Chapter 6Hedging Foreign Subsidiaries

A group will often carry out activities through foreign operations. Foreign operations are those entities in a group's financial statements incorporated by consolidation, or the equity method, for which their functional currency is different from the currency in which the group's financial statements are reported (the presentation currency). A foreign operation's results and financial position are translated into the group's presentation currency, creating a foreign exchange exposure called translation exposure. For example, the revaluation differences resulting from the translation of net assets of a foreign operation into a group's presentation currency are included in the translation differences (or exchange differences) account, a component of consolidated shareholders' equity.

Many companies consider that the foreign exchange risk arising from foreign operations is only a translation risk – merely an accounting issue – with no impact on cash flows, and as a consequence there is no need to hedge it. This stance is flawed, especially in today's dynamic and competitive environment, as companies frequently buy and sell foreign operations. Disregarding translation exposures as “accounting exposures” and focusing solely on cash flows or transaction exposures could be risky. For example, adverse translation movements may result in a significant decrease of total consolidated equity and, in turn, a higher debt-to-equity ratio that could trigger ...

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