Exchange Rate Risk
In the current business world of increasing growth and unpredictability of currency, alterations in exchange rates have a significant determinant on multinational companies’ trading procedures and profitability. The unpredictability of the exchange rates affects the large multinational corporations and even businesses as well. Foreign exchange, also referred to as currency risk, is the risk that interchanges in the proportional value of certain currencies that reduces the investment value dominated in the foreign currency. Multinational corporations are a wide range of domestic companies that engage in business with other foreign companies in many ways. This risk regularly affects investors making international investments and businesses importing or exporting commodities (Khanna, Palepu & Bullock, 2010). For instance, when it is necessary to convert money to another foreign currency for an investment to be carried out, then any alterations in the currency rate of exchange will establish the value of that investment to either increase or decrease when it is sold and converted back into the original currency.
One major point that can be remembered is that all the MNC’s deal with exchange rates, independent of the type of business they are involved in. As a part of their daily businesses they have to purchase or sell foreign currencies. Thus, they encounter foreign exchange risk every day. Some of the MNC’s are importing or exporting firms that engage in selling the domestic goods abroad or buying foreign goods. Therefore, a German company exporting its goods to an American company is a multinational firm. Consequently is a German firm that imports from America and both of them are affected by the exchange rates (Khanna, Palepu & Bullock, 2010). For example, when the German importer is billed by the American firm in Euros, the former receives payment in Euros. However, an American company will sell the Euros as soon as it receives since it cannot use them on a daily basis. On the other hand, German importer is responsible for purchasing dollars and paying the American firm when the American exporter bills the German importer in dollars.
Exchange rate risk is important because the amount of money the investor actually receives is affected by the rate of exchange and this successively influences what is the eventual rate of return of the investors. The interest rates between two nations usually reflect the anticipated variations in the rate of exchange among them. For example, when Canada’s interest rates are higher, the United States dollar will likely reject in rate proportional to the dollar in Canada. This is because international money flows in a particular country catch the high yields when interest rates increase in that country. Hence, currency value of the country is promoted higher (Ehrhardt & Brigham, 2003). The exchange rate risk also entails that foreign bond’s investors can participate indirectly in the foreign exchange markets. The type of risk the MNC’s are disclosed to include transaction exposure, translation exposure, and economic exposure.
Transaction exposure occurs when a firm has contractual cash flows, assets and account payables, economic value of which are important to unforeseen alterations in the rates of exchange because of an agreement being designated in a foreign currency. It relates to the modification in the rate of exchange among the period an organization starts a business transaction and ends it. Firms with transaction exposures are impacted by re-measurement process when public accounting rules are applied (Dohring, 2008). Re-measuring of the current rate of contractual cash flow occurs at yearly balance sheet. A change in the cash flow of this expected value will occur as in the rate of the exchange of assets. In measuring the transaction exposure, firstly, the net amount of inflows and outflows should be planned in every foreign currency. Secondly, the multinational company should find out in general the danger of exposure to those currencies. For example, in considering each currency situation together with the currency’s variability and the correlations among the currencies, a multinational company’s exposure in general can be assessed. One measure of currency variability is the standard deviation statistic on historical data though the currency variability points interchanges with time (Dohring, 2008). A company has economic exposure to the extent that unexpected exchange rate changes influence its market value. Such fluctuations to the rate of exchange can seriously influence the market share perspective of the firm with respect to its future cash flow, competitors and eventually the value of the firm. Any business transaction that reveals the company to foreign exchange dangers also discloses the company economically (Dohring, 2008).
The extent to which exchange rate movements affect firm’s financial reporting is its transitional exposure. Generally, as all firms must prepare financial statements for recording and reporting functions, for multinationals it involves transforming the foreign assets and obligations from the foreign currency to domestic currency. Although it may not affect the cash flow of a firm, it could have a substantial effect on the reported earnings of a firm and hence its stock price (Ehrhardt & Brigham, 2003). The distinguishing factor between the transaction risk and translation exposure is resulted from financial gain and losses from different types of perils. The degree of translation exposure of an MNC is dependent on the proportion of its businesses carried out through its accounting procedures, foreign subsidiaries and its location.
