Money, Banking, and International Finance

rates to calculate a company’s financial statements. Company must consider the accounting
rules among different countries, and how cash flows will impact a company’s financial
statements.
Tax exposure is fluctuations in currency exchange rates affect a company's cash flow, and
hence its taxable income. Thus, losses from transaction exposure can reduce taxable income,
whereas losses from economic exposure reduce taxable income over future years. On the other
hand, translation exposures are not related to cash flows and do not reduce taxable income.
Thus, companies could gain profit from favorable changes in the exchange rates.

Measuring and Protecting against Transaction Exposure

We can identify and measure transaction exposure. Firms sell products or purchase
resources by entering contracts. Firms can even buy and sell contracts on the derivatives markets
to hedge against price uncertainty. If firms do not have contracts, then they must forecast future
spot prices, and spot prices can fluctuate wildly.
For example, Swiss Cruises sold cruise packages to a U.S. wholesaler for $2.5 million U.S.
dollars and bought fuel oil for $1.5 million in U.S. dollars. Both transactions will occur in 30
days, giving a predictable cash flow. If today's spot exchange rate is 1.45 Swiss francs equal $1,
then we calculated the profit, 1.45 million francs by using Equation 1.

$2,500, 000 $1,500, 000 =1,450, 000 francs

$ 1

1.45franc

profit=  (1)

However, the transaction occurs in 30 days, and the spot exchange rate can fluctuate.
Consequently, Swiss Cruises profits in francs will fluctuate along with the exchange rate. A
large company would employ a specialist who predicts and forecasts prices and exchange rates.
In Swiss Cruises' case, the specialist has determined the franc-U.S. dollar exchange rate
fluctuates ±10%. Thus, the net transaction exposure could fluctuate between 1 , 305 , 000 and
1 , 595 , 000 francs, which we calculate by multiplying the profit by 1 ±0.10, or by 0.9 for the
lower number and 1.1 for the upper number. In this case, Swiss Cruises has a favorable
transaction exposure because revenues in dollars always exceed the costs in dollars.
A company can use strategies to protect its revenues and expenses in a foreign country. For
example, a U.S. company, Trident, sold equipment to a British company for 3 million pounds
due in 90 days as an accounts receivable. Although Trident sold the equipment, it must wait 90
days for its revenue, and anything could happen within 90 days. An analyst at Trident views
four strategies to reduce any losses from this international transaction. Strategies are:

1. Spot exchange rate equals $1.762 per 1 pound, and the company will use the spot exchange
   rate in 90 days.


2. Trident Company can use a derivatives contract. Trident can buy a 90 - day forward contract
   with an exchange rate of $1.785 / 1 pound from a large bank.