Foreign Exchange Risk Management In Multinational Corporations Finance Essay
Globalisation has had economic, cultural, technological and political effects. Over the last few decades the increase in globalisation has led to rapid growth in several industries around the world and it has also had a strong influence on the flexibility of firms. Hundreds of new MNCs have emerged globally due to the liberalisation of trade and capital markets. MNCs are not limited to the big firms with huge investments like Coca Cola, Nike and Shell, due to advances in technology and liberal markets many small firms operate internationally to maximise their profits. This growth has highlighted the various risks faced by MNCs operating in different countries. One such risk is the financial risk involved with the foreign currency exchange markets. Most of the time MNCs deal in more than one national currency and hence the changes in the foreign exchange rates can have an adverse effect on the firms' profits. This paper discusses the various foreign exchange risks faced by multinationals around the globe and the necessary steps taken to manage these risks. A study on the Malaysian MNCs has also been covered in the paper.
Foreign Exchange Risks:
Struggling with your essay?
Foreign Exchange risks also known as exposures can be termed as an agreed, projected or contingent cash flow whose scale is not certain at the moment. The magnitude depends on the value of the changes in the foreign exchange rates which in turn depends on various variables such as the interest rate parity, purchasing power parity, speculations and government policies on exchange rates.
According to G.Shoup (1998), a company has exposure if there is a currency mismatch in some aspect of the business such that a shift in foreign exchange rates, nominal or real, affect its performance either positively or negatively. These exposures may be classified into three different categories:
Translation Exposure; this is the net asset/liability exposure in the home currency of the MNC. In other words, it is the profit gained or loss incurred in translating foreign currency financial statements of foreign subsidiaries of the MNC into a single currency which it uses in its final reports (Yazid & Muda, 2006). In essence, translation risk can be defined as the effect of exchange rates on the figures shown on the parent company's consolidated balance sheet. Although this exposure does not affect the shareholder's equity, it does influence the investors due to the changing values of the assets or liabilities. (Shoup, 1998)
Transaction Exposure; it is a risk associated with a transaction that has already been contracted. It is as a result of unexpected changes in foreign exchange rates affecting future cash flows which the MNC has already committed itself to. Usually MNCs enter an international contractual obligation, the payment or receipt of which is expected on a future date, hence any change in the foreign exchange rate during that period will expose the MNC to transaction risks. Transaction risks can be easily identified and thus get more attention from the financial managers. (Eiteman, Stonehill, & Moffett, 2007)
Economic Exposure; this is the most complex risk as it not only involves the known cash flows but also future unknown cash flows, hence also termed as a hidden risk. It is a comprehensive measure of a company's foreign exchange exposure and therefore sometimes termed as a combination of translation and transaction exposure. Identifying economic risks involves measuring the change in the present value of the company resulting from any changes in the future operating cash flows of the firm caused either by adverse or desirable change in the exchange rate. (Eiteman, Stonehill, & Moffett, 2007). As Dhanani (2000) noted, economic risk can be viewed as the consequence of long-term exchange rate fluctuations on a firm's predicted cash flows and as the cash flows linked to the risk are not certain to materialize, the risk is hard to identify. Economic exposure to a MNC may last for a long duration making it difficult to be quantified and hence limiting the use of possible management techniques. (Shoup, 1998)
Foreign Exchange Risk Management
Foreign exchange risk management is a process which involves identifying areas in the operations of the MNC which may be subject to foreign exchange exposure, studying and analysing the exposure and finally selecting the most appropriate technique to eliminate the affects of these exposures to the final performance of the company. (Shoup, 1998)
Risks involving short term transactions can be dealt with using financial instruments but long term risks often require changes in the operations of the company. As in the case of translation exposure the MNC can have an equal amount of exposed foreign currency assets and liabilities. By doing so the company will be able to offset any gain or loss it may have due to changes in the exchange rates of that currency, also known as balance sheet hedging. (Eiteman, Stonehill, & Moffett, 2007)
