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Multinational corporations, firms, or individual investors face a unique set of challenges that hinder their operations overseas. Madura (2014) observes that exchange rate fluctuations are one of the most common challenges faced by companies and investors with businesses abroad. Any change in currency exchange rate has dire effects on firms with foreign operations. Cash flows, values of foreign assets, competitiveness, and market value decline as a result of currency fluctuations. As such, multinational companies should opt for operational exchange rate management techniques because such measures are long-term and have a permanent effect when compared to financial exchange rate management techniques.
Accounting Vs Economic Risks Associated with Currency Exchange Rate Fluctuations
Habibnia (2013) defines risk as the exposure to any form of uncertainty. Multinational companies are exposed to accounting and economic risks when currency exchange rates fluctuate. Accounting risks are also referred to as translation risk and exist since uncertainty surrounds the net worth of parent company as it consolidates the financial statements of its overseas subsidiaries (Dohring, 2008). In this case, the foreign currencies have to be converted into the local currencies and fluctuations in currency exchange rates raise significant concerns. It occurs when companies with foreign branches have to fuse their financial statements, which consequently prompts the conversion of foreign currencies into local ones. Nevertheless, the occurrence of such transactions may likely impact the parent company’s net worth, hence presenting exchange rate exposure risks. According to Madura (2014), translation exposure takes place when there is a change in the value of exchange contracts as a result of fluctuations in currency exchange rates.
Conversely, economic risks arise due to the uncertainty that surrounds a company’s future cash flows as a result of currency exchange rate fluctuations (Madura, 2014). Habibnia (2013) defines economic exposure as the change in a company’s financial performance due to currency exchange rate fluctuations. It is the possibility that an economic downturn will hurt overseas investment. A good example of an economic risk would be the uncertainty that surrounds the performance of a luxury product launched shortly before an economic recession. There is a positive correlation between economic risk and political risks since the policy decisions related to the economy directly affects investments.[“Write my essay for me?” Get help here.]
Economic exposure risk is composed of transactional and operating exposures (Madura, 2014). Transactional risks stem from variations in value witnessed in foreign currency indentures due to fluctuations in currency conversion rates (Kim, 2011). Transaction risk is a headache for most multinational companies because exchange rates can change significantly over a short period, thus affecting its cash flows. Operational exposure risk, on the other hand, results from alterations in future revenues and costs due to changes in currency exchange rates (Kim, 2011).
Multinationals cannot assume that economic risks, which are broader and more prevalent than accounting risks, do not exist. According to Madura (2014), given the effect of economic risks (whether transactional or operational) on future cash flows, it is necessary that action is taken to minimize or if possible, eliminate them. Hedging refers to all measures adopted by a multinational company to reduce or eliminate the undesirable effects of exchange rate fluctuations on its future cash flows and anticipated strategies (Kelley, 2001). Most multinational corporations do not take translational (accounting) exposure risks too seriously because they have only little effect on a company’s net worth in the long run. Madura (2014) continues that most hedging efforts usually target economic exposure risks due to their serious effects on a company’s net worth in the long run.
Multinationals can use various financial and operational hedging techniques to remedy the economic risks resulting from exchange rate fluctuations (Dohring, 2008). However, these companies need to understand and verify their economic exposures before taking any action to manage them (Habibnia, 2013). Through various measurement techniques, multinational corporations can determine the level of risk exposure to each currency. This is done through an analysis of present and future cash inflows and outflows. However, management of economic risk gets complicated in case the impact of exchange rate fluctuations extends beyond the fiscal period during which the fluctuations occur (Madura, 2014). Habibnia (2014) argues that regardless of all these factors, multinationals need to be selective with the hedging approach they choose against both transactional and operational exposures. There are financial hedging techniques against both these types of risks[Need an essay writing service? Find help here.]
