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McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 14-* Translation Exposure versus Transaction Exposure Translation Exposure The effect that unanticipated changes in exchange rates has on the firm’s consolidated financial statements. An accounting issue. Transaction Exposure The effect that unanticipated changes in exchange rates has on the firm’s cash flows. A finance issue and the subject of Chapter 13. It is generally not possible to eliminate both translation exposure and transaction exposure. McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 14-* Hedging Translation Exposure If the managers of the firm wish to manage their accounting numbers as well as their business, they have two methods for dealing with translation exposure. Balance Sheet Hedge Derivatives Hedge McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 14-* Balance Sheet Hedge Eliminates the mismatch between net assets and net liabilities denominated in the same currency. May create transaction exposure, however. McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 14-* Derivatives Hedge An example would be the use of forward contracts with a maturity of the reporting period to attempt to manage the accounting numbers. Using a derivatives hedge to control translation exposure really involves speculation about foreign exchange rate changes, however. McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 14-* Translation Exposure versus Operating Exposure The effect that unanticipated changes in exchange rates has on the firm’s ongoing operations. Operating exposure is a substantive issue with which the manageme