Question

ou are the CFO of a U.S. firm whose wholly owned subsidiary in Mexico manufactures component parts for your U.S. assembly operations. The subsidiary has been financed by bank borrowings in the United States. One of your analysts told you that the Mexican peso is expected to depreciate by 30 percent against the dollar on the foreign exchange markets over the next year. What actions, if any, should you take?

Answer 1

Businesses often face risk related to changes in exchange rates. This is also a case where the business is exposed to the exchange rate risk because of the expectation that the mexican peso will depreciate against the dollar on foreign exchange markets. If the mexican peso will depreciate against the dollar then the dollar value of the company’s Mexican subsidiary would decrease substantially. This can limit the firm's access to the capital market because this would reduce the total dollar value of the firm’s equity reported in its consolidated balance sheet, raising the apparent leverage of the firm, which could increase the firm’s cost of borrowing. In order to deal with this situation the firm should take the following steps:

1) The firm should engage in a lead strategy and collect its foreign receivables early. It will be wise for the firm to collect its receivables as fast as possible in a country in which the local currency is expected to depreciate. A lead strategy means either collecting foreign currency receivables before they are due when the foreign currency is expected to weaken or paying foreign currency payables before they are due when the foreign currency is expected to strengthen. In this case mexican peso is expected to depreciate so the firm should start collecting its receivables at the earliest.

2) The firm should use forward contracts to protect itself from the currency movement for individual transactions. These instruments allow financial officers or managers to buy or sell currency at a specific future date at an agreed upon exchange rate. In this way, whenever the mangement is concerned about the value of a receivable in the future, it can guarantee a fixed exchange rate and minimize the possibility of currency risk. The firm can also employ currency options, a contract that grants the holder of the right to buy or sell currency at a specified exchange rate during a specified period of time.

So, in order to avoid the loss that might occur due to exchange rate risk or currency risk that is the risk of loss from the fluctuating foreign exchange rates, the firm should take the above mentioned actions.