Transactional Economic Exposure
Financial techniques to hedge against transactional exposure. Transactional exposure is common with multinationals. Its main characteristic that differentiates it from operational exposure is its ease of identification and measurement. Also, transactional exposure occurs within a definite time frame and can thus be easily hedged using financial instruments. Forward contracts, future contracts, money market hedges, and foreign currency options are the most common standard hedging techniques against transactional exposure (Kim, 2011). The main disadvantage of financial techniques is that they only cover a limited period and can only be used in countries with stable market exchanges that trade in a broad range of currencies (Kim, 2011).
Forward contracts. Forward contracts are currency exchange contracts for the future that are meant to shield a multinational from transactional risks (Madura, 2014). In forward contracts, an agreement is signed stating the price at which the multinational company is to buy or sell currency if it is to receive or pay a fixed amount of time in the future. This way, the multinational corporation shields itself from any liabilities/losses that might arise due to currency exchange rate fluctuations (Madura, 2014). The uncertain future home currency value to be obtained on the stated period becomes certain regardless of the conversion rate changes.
Future contracts. Future contracts work in a similar manner to forward contracts. However, since they occur on the futures exchange trading floor, they are standardized to cover specific contract sizes, maturity dates, and collateral. Madura (2014) states that they are safer and easier to secure and unwind compared to forward contracts. Also, they eliminate virtually all credit risk involved in futures trading.
Money market hedging. Money market hedges are also referred to as synthetic forward contracts (Emm, Gay, & Lin, 2007). They are an option for multinational corporations to hedge against currency exchange risk without necessarily having to enter into the futures market. They are liquid and relatively short term in nature trading in the currency exchange floor where treasury bills, bonds, and commercial paper trade. Additionally, money market hedging are convenient for currency amounts that are not large enough to warrant forward or future contracts. Madura (2014) further notes that their primary disadvantage is that they are short-term and cover only a specific amount of period.
Foreign currency options. These are indentures that allow the owner to exchange/trade futures for foreign currency on specific terms (Madura, 2014). The specific terms include a particular period, price, and quantity.
Operational techniques to mitigate transactional exposure. Multinationals can also opt to use operational strategies to manage transactional exposure. According to Emm et al. (2007), when comparing operational techniques and transactional exposure, operational techniques have the advantage of being long term, completely offsetting the risk, and functioning effectively even in markets where forward derivatives are not present for the currencies in context.
Risk shifting. Risk shifting enables a multinational company to completely offset the transactional risk. It entails the company invoicing all transactions in their foreign currency (Madura, 2014). However, this technique cannot work for everyone. One of the two transacting companies must bear the risk (Kaplan Financial Knowledge Bank, n.d.).
Currency risk sharing. This is the second option for multinational to manage transaction risk. The two companies in trade agree to share the transactional risk that might occur in the future (Kaplan Financial Knowledge Bank, n.d.). A contract is written clearly indicating how risks will be split between the parties during that period.
Reinvoicing centers. A reinvoicing center is a separate subsidiary of the multinational company that is charged with the responsibility of managing transaction risks from all other subsidiaries in one location (Emm et al., 2007). Reinvoicing centers can absorb all transaction exposures if properly maintained.
Operational Economic Exposure
Financial techniques for managing operational exposure. Financial techniques for managing operational exposure can be broken down into two categories. The goals of these two classes are the same; it is just the approach that differs. One type of these techniques entails the denomination of a firm’s debt (Kim, 2011). Since operational exposure occurs from long-term currency flows and not in the short term currency flows, future expected currency flows are affected by fluctuations in currency exchange rates. However, companies can offset expected adverse effects on future cash flows by denominating some of their long-term foreign debts in foreign currency.
The other financial technique that multinationals can use to hedge operating exposure is swaps. Folsom and Boulware (2014) defines a swap as the financial instrument that allows buyers to switch one set of cash flows for another. In this case, the buyer of a swap can make periodic payments on a given financial price while receiving regular payments from the seller at some other price. Madura (2014) writes that swaps, as financial instruments, have the disadvantage of applying for a fixed period and to a given contract.
