterling cost of servicing and repaying the debt. Currency swapscan
overcome this problem. Here, two borrowers based in different countries, each having
a similar-sized debt in the other one’s currency, agree to swap the cash flow obliga-
tions of their debts. So a UK business may agree to take over paying interest and
repaying the principal on a foreign one’s debt in sterling. In exchange, the foreign
business takes over the obligations regarding the UK business’s debt in the foreign
one’s home currency.
The Ricci and Di Nino (2000) survey shows currency swaps to be a popular means
of handling economic risk, being used by 81 per cent of respondents, at least to some
extent.First Choice Holidays plcis an example of a business that has particular transaction
and economic foreign exchange risk exposure. This is because, in the main, the busi-
ness sells holidays to its customers in one currency (sterling), but incurs most of its
direct costs of those holidays in foreign currencies. In its 2006 annual report the
business said: ‘Currency exchange risk, which arises principally from the mismatch
between the Group’s UK businesses’ sterling revenue streams and foreign currency
operating costs, is managed by the use of foreign exchange forward, swap and option
contracts.’Translation risk
The problem
The last element of exchange rate risk is translation risk. This is associated with the
fact that a business that has assets in a foreign country whose currency weakens
against the business’s home currency suffers a reduction in its wealth, as measured in
the home currency. This is not the same as either transaction or economic risk, where
the risk is concerned with cash flows. There is not necessarily any reason why cash
needs to flow from the foreign operation to the home country. The business may well
be able to use funds generated from trading to make local acquisitions (that is, in the
foreign country) to expand the foreign operation.
Translation risk tends to give particular concern because, under the accounting
rules that apply throughout much of the world, the performance and position of all
of the business’s operations, including foreign ones, have to be incorporated in its
income statement and balance sheet, respectively. In the case of foreign operations,
this requires translating figures expressed in foreign currencies into the home one.
If the foreign currency is weak relative to the home one, both profit figures and
asset values will be below what would have been the case had the foreign currency
been stronger.
It is a matter of some debate as to whether translation risk has any economic impact.
If a business has assets in a foreign country whose exchange rate has weakened
against its home currency, in terms of the home currency those assets are worth less‘
‘