Question

Explain why a nominal increase in an exchange rate that leaves real exchange rate unchanged may still an impact on the profit margins of a MNC.

Answer 1

Solution :

In order to answer this question, we have to understand two things

1. How MNC converts the financial statements from the foreign subsidy

2. How nominal and real rates are related

So, Let's understand each point in detail

1. Conversion of foreign currency by MNC from subsidy: There are two methods of conversion- Temporal and Current rate method

Temporal method: In this method conversion of currency is done based on the exchange rate at time when assets or liability are created

Current rate Method: In this method, conversion is done based on the current rate irrespective of the time when financial statements are converted based on the current exchange rate

2. Nominal interest = Real interest + Inflation

So if the nominal increase in the exchange rate means the increase is due to nominal interest rate and this is due to inflation because the real rate is same.

According to GAAP

Income Statement should be converted based on the Exchange rate on the date that income or an expense was recognized

And conversion is done based on the nominal exchange rate not on the real exchange rate so any change in nominal exchange rate will affect the Income statement and finally the profit margin