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Exposures Hedged

We already outlined in section III.A that the prime area of derivatives usage is FX management for both US and German firms. An important question to be considered is how companies define exposure. It is common in the international finance literature to distinguish between translation exposure, transaction exposure, and economic exposure.

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Translation exposure results from translating local currency denominated financial statements of foreign subsidiaries to the currency to be used for group financial statements. The exposure depends on the translation method to be used. For US firms, Statement of Financial Accounting Standard No. 52 suggests the use of the current rate method for self-contained foreign subsidiaries and the use of the temporal method for integrated foreign subsidiaries and for subsidiaries in high inflationary countries. The exposure under the current rate method is given by the net equity of the foreign subsidiary whereas under the temporal method it is the net amount of assets and liabilities translated at the current exchange rate. Changes in exchange rates on foreign operations thus always cause changes in group net equity and under the temporal method these change also affect group net income.
For Germany, there is no explicit legal requirement covering foreign currency translation. The law only requires to report on the method used (ยง 313 sec. 1 Nr. 2 Commercial Code).14 A proposed statement of the accounting professional organization (Institute of Chartered Accountants) offers companies the free choice of translation method.15 As a result, German corporate translation practices generally reflect variations of the current-rate method or – less frequently – of the temporal method.