A review of foreign exchange translation exposure and related economic implications
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School of Business | Master's thesis
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AbstractI examine the foreign currency translation exposure and its economic implications. I do this by reviewing the relevant literature on translation exposure and by including an empirical part of my own. I contribute to the extant literature by conducting an empirical study related to translation exposure, using data from Finnish stock-listed firms. The thesis is written as a commissioned work for a case company. In the thesis I show that despite the traditional recommendation of not to hedge translation exposure, many firms still do so. This is explained mainly by market imperfections and by the adverse effect that translation exposure can have on a company's leverage ratios. At the present levels neither the case company's debt-to-equity ratio nor its risk tolerance assigned to translation exposure are being endangered due to the existing exposure. I discuss the special aspects of hedging for translation exposure and notice the challenges that are related to the time horizon and liquidity effects of hedging it. I reflect on the economic implications of translation exposure and show that the IFRS rules for translating foreign subsidiaries' financial statements do not take into account real changes in exchange rates perfectly. After that, I discuss the differences of translation effect and foreign economic effect, and argue that the two exposures actually have opposing effects under certain conditions. At the end of the thesis I review the extant empirical literature on the value-relevance of translation exposure. The literature generally recognizes a positive association between translation adjustments and changes in firm value, implying that translation effect dominates foreign economic effect. In line with this, I find a positive association using data from Finnish stock-listed firms. I conclude that this is in major part explained by two facts. First, a positive coefficient for translation effect implies improved export-competitiveness for Finnish firms, and second, the sample consists of firms from varying industries. I would like to extend my special thanks to Jyrki Tammivuori and Petteri Kärnä for the important and generous help they provided me with during the process of writing the thesis.
translation exposure, economic exposure, foreign exchange risk, hedging, currency, FX