In dealing with economic exposures efficiently, a MNC may have to diversify either its finance or its operations. It can diversify its operations by either moving to locations where the cost of production is low, or having a flexible supplier policy, or changing the target market for its products and the types of products it deals in. As it can be illustrated from the 1994 example of Toyota, when a strong Yen made Japanese exports to US more expensive, it decided to shift its production from Japan to US, where it achieved comparatively lower costs of production, enabling it to compete in the US car market. (Eun & Resnick, 2007)
This essay is an example of a student's work
The management of transaction exposures may either involve hedging using special techniques or applying pro-active policies. The pro-active policies commonly used include (Eiteman, Stonehill, & Moffett, 2007):
Matching currency cash flow
Risk sharing agreements
Back to back loans
Lead and Lag payments
Use of re-invoicing centres
Hedging is the act of protecting a pre-existing position in the spot market by trading in derivative securities; that is guarding of existing assets from future losses. According to Eiteman et al (2007), hedging is the taking of a position, acquiring a cash flow, an asset or a contract that will rise or fall in value and hence offset a fall or rise in value of an existing position. Several studies on this issue have emphasized that MNCs have a higher probability of facing exchange rate volatility in their operations as they expand their involvement throughout the world. Therefore, the extensive use of various hedging techniques by most companies has been widely recognized to ensure the company's overall interests, cash flows and equity are safeguarded. Some of the most commonly used hedging techniques include:
Forward market hedge
Money market hedge
Options market hedge
Forward market hedge; this is the case where the MNC in the forward contract has a legal obligation to buy or sell a given amount of foreign currency at a specific future date which is known as the contract maturity date at a price agreed upon at present. (Nitzche & Cuthbertson, 2001)
Money market hedge; under this hedging technique, the transaction exposure can be hedged by lending and borrowing in the local and foreign markets. For instance a MNC may borrow in a foreign currency to hedge the amount it expects to receive in that currency at a later date and similarly it could lend to hedge payables in a foreign currency. By doing so, the MNC will be matching its assets and liabilities in the same currency. (Eun & Resnick, 2007)
Options market hedge; this is a technique used by a MNC which gives it the right but not the obligation to buy or sell a specific amount of foreign currency at a specific price, by or on a specific date. Although not a widely used tool, it can be useful when a MNC is uncertain about the future receipt or payments of foreign currency. (Nitzche & Cuthbertson, 2001)
Hedging helps in reducing the risks involved in international transactions and also improves planning capability. By hedging a MNC can ensure its cash flow does not fall below a necessary minimum, particularly in cases where there is a tendency of a company to run out of cash for necessary investments (Eiteman, Stonehill, & Moffett, 2007). A very good example would be that of Merck, a pharmaceutical company. Kearney and Lewent (1993) identified that Merck was one of the pioneers to have used hedging to ensure that its key investment plans could always be financed, which in their case was the research and development aspect of their business. Mathur (1982) came to the conclusion that, to decrease the negative outcomes caused by fluctuations of foreign exchange rate on earnings and cash flows, most companies employ a hedging program. He also noted that a formal foreign exchange management policy is more common among larger firms. According to Bartov et al (1996), if MNCs do not institute a hedging program, they are more likely to be exposed to risks which may result in substantial losses.
Despite its advantages, hedging does not increase the company's expected cash flows, on the other hand it uses up the company resources in the process (Eiteman, Stonehill, & Moffett, 2007). According to G.Shoup (1998), unless there are clear defined objectives, safeguards in place and clear communication at every level of management, a hedging program may turn into a disaster. As the chairman of Zenith Electronic Corporations, Jerry K Pearlman once said, "It is a, damned if you do and damned if you don't situation." (Shoup, 1998, p15.)
In 1984, Lufthansa a German airline company placed a major purchase order for airlines from an American firm. The financial managers at Lufthansa had forecasted a stronger dollar in the days to come and therefore locked up the German Duetsche mark against the American dollar. Due to an unfavourable effect, a weak dollar, in one year Lufthansa lost around US$150 million and half of the financial managers' team lost their jobs (Shoup, 1998). In another instance, two years later in 1986, the chairman of Porche found himself unemployed as he had engineered the company into a dependence on the US market for 61% of its revenue without hedging against a downturn in US$, as a result forcing Porche to suffer major financial losses. (Shoup, 1998)
Freelance Essay Writing Vacancies
Looking to become a writer?
