Question

Assume that you are a US based MNC. Please tell me how you would assess and reduce the economic exposure for a company that the US MNC owns in Lebanon.

Answer 1

MANAGING ECONOMIC EXPOSURE

The risk of economic exposure can be hedged either by operational strategies or currency risk mitigation strategies.

A) OPERATIONAL STRATEGIES

The following are the operational strategies which can be used to alleviate the risk of economic exposure:

1. DIVERSIFYING PRODUCTION FACILITIES AND MARKETS FOR PRODUCTS

Diversifying the production facilities and sales to a number of markets rather than concentrating on one or two markets would mitigate the risk inherent. However, in such cases, the companies have to forgo the advantage earned by economies of scale.

2. SOURCING FLEXIBILITY

Companies may have alternative sources for acquiring key inputs. The substitute sources can be utilized in case the exchange rate fluctuations make the inputs expensive from one region.

3. DIVERSIFYING FINANCING

A company can have access to capital markets in a number of major regions. This enables the company to gain flexibility in raising capital in the market with the cheapest cost of funds.

B) CURRENCY RISK MITIGATION STRATEGIES

The following are the currency risk mitigation strategies which can be used to alleviate the risk of economic exposure:

1) MATCHING CURRENCY FLOWS

This is the simplest form of mitigating economic exposure by matching foreign currency inflows and outflows. For example, if a European company has significant inflows in US dollars and is looking to raise debt, it should consider borrowing in US dollars.

2) CURRENCY RISK-SHARING AGREEMENTS

An agreement is framed between the two parties involved in the purchase and sales contract. The agreement states that the parties must share the risk arising from the exchange rate fluctuations. The agreement consists of a price adjustment clause which states that the base price of the transaction will be adjusted in case of currency rate fluctuations.

3) BACK-TO-BACK LOANS

This method, also known as credit swap involves two companies located in different countries entering into an arrangement to borrow each other’s currency for a fixed period of time. Once the defined period is over, the currencies are repaid.

4. CURRENCY SWAPS

The currency swap method is similar to the back-to-back loans method, however, does not reflect on the balance sheet. This method involves two firms who borrow currencies in the world market where each can benefit from the best rates and then swap the proceeds.