FRA - Current rate method method

AndyNZ

The U.S. dollar has been depreciating relative to the local currency over the past year. The use of the current rate method to translate a foreign subsidiary's financial statements to U.S. dollars will most likely have which of the following effects on return on equity (ROE) relative to what the ratio would have been without the effects of translation?

A) ROE will most likely rise.

B) ROE will most likely decline.

C) The impact of the depreciation of the US dollar on ROE is indeterminate.

Please explain.
Thanks

b_sea93

If the dollar is depreciating, the translation will be supressed, SE is at historical rates either way and NI is at an average rate, so B it will decline because the SE would be higher

lucasg85

Assuming no differences in NI or Equity other than the translation adjustment - and given that this is the all current method we are using the translation adjustment is allocated as a portion of equity.

with the dollar depreciating the translation from one period to the next would be less in the domestic currency so with same NI and lower Equity the ROE would most likely rise

Ans.-A

spreads

Choice A.
same reasoning as FinNinja

Equity would be lower, given USD is depreciating.
Net Asset position (since company would have equity).
so Equity will carry a negative Cumulative Translation adjustment.

This will reduce equity,

Net Income would be at the average rate - so the reduction in Net Income would not be as much.

NI/CE will thus increase.

CP

tarunajwani

I'm thinking Northeastern Student is correct (Option B)?

From reading the question the local currency i.e. not the dollar has appriciated over the year. We want to convert from local currency --> USD / local currency (not stated) --> presentational currency (USD).

Assuming the local currency appriciates against the dollar this would create a positive CTA. Leading on from this there is a higher level of shareholders equity, which in turn would lead to a decrease in ROE (as NI doesn't change as much)

Or it could be that I'm completely wrong and I should go to bed!

(Hmmm, fourth edit, definitely time for bed)



Edited 4 time(s). Last edit at Tuesday, May 25, 2010 at 07:44PM by Smiffy.

senlinlang

I disagree. The question is:

which of the following effects on return on equity (ROE) relative to **** what the ratio would have been without the effects of translation? *****

If the USD is depreciating, the average rate will be lower than the current rate. Making up some numbers:

Avg = $0.80
Current = $0.85

NI = 5 (foreign curr)
SE = 100 (foreign curr)
ROE (foreign curr) = 5%

Tranlated:
NI = $4
SE = $85
ROE (USD) = 4.7% ---> B

Analyze_This

without using any maths, I believe the answer is B

If the foreign currency is appreciating against the $US, with a net asset position this would result in a gain. An increase in CTA which would increase equity and reduce ROE

Sportsman

Agree with B - Local currency is appreciating----> current rate so gain would go into CTA increasing equity thereby reducing ROE.

Uranus08

A is my answer.

The problem with calgaryeng's explanation is if the US dollar is depreciating, your exchange rates are backwards. The current rate should be $0.8/1LC and the average rate should be $0.85/1LC.

jacksparrow

Used to think A...definitely B upon reflection

Net asset exposure = gain = positive CTA

BS under current rate (higher conversion) vs. Net income (lower conversion FX rate)

Thus, the BS amount will just be plain higher...I think