Due to high demand for our services we're always looking for new writers. If you're interested in becoming a freelance writer then why not read more about our freelance writer jobs.
According to a study by Marshall (2000), the trend in the objectives of managing foreign exchange risks was quite similar between the UK and US multinationals who gave significant importance to certainty of cash flow as well as minimising fluctuations in earnings. On the other hand, a higher number of Asian multinationals managed these risks to minimise fluctuations in their earnings. The trend observed is summarised in Figure 1 below.
Figure 1: "Foreign exchange risk management in UK, USA and Asia Pacific multinational companies" by Andrew P Marshall, Journal of Multinational Financial Management, 2000.
Belk and Glaum (1990) undertook a study which involved investigating several UK MNCs. The study revealed that although majority of the companies considered translation exposure to be important, not all were prepared to hedge this risk actively. On the other hand transaction exposure was given most importance in the management of foreign exchange risks. The level of hedging the transaction exposure varied between the companies investigated, some hedged totally while others did so partially. The study also seemed to show that the size if the MNC influenced its involvement in foreign exchange risk management, the larger the company the higher the propensity.
In another study carried out by Makar and Huffmann (1997), it was found that there is a linear relationship between the amount of foreign exchange derivatives employed and the degree of foreign currency exposure in US MNCs.
Foreign Exchange Risk Management in Malaysian Multinational Corporations (MNCs)
During the financial crisis of 1997, most Malaysian MNCs suffered foreign exchange losses due to currency fluctuations, thus leading to the increased involvement of Malaysian MNCs in foreign exchange risk management (Yazid & Muda, 2006). It can be seen that before the financial crisis fewer MNCs considered hedging their foreign exchange risks to be vital, as the General Manager of the Malaysian Monetary Exchange Bhd indicated that local MNCs were very passive and reactive in managing their financial risks (New Strait Times, 30 May 1998: 11). A similar statement was given by the then Minister for International Trade and Industry, Rafidah Aziz, which implied that MNCs should manage their foreign exchange risks well (New Strait Times, 3 July 1998). A very good example of the losses suffered would be that by Malaysian Airline System (MAS), MAS lost around M$400 million in the first half of 1998 because of its foreign debt of about M$3.16 billion. Yazid and Muda (2006) studied 90 out of the then 113 MNCs listed under the Bursa Malaysia. The main objectives cited by MNCs in this study relating to the foreign exchange risk management were to minimise the following;
Losses on operational cash flow
Cash flow fluctuations
Losses on consolidated balance sheet
Losses on shareholders' equity
Foreign exchange risk to a comfortable level
According to Yazid and Muda (2006), Malaysian MNCs became very proactive in managing their foreign exchange risks during the financial crisis and once the crisis was over, the priority attributed to foreign exchange risk management decreased slightly but not to the point it was before the crisis. This has been illustrated as a summarised result of the survey shown in table 1.
Minimise Losses on operational cash flow
Minimise Cash flow fluctuations
Minimise Losses on consolidated balance sheet
Minimise Losses on shareholders' equity
Minimise Business uncertainty
Minimise Foreign exchange risk to a comfortable level
Table 1 (Yazid and Muda, 2006)
Note: The results are based on five-point progressive Likert scale (1 is the least important; 5 is the most important)
Large MNCs in Malaysia are more likely to get involved in foreign exchange risk management compared to smaller firms or firms with relatively lesser operations outside Malaysia. This trend seems to be consistent with other MNCs around the globe (Yazid et al, 2008). Majority of the Malaysian MNCs centralise their foreign exchange risk management and it can be said that foreign exchange risk management in Malaysia is still at its 'infant stage' in comparison to other MNCs in the west. Their management practices are very informal and no proper documented policies can be found in regard to foreign exchange risks. Although the use of hedging tools is on a steady rise amongst the Malaysian MNCs, the objectives behind their involvement remain uncertain (Yazid and Muda, 2006).
