Question

As the Chief Financial Officer of a large multinational corporation, you are seriously concerned about the volatility in foreign exchange rates and their impact on your company’s profits.

Explain the three types of foreign exchange exposure that your multinational company may be exposed to, and how each of these exposures might affect the company’s strategy and performance. Discuss the various hedging strategies that the multinational company can pursue to overcome the adverse impact of foreign exchange rate changes, while doing international business in different currencies.

Answer 1

The three types of exposure faced by MNCs:

1. Transaction Exposure- This is the risk that arises from the uncertainty in international trading. This arises when a firm enters an agreement to be fulfilled on a future date. The exchange rate fluctuations which might happen between the time that the agreement is entered into and completed create risk for the company. This is basically the risk arising out of exchange rate fluctuations before an agreement is settled. Translation exposure affects the performance of a company as there might be losses if a firm enters into a contract seeing the present exchange rate but will have to pay more in the future because of depreciation in the home currency. They can hedge the transaction risk by entering into forward contracts, this way they will not incur a loss if they have to pay more to complete the agreement in the future.

2. Translation Exposure- This risk arises because the MNC does business in various countries and so a portion of its assets and liabilities are denominated in a foreign currency. When the firm finally has to consolidate all its assets in terms of the home currency from other foreign currencies, exchange rate fluctuations at that time create this risk. Translation exposure may bring changes in the assets and liabilities of the company.

3. Economic Exposure- This is also known as operating exposure. This arises when the firm makes changes in its operations like production because of anticipated changes in the exchange rate. The company's cash flows get effected because of these fluctuations.

MNCs can follow several hedging strategies in order to avoid the exchange rate risk, these include:

1. Currency Swaps- Firms can hedge currency or exchange rate risk by swapping a certain amount of money to the foreign currency at a pre determined rate.

2. They can internally hedge the risk by transferring the funds they will require in the future at the present rate itself. This will not lead to a loss if the currency becomes expensive in the future.