Question

Salient, Inc. is a U.S. multinational corporation with subsidiaries in Germany, Canada, Mexico, and Japan. All products that are sold in the company’s subsidiaries are manufactured in the United States. (a) What types of exposure does Salient have? (b) Explain whether you think Salient has a low or high level of exposure, and why. (c) Can Salient do anything different to change exposure?

Answer 1

a) MNC’s like Salient Inc have large volumes of operations in different countries. In this case, the foreign countries involved in operation process include: Germany, Canada, Mexico, and Japan. It is said that all products that are sold in the company’s subsidiaries are manufactured in the United States. When it comes to selling the products, there is a time lag between the start and finish of the transaction, which exposes the US MNC (Salient Inc.) to certain risks due to the fluctuation of exchange rates on the above mentioned foreign countries. Here, the foreign countries are the buyers and Salient Inc is the seller. Thus the different types of exposures faced by Salient Inc.are:

i) Transaction exposure: This arises as a result of exchange rate fluctuations that affect both the buyers and the seller. If the exchange rate changes after both sides have entered into a financial obligation, then a high level of fluctuation in the exchange rate leads to high exposures and a low level of fluctuation leads to low exposure. Eg, if the Dollar appreciates in terms of the Mexican Peso, then Salient Inc will be worse off because the earnings converted into the new and appreciated USD will be lower in terms of value. . This exposure however ranges from short term to medium term.

ii) Economic Exposure: This exposure is also known as operating exposure and has long term effects as opposed to medium or short term effects in the case of transaction exposure. For example, here Salient Inc gets a large portion of revenues from its foreign subsidiaries. If US experienced a steady decline of the USD with respect to the other currencies and it already factored this in while calculating the future operating forecasts, then a sudden appreciation of the USD represents an economic exposure of the company. It is the unprecedented change in the direction of the exchange rate fluctuation that causes this risk. The risk is high here because an appreciated USD implies that when foreign earnings are converted into Dollars, the value will be lower.

iii) Translation Exposure: This risk arises from exchange rate fluctuations that go on to affect the company’s assets, liabilities, equities etc. Also called ‘accounting exposure’, this risk only materializes when the MNC denominates a part of its equities or liabilities or assets in a foreign currency. Whereas transaction risk arises in the occasion of a transaction happening between two countries, translation exposure depends on the assets held by Salient Inc and not on the transaction.

b) It is clear that when the USD appreciates, Salient Inc is exposed to more risk. This can be explained through a simple example. Let us assume that the previously, 1 USD exchanged at the rate of 10 Mexican Pesos and each Salient product is sold in Mexico for 40 Pesos, which means that earnings in USD was $4. Now, if the USD appreciates in relation to Peso such that 1USD exchanges at the rate of 20 Mexican Pesos and each Salient product is still sold in Mexico for 40 Pesos then this means that the earnings in USD are now $2. Thus, exposures rise with appreciation. In the real world, Germany’s Euro, Japan’s Yen and Mexico’s Mexican Peso are among the topmost volatile currencies in the world with respect to the USD. In all these cases, the USD experienced surges or appreciations, which increases the exposures of Salient Inc because Salient Inc is a seller in the global market. Thus, Salient Inc being a US MNC with foreign subsidiaries has a high level of exposure.

c) Few of the ways in which exposures can be reduced are :

i) Forward or Future Hedges: This tool helps in reducing the transaction exposure by utilizing currency futures (future hedges) or sealing transactions at future exchange rates by using forward contracts (forward hedge). In order to reduce transaction exposure and protect its receivables, Salient Inc can sell currency futures or negotiate a forward contract to sell the currency forward.

ii) Restructuring: Economic exposures are the most difficult exposures to measure and reduce. This is because, the changes are related to real growth, inflation etc. However, one of the ways to reduce economic exposure is by restructuring or shifting the sources of revenues and costs to other locations to bring the cash inflows and outflows at par. This is quite a difficult task, and has long-term effects that involve a lot of scrutiny before the final action is taken up. This is because, actions like increasing sales in other countries or reducing sales in existing countries bring with them a series of costs which are expected to be outweighed by the benefits in order for Salient Inc to sustain.

iii) Hedging: Similar to reducing transaction exposure, translation exposure can be reduced by hedging. This can be done by using currency swaps, or by using currency futures, a technique explained in the case of reducing transaction exposure. Alternatively, Salient Inc can use a combination of these techniques as opposed to using them in isolation, depending on the need of the hour.