The past decade has seen rapid growth of a new segment in the global finance industry, the Islamic finance sector. To qualify for Islamic foreign exchange hedging, transactions must involve tangible assets. Malaysia, which is pre-dominantly an islamic country has highlighted the need of hedging tools which are compliant with Islam. Hence CIMB, a leading Malaysian bank among others, have introduced an 'Islamic foreign exchange hedging instrument', which would assist their clients to manage their risks. (Reuters, 2008)
Astro, which is a leading services provider in the Asian entertainment indutry is based in Malaysia. Being a MNC, foreign transactions are dealt in different foreign currencies other than the Malaysian Ringgit. Consequently, there is an exposure to foreign currency exchange risk. Astro uses foreign currency derivatives such as forward contracts and interest rate swap contracts to hedge currency exchange risks. Forward contracts are commonly used to limit exposure to currency fluctuations on foreign currency receivables and payables as well as on cash flows generated from anticipated transactions denominated in foreign currencies. In 2007 Astro made a loss of RM 137,000 due to foreign exchange fluctuations and henceforth decided to emphasize the use of hedging techniques. This can be proven by Astro's estimated principal amounts of outstanding forward contracts which as at 31st January 2009 was RM188,083,636, whereas at the same time a year before it was at RM 5,109,000. The emphasis on risk management resulted in a substantial gain of RM 7,680,000 for Astro in the year ended 2008. In addition, as Ringgit Malaysia is Astro's functional currency; all the financial statements have to be consolidated into this currency. Hence Astro is exposed to translation risk due to the fluctuating exchange rates. According to Table 2.0, the significance of the foreign currency risk management is noticeable as Astro experienced a huge gain in 2008 relative to the loss they suffered in 2007.
Table 2.0: ASTRO; Result of Foreign Exchange Risk Management
Cash Flow due to Operating Activities
Net Effect of Currency Translation on Cash and Cash Equivalents
Gain on Realisation of Foreign Forward Contracts
However, hedging of foreign exchange does not always yield a positive result, as illustrated in the case of AirAsia, one of the leading budget airlines in Asia. AirAsia like many international airlines used a technique refered to as fuel hedging, this allows the airline to purchase fuel at a price fixed at an earlier date despite an increase in the fuel price. During the fuel crisis of 2007-2008 when prices rose to over US$150/barrel, AirAsia made a significant loss as it had hedged for fuel prices not to exceed US$90/barrel and as a result AirAsia recorded its first ever full year loss of RM471.7 million for the year ended 31st December 2008, despite achieving a growth of 36.6% in revenue. This led to the removal of all hedges on fuel prices and AirAisa declared itself as 'completely unghedged'. Although AirAsia intends to re-introduce fuel hedging in 2011, for now it deals in spot prices for its fuel. (Leong, 2009) (Ooi, 2008)
Multinationals are exposed to various kinds of risks, which includes the foreign exchange risk. This risk which is as a result of exchange rate volatility is said to have a pervasive impact on the profitability and certainty of a MNC. Globally, multinationals face translation, transaction and economic risks due to the frenzied system of floating exchange rates. To avoid the adverse effects of these risks, multinationals often take measures which although do not entirely eliminate the losses; they do enable the firms to minimize the losses. Hedging is very common risk management tool used by multinationals and has often resulted in positive results when used after a correct analysis of the exposure is made. Despite its advantages, not all multinationals around the globe decide to manage their risks in this way. The objectives behind foreign exchange risk management and the techniques used to manage are seen to differ across regions.
In the case of Malaysian multinationals, foreign exchange risk management is deemed to be at a lower level relative to their counterparts globally. Until recently, majority of the Malaysian multinationals were not actively managing these risks. The Asian financial crisis in the late 1990's had a significant effect on their stance and the level of foreign exchange risk management amongst Malaysian multinationals has since increased considerably.
If you are the original writer of this essay and no longer wish to have the essay published on the UK Essays website then please click on the link below to request removal: