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TABLE OF CONTENTS

EXECUTIVE SUMMARY..............................................................................................................2

INTRODUCTION ...........................................................................................................................2

CURRENCY FLUCTUATION.......................................................................................................3

SIGNIFICANCE OF FOREIGN EXCHANGE RISKS................................................................3

THE IMPACT OF EXCHANGE RATE UNCERTAINITY ON TRADE FLOWS……………3

TRANSACTION EXPOSURE........................................................................................................4

ECONOMIC EXPOSURE..............................................................................................................4

TRANSLATION EXPOSURE........................................................................................................4

MITIGATION OF FOREIGN EXCHANGE RISKS…………………………………………….4

MANAGING TRANSACTION EXPOSURE................................................................................5

FUTURE HEDGING.......................................................................................................................5

FORWARD HEDGING..................................................................................................................6

MONEY MARKET HEDGING.....................................................................................................6

CURRENCY OPTION HEDGING................................................................................................6

MANAGING LONG TERM TRANSACTION EXPOSURE.......................................................7

MANAGING ECONOMIC EXPOSURE.......................................................................................8

MANAGING TRANSLATION EXPOSURE................................................................................8

ADVANTAGES OF CURRENCY FLUCTUATION....................................................................8

ADVANTAGES OF CURRENCY FLUCTUATION WHEN MAKING SHORT TERM


DECISIONS.....................................................................................................................................8

ADVANTAGES OF CURRENCY FLUCTUATION WHEN MAKING LONG TERM


DECISIONS.....................................................................................................................................9

CONCLUSION & RECOMMENDATION.................................................................................10

REFERENCES...............................................................................................................................11

EXECUTIVE SUMMARY
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Multinational corporations are involved in world trade and continuously seek opportunity
to expand its business in foreign countries. Therefore they are engaged in in foreign
exchange. Exchange rates have major impact on MNC because they fluctuate over time.
Currency fluctuation is the difference or change between the values of the currencies of
various countries. MNC can gain or loss when currency appreciates or depreciates. MNC
can use different techniques to hedge against the currency exposure risk and attain potential
advantages from currency fluctuations.

INTRODUCTION

Multinational corporations are mostly engaged in international trade, direct foreign


investments and international arrangements. MNC’s also have foreign subsidiaries. There
can be cash flows from MNC to finance the operations of foreign subsidiaries and cash
flows from foreign subsidiaries to parent in form of earnings. MNC generally have cash
outflows when they pay for imports and expand businesses in foreign countries. They have
cash inflows when they receive payments for its exports, payment for services provided in
foreign countries and earnings form subsidiaries. Therefore multinational corporations are
involved in foreign exchange to do its operations. The MNC’s are exposed to exchange rate
risk because the exchange rates fluctuate over time. The level and volatility of exchange
rate can have significant effect on investment of firm. The impact of currency movements
are expected to vary across MNC due to different locations and different operations. The
Corporation should make decisions in order to take advantage form currency fluctuations
while mitigating the exchange rate risk.

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CURRENCY FLUCTUATION

Each country has its own currency through which national and international transactions
are conducted. All international transactions involve the exchange of one currency against
another. The difference or change between the values of the currency of a country is called
currency fluctuation. Currency fluctuations happen on daily basis and affect the relative
velocity between currencies on a regular basis. Since exchange rates change constantly, so
companies are exposed to exchange rate fluctuations. Therefore, assets or liability or the
company's cash flows, which is denominated in foreign currencies change their value over
time. This variability in the value of the assets or liabilities, or cash flow refers to the
exchange rate risk.

SIGNIFICANCE OF FOREIGN EXCHANGE RISKS

The exchange rate exposure is the degree to which an MNC is affected by exchange rates
fluctuations. Exchange rate movements effects MNC with its subsidiaries in foreign
countries and its international trading. The impact of exchange rate movements on a firm
value is determined by firm’s net position in foreign currency. The firm can gain or loss
when currency appreciates or depreciates.

THE IMPACT OF EXCHANGE RATE UNCERTAINITY ON TRADE FLOWS

The exchange rate uncertainty effects international trade both favorably and unfavorably.
There is also the possibility of ambiguous effects on trade flows depending on the
aggregate exposure to currency risk.

MNC should measure the amount of risk it can face due to exchange rate fluctuations.
Three types of currency risk exposure are there:

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TRANSACTION EXPOSURE

Transaction exposure measures the rate to which the future cash flows of MNC will be
affected by exchange rate fluctuations. Transaction exposure occurs from transactions that
will take place in a future period and MNC will have foreign currency cash inflows and
cash outflows.

ECONOMIC EXPOSURE

Economic Exposure measures the rate to which the MNC will be affected by exchange rate
fluctuations. The volatility of currencies has effects on the value of MNC’s cash flows,
Income Statement and Balance Sheet and affects its competitiveness. Currency
fluctuations also affect the value of imports and exports. Economic exposure is long term.

TRANSLATION EXPOSURE

Translation Exposure refers to change in a firm's financial position of the MNC when
consolidated financial statements are affected by currency fluctuations and volatility. It
involves translation of subsidiaries financial statements from foreign currencies to home
currency. The potential loss which can occur due to translation exposure is that the
investors may not invest when they analyze the financial statements of the corporation.

MITIGATION OF FOREIGN EXCHANGE RISKS

HEDGING CURRENCY

The exchange rate is a very important factor in international business and they must be
monitored continuously. Hedging is a technique used to mitigate the currency risks
exposure. Captivating a new risk that offsets the existing risk is referred as hedging
currency. It helps to reduce the MNC’s exposure to adverse change in currency rates,
interest rates and prices of its products. MNC can protect itself against these risks through
various techniques like forward, futures, options and currency swaps

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MANAGING TRANSACTION EXPOSURE

MNC faces transaction exposure when its expected future cash transactions can have
effects on the value of cash flows due to exchange rate movements. MNC cannot exactly
forecast the value of currency which it will need in future. The hedging techniques MNC
can use to hedge its transaction exposure are:

1. FUTURE HEDGING

Future contract is the agreement between two parties that describes the amount of
foreign currency that would be received in future at a specific rate and specific date.
Futures are traded on an exchange. In future contract two parties undertake an
agreement to buy or sell certain currency that is needed in future at a certain exchange
rate that is fixed today.

• PURCHASING CURRENCY FUTURES

MNC that purchase a future contract is authorized to buy a particular


amount in a specific currency for a given rate on a specific date. MNC
purchases future contracts to hedge its payments on payables in future which
are needed in a foreign currency. The company purchases a currency future
contract for that foreign currency which will be required in future. The
contract locks its home currency value at specific rate needed to make
payments in future.

• SELLING CURRENCY FUTURES

MNC that sells a future contract is authorized to sell a particular amount in a


specific currency for a given rate on a specific date. MNC sells future
contracts to hedge its local currency on receivables that it will receive in
foreign currency.

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2. FORWARD HEDGING

Forward contract is the agreement between two parties which fixes the exchange
rate of currencies today for future transactions. Forward contracts are used for large
transactions of currencies while future contracts are used for small transactions.
MNC that’s needs foreign currency in future purchases forward contract thus
locking the specific exchange rate at which the foreign currency will be exchanged
at some future date.

3. MONEY MARKET HEDGING

MNC uses money market hedging technique hedge its payables or receivables by
utilizing money market.

• MONEY MARKET HEDIGNG ON PAYABLES

If MNC has an obligation to pay certain amount, it may face a risk if local
currency depreciated by the time of payment then loss can occur due to this.
To mitigate this risk MNC can use money market hedging technique to
hedge its payables. To use this technique MNC borrows amount in the local
money market and Invest in the foreign country

MONEY MARKET HEDIGNG ON RECEIVABLES

If MNC has to receive certain amount in future, it has risk if local currency
appreciated by the time of collection then loss can occur due to this. MNC
will use money market hedging technique to hedge its receivables. To use
this technique MNC borrows amount from the foreign money market and
Invest in the local country

4. CURRENCY OPTION HEDGING

MNC can use currency option hedge technique to hedge transaction exposure .Two
parties agree upon an agreement. The agreement gives right but not obligation to

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buy or sell a specific amount of currency at a specific rate on or before a maturity
date from the seller of the option. The buyer of option has right but not obligation
but if the buyer exercises the option then the seller of the option is obliged to fulfill
the agreement. The seller of option charges price or option premium for giving a
right.

• CALL OPTION

A currency call option gives the buyer the right to buy a specific amount of
currency at a specific rate on or before a maturity date. Call option is used to hedge
payables of a MNC.

• PUT OPTION

A currency put option gives the buyer the right to sell specific amount of currency
at a specific rate on or before a maturity date. Put option is used to hedge
receivables of a MNC.

Since options are not obliged to be exercised they can insulate a firm from adverse
movements in exchange rates, though company may benefit from favorable
currency movements.

MNC usually compare the future expected cash flows of each technique of hedging before
choosing which technique will be used to hedge against risk exposure.

