translation gain or loss

CFA Level II FRA
#1

Question: Why the two cases below will cause translation loss instead of translation gain?

  1. Total assets exceed total liabilities when the foreign currency is depreciating using the current rate method.

  2. Monetary assets exceed monetary liabilities when the foreign currency is depreciating using the temporal method.

Thank you in advance.

#2
  1. Total Assets > Liabilities means you have a Net Asset Exposure to foreign exchange movements. A depreciating foreign currency means net asset is worth less than it used to before in local currency (which is a loss). On the other hand, if you have a Net Liability Exposure (total liabilities > assets), then a depreciating currency would help you because your liabilities are worth less in local currency.

For example: you, a company set in US, own foreign activities in Europe with A and L at 100 Euros and 80 Euros giving you a net 20 Euro asset exposure. Assuming the exchange rate for EUR/USD goes down from 1.2 to 1.0 (euro, the foreign currency, depreciated)

Before depreciation: Net exposure in USD is 24 (you have a net asset position at 24 USD)

After depreciation: Net exposure in USD is 20 (you have a net asset position at 20 USD).

You “lost” 4 USD simply because of the depreciation of EUR/USD.

the reverse also apply to Net Liability Exposure.

  1. Under Temporal method, Monetary A and L are translated using the most recent rate (current). if the foreign currency is depreciating, the same idea applies as point number 1. Non-monetary A and L are translated at the historical rate on the date of purchase so forex movement do not impact them.
#3

Because you have a net asset on the investee balance sheet. The foreign currency is depreciating so when you convert to the parent balance sheet, you will have a lower number, which result in a loss. If it is a net liability, then you will have a gain since your liability will be lower after translation

#4

Thank you Edbert for you detailed explanation.

I realized my problem as wrongly think the net asset exposure is in local currency.

#5

so the practices of hedging for this case shall be borrow more cash in foreign currency and reduce equity to make a profit. Is that correct?