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In: Economics

How does exchange rate fluctuation or exposure affect multinational enterprise? Discuss at least two risks associated...

How does exchange rate fluctuation or exposure affect multinational enterprise? Discuss at least two risks associated with them. How do MNEs hedge against those risks? Provide an example of an MNE which recently or in the past experienced currency risk.

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Expert Solution

The exchange rate fluctuation is an important thing for most of the companies especially multinational corporations. There are many ways for dealing with such fluctuation which all of them have the same aim to reduce foreign exchange losses and reduce the instability of cash flow.

Exchange rate can be broken down into two types expected changes and unexpected changes. Usually companies have the ability to respond to an expected exchange rate but it comes more complex when it comes to unexpected change.

Unexpected fluctuation in exchange rate is for measuring the positive effect of this change on multinational companies, whereas expected fluctuation measures the negative impact on the corporation. The fluctuation of exchange rate will affect the corporation’s cash flow through the transaction risk, translation risks, and economic exposure risk.

Translation risk is the risk that results from the changes done to the financial statements of the multinational corporations. This translation risk with the fluctuation of currency exchange rate my lead to the loss or gain in translation of multinational companies annual accounts. For this reason many companies seek to have a balanced balance sheet. The main source of risk for most of the corporations is the translation risk; translation profit or loss has a huge impact on the profitability of the company which has more harmful effects than those caused by operational activities like sales and profit margins

Foreign currency translation from an accounting respective: assets and liabilities are translated at exchange rate at the balance sheet date, whereas the profit or loss is translated at an average rate for the whole financial year or at the closing year rate of exchange; nevertheless the share capital is translated at the historical rate of exchange which is the rate when it was first issued.

The second risk is the transaction risk, which is the cash flow risk that is generated from region currencies. Transaction risk is easier than translation risk to measure and reduce it since multinational companies always hedge policies against transaction risk but they rarely do for balance sheet account and translation risk. There are two reasons for the multinational corporations not to hedge against translation; the first is that the deflation and reduction in one country will affect its branches in other countries. Second reason is that in long term the net worth of the company will not be affected by exchange rate fluctuation because exchange rate is affected by the productivity of the corporations.

There are 3 types of financial and operational hedging: (i) the number of countries the company operates in, (ii) the number of large area which the company is located, (iii) the geographic distribution of its subordinate. To know whether the corporation exchange risk is affected by hedging or not the corporation should consider 2 factors which are the company’s stock rate of return and the exchange rate index

When the company uses geographic distribution as a technique to reduce exchange rate risks (hedging), then a negative relationship will take place; companies that have huge operation regions have high exposure. As corporations increase their foreign revenues, the higher is the exposure; foreign revenues are part of the total revenues generated by the company which are used in financial hedging to proxy the company’s exchange rate exposure. Financial hedging is related to the sales ratio which indicates that the more the sales are the most likely that the corporation will use financial hedging. Financial hedging will not be represented by hedging the foreign exchange rate but it is by hedging the usage of currency derivatives.
Despite rising sales revenues, BMW was conscious that its profits were often severely eroded by changes in exchange rates. The company’s own calculations in its annual reports suggest that the negative effect of exchange rates totalled €2.4bn between 2005 and 2009. BMW did not want to pass on its exchange rate costs to consumers through price increases. Its rival Porsche had done this at the end of the 1980s in the US and sales had plunged.


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