Corporate Foreign Exchange Risk Management

Chapter 4Balance Sheet Exposure to FX

Net income, the focus of the previous chapter, is perhaps the most widely communicated performance metric of them all. It is not surprising that managers try to limit the impact of various external factors, such as exchange rates, on this bottom line. Accounting standards, however, have it such that only some translation GLs are to be reported in net income, namely those relating to monetary ALs. But this does not mean that the translation GLs excluded from net income – relating to non‐monetary ALs – are of no importance. They have the potential to affect shareholders' equity and any financial ratio based on it in a major way. This chapter is about mapping out and better understanding these effects.

A real‐world episode can illustrate how the translation of non‐monetary ALs can take the company's leadership by surprise. The executives and directors of the company in question were pleased to announce the firm's largest profits ever. Much to their surprise, however, equity did not increase in that year despite profits running in the billions. The explanation was a translation loss on non‐monetary assets that cancelled out the positive effect that net income had on equity. Management had not anticipated this, nor could they easily see how it came about. The mechanisms were poorly understood.

Sometimes this kind of translation GL can have real consequences. As discussed in Chapter 1, a case can be made for avoiding financial ratios reaching ...