Chapter 3Net Income Exposure to FX

In most of the preceding chapter we took the view of an exporting firm with its cost base in its home currency. This structure gives the most straightforward of FX exposures: foreign‐denominated cash flows that need to be converted to home currency. As firms grow and become larger, however, the issue of international expansion tends to come up on the agenda at some point. This can be achieved by setting up selling and/or production units in another country. It can also be done through acquisitions. Perhaps acquiring the foreign firm is considered a more efficient way to expand compared to gradually building up a presence in that market through organic expansion.

Regardless of the form it takes, the creation of foreign subsidiaries leads to the next step in FX exposure management. We are now talking about a consolidated group with at least one foreign subsidiary, which changes the rules of the game quite substantially. Why? Because foreign subsidiaries are legal entities often denominated in a currency different from the one the firm uses to prepare its consolidated accounts. This gives rise to translation effects, as the exchange rates needed to translate the subsidiaries' accounts into home currency fluctuate between different balance sheet dates. There may also be translation effects on assets and liabilities that the parent company holds in its own books, for example, if it issues debt in foreign currency.

Firms often take these translation ...

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