The alterations in the exchange rates can have a substantial effect on a multinational company’s returns. When multinational companies do not pay much attention to the various business risks associated with price, interest rates risk and currencies, other stakeholders such as creditors, suppliers and customers will suffer substantial costs. An increase in the currency rates will affect the transactions of a multinational company in that their outstanding tenders and assets will drop sharply and even its competitive status will weaken to its foreign competitors. An increase in the currency rates can cause a substantial reduction in the company’s profits and cash flow, which in the end affect its ability to service the debts (Baker & Powell, 2009). Customer assessment for the company’s ability to provide better services will also be affected by the financial weakening. The multinational companies can manage this by hedging its exchange rate exposures and develop other strategies such as currency swaps to finance its foreign operations. This may also increase the willingness of the customers buy their products because of their ability to withstand financial difficulties. In the end, there will be an increase in the market value of its common stock, a result that would be desired by its shareholders.
The MNCs’ may realize important shifts in their profitability, as locally held currencies became more valuable by foreign exchange rates (FX). The multinational modern theory has no special implication for exchange rates. Multinationals have a well-determined role in determining the exchange rate and acts as a passage for capital flows. However, the factors responsible for the dramatic rise in currency trading are the corporations evidenced by the growth of international bond markets and swaps (Ehrhardt & Brigham, 2003). Through their real investment decisions the multinationals influences exchange rates. The Foreign Direct Investment (FDI) spent on new investments stabilizes the real exchange rate. For example, when the dollar depreciates suddenly, real interest rates will reduce in the U.S and the foreign companies will utilize the chance by investing pounds in order to produce in the United States.
Volatility of the future exchange rates is another concern that affects the decision to export. For instance, when a firm in the United Kingdom decides to export goods to United States, a huge reduction in the dollar would make the company uncompetitive hence they would stop exporting since it cannot sustain its losses. If there is uncertainty in the future exchange rates, there is constantly a risk that there will be no profit from export from United Kingdom. This effect may in turn overstate the unpredictability of the exchange rates. Since the exchange rates are highly unpredictable, companies will be more reluctant to start exporting. However, in this case the exchange rate must largely move to alter the trade balance with a different given amount (Dransfield, 2014). Therefore, in times of uncertainty the rate of exchange balancing function satisfied by trade flows is reduced.
However, the foreign direct investment is not sensible to volatility about the future rate of exchange. For example, when a United Kingdom company produces in the U.S, it earns profits, which when viewed differently is subject to exchange rates, Multinational Corporation and risk in direct investment. On the other hand, if the companies in the United Kingdom are producers, then the completely gross revenues that they have earned in the U.S are subject to exchange risk, although profit covers a small portion of the gross revenue. Therefore, the location decision of a production of a firm will be less affected by unpredictability in the rate of exchange than its decision to trade (Dransfield, 2014). In the case where the U.S turns to be a low place to produce, foreign companies will take the chance to relocate there even if the rate of exchange is uncertain. Unlike trade flows, the rate of exchange volatility is not likely to influence foreign direct investment stability on exchange rates.
The value of multinational companies can be increased by risk management strategies through dealing with the underinvestment trouble. Companies that are active internationally can reduce their exposure to the variations through domestic currency invoicing and hedging. Through invoicing in domestic currency, transaction risk can be shifted by the exporter to his or her customer abroad. Hence, there would be much expectations of strong interest on exporter’s side for invoicing domestic currency. The multinational companies can apply risk management strategies through financial derivatives and operational hedges (Baker & Powell, 2009). The difference between financial and operational hedges is that financial hedges constitute foreign currency loans and derivative instruments while operational hedges are the variegation sales, sourcing and production geographically.
When a company uses financial contracts to hedge the business transactions exposure, contractual hedging would develop. Contractual hedging is carried out in many ways that include: forward contract, futures, which are exchange traded tools and swaps. Natural hedging illustrates how a company might protect itself from risk by better arrangement of its operational techniques. The strategies that can be used include lagging of receipts, exposure netting, leading of payments. Leading and lagging process refers to modifications in the payment request timing to reflect the expectations about future currency movements. Leading involves hastening a payment while lagging is the deferring of a payment (Baker & Powell, 2009).
In conclusion, for the survival of multinational companies and good relationship with its stakeholders there is need to consider and adapt the different risk management strategies that will help increase the firms value, reduce the cost of financial distress and bankruptcy, lower the company’s expected tax payments and develop plans and funding programs. Managing financial risk entails measuring company’s exposure to risk, implementing the policies constructed for protecting the company from financial risk and monitoring the policies. This will in turn help in planning appropriately for uncertain risks that the business might encounter.