MANAGING LONG TERM TRANSACTION EXPOSURE

Three techniques can be used to mitigate transaction exposure in long term

• LONG TERM FORWARD CONTRACT

MNC uses long term forward contract to hedge against currency fluctuation
when cash flows are expected after a long period of time.

• CURRENCY SWAP

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In a currency swap two parties agree that in future they will exchange
particular amount of currencies on specific date.

• PARALLEL LOAN

In parallel loan the two parties exchanges currencies with each other and
agrees to re-exchange the currencies at a specific rate and at some specific
future time period.

MANAGING ECONOMIC EXPOSURE

Economic exposure can be hedged by balancing the sensitivity of revenue and expenses to
exchange rate fluctuations.

MANAGING TRANSLATION EXPOSURE

Translation exposure can be hedged by forwards and futures.

ADVANTAGES OF CURRENCY FLUCTUATION

MNC when making decisions can take advantage or gains of currency fluctuation by
forecasting the currency changes and by managing their exposure to risk of currency
fluctuations. By analyzing the volatility of currencies MNC can develop appropriate
financial hedging plan in order to take advantage.

ADVANTAGES OF CURRENCY FLUCTUATION WHEN MAKING SHORT


TERM DECISIONS

In short term MNC manages its short term funding which includes payables, receivables. It
can gain advantage through exchange rates spread. MNC needs short term borrowing
therefore it needs to make decision which currency to borrow keeping in view the interest
rate parity, forward rate forecasts and exchange rates forecasts it can take advantage from
currency fluctuation and can attain potential gains. To offset net receivables in a foreign
currency MNC may take decision to finance in a foreign currency. MNC can also use
foreign financing in order to reduce its financing costs. Lower financing costs can be
attained if interest rate of foreign country is relatively low. MNC can invest in a portfolio

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of different currencies and gain advantage if the currencies are not highly positively
correlated. Borrowing from a portfolio of currencies that have low interest rates can
increase the probability of attaining low financing costs.

ADVANTAGES OF CURRENCY FLUCTUATION WHEN MAKING LONG TERM


DECISIONS

MNC decisions in long term usually include investment in foreign countries (Foreign direct
investment).To accomplish this MNC needs long term financing. MNCs
generally acquire equity funding in home currency and engage in debt financing in foreign
currencies. MNC take decisions to invest in foreign currency in order to get the future
benefits of cash flows from its subsidiaries. MNC in long term takes benefit of volatility of
currencies by using long term hedging techniques like currency swap hedging, long term
forward contract hedging, and parallel loan hedging.

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CONCLUSION & RECOMMENDATION

MNC’s are exposed to exchange rate risk as they are engaged in international transactions.
MNC reduces its exposure to risk by using various risk mitigation techniques when making
decisions. MNC must analyze the impact of volatilities of currencies and make appropriate
plan to mitigate this and achieve potential gains. Various risk mitigation techniques like
locking in currency swaps forward contracts and currency options can be used to immune
from losses. MNC should also invest in a well-diversified portfolio of different currencies
which are not highly positively correlated in order to get advantages and gains.

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REFERENCES

• Madura, jeff (2006). International Financial Management. 8th ed.Thomson South-


western.

• Ross, Wester et al. (1999). Fundamentals Of Corporate Finance. 5th ed. Mcgraw-
Hill Professional.

• Donald, Chew et al (2000). The new Corporate Finance. 3rd ed. McGraw-
Hill/Irwin.

• Hsu, Judy . (04 May 2010). How do innovation and exchange rate changes affect
firm’s mode of foreign expansion. The Journal of International Trade & Economic
Development.

Available: http://dx.doi.org/10.1080/09638190903003044 [Accessed 12th Feb


2011].

• Mustafa Cagayan, Omar S. Dahl and Firat . (n). Exchange Rate Uncertainty and
Financial Depth.

• Qing, Chen. (2007). Exchange rate exposure, corporate hedging and firm market
value.

• http://www.finpipe.com/hedge.htm [Accessed 13th Feb 2011].

• http://www.oppapers.com/essays/Currency-Hedging/81749 [Accessed 13th Feb


2011].

• http://www.oppapers.com/essays/How-Currency-Exchange-Rates-Affect-
Global/205655 [Accessed 13th Feb 2011]

• http://www.lariba.com/knowledge-center/articles/pdf/Malaysia%20-%20GOLD
%20-%20Hedging%20With%20Dinar.pdf [Accessed 16th Feb 2011]

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