Operational techniques to hedge against operational exposure. Operational techniques to hedge against operational exposure are the best option for a multinational company. Just like the case of financial exposure, operational exposure can best be mitigated through long-term operational strategies in areas such as marketing and production (Madura, 2014). They entail a firm setting up their production and marketing such that they can adjust their operations to fluctuations in exchange rates to either take advantage of competitiveness or reduce the harm caused by reduced competitiveness as a result of the fluctuations.
Through market selection and marketing segmentation as a technique, a company would consider what market to sell its product and how much support to devote to each market based on how competitiveness has changed depending on the direction of the fluctuations (Folsom & Boulware, 2014). A good example would be a firm deciding to withdraw from an unprofitable market and venture into a new market due to real conversion rates.
Pricing policies is another technique that multinational firms can adopt to adjust to changes in real exchange rates. The technique would entail an organization making a price decision regarding a foreign market based on the foreign currency price (Folsom & Boulware, 2014). A multinational would, for example, increase prices in overseas markets where recent exchange rate fluctuations have put its domestic currency at a disadvantage.
Beneficial Impacts of Operational Hedging Over Financial Hedging
From the descriptions of the individual techniques above, it is clear that any company would benefit more from operational hedging as compared to financial hedging in both the case of transactional and operational economic exposures. According to Aabo (2015), operational hedging of economic exchange rate exposures presents a company with a broad range of benefits though it might not result in zero cash flow variance with currency movements. This simply means that compared to financial hedging techniques, firms that opt for operational economic exposure hedging techniques are not likely to achieve zero cash flow changes in the event of exchange rate fluctuations. However, they get to enjoy a set of other benefits that are better than zero cash flow variances in the event of exchange rate changes.
Operational hedging techniques enable an organization take full advantage of beneficial movements in currency exchange rates and reduce the adversarial effects of negative currency movements. Such an opportunistic behavior creates some nonlinearity in a company’s economic exposure. Non-linearity in economic exposure is beneficial to a company’s because it reduces the harm that the corporation can accrue as a result of very adversarial movements in exchange rates (Treanor, Simkins, Rogers, & Carter, 2014). A company can yield better results in volatile markets if it can benefit more from positive exchange rate movements and suffer less from negative exchange rate movements. A firm can enhance its net value better through operational hedging than it can with purely financial hedging.
Though it might appear uneconomical in the short run, operational hedging pays off in the long term. With an option to adjust production, sales, and operations, a multinational company can hedge economic exposures for a couple of years whereas it can only achieve a maximum of one year with any hedging techniques (Madura, 2014). In case a company using financial hedging fails to foresee exchange rate risks in the future, and the current hedging contract expires, the effects of currency fluctuations in this unaccounted period spill over to other financial years, consequently causing massive complications in accounting and future mitigations (Kim, 2011).
Economic Risk Exposure Management at GM Motors and Toyota Motor Corp
GM is the world’s second largest automotive manufacturer with more than 20% market share (McGrath, 2016). GM operates in many foreign markets in Europe, North America, South America, and Asia. However, since 2007, GM has been registering dismal performance and seems to be losing its market share to rivals such as Toyota. It has sold several of its Europe-based subsidiaries due to persistent losses. To some extent, the hedging techniques used by GM contribute to revenue losses that translate to losses both in the short and long run. GM uses financial instruments forward contracts, future contracts, and options to hedge against currency exchange risks (General Motors Company, 2012). These financial hedges that forecast risks three years into the future have proven to be ineffective. According to Wikinvest (2007), GM witnessed an increase of $ 17.4 million in its cost of sales for the year ended 31 Dec 2006 due to ineffectiveness associated with its financial cash flow hedging techniques.
Toyota has been the world’s largest motor corporation in the world since 2009 when it took over from GM (McGrath, 2016). Toyota does not use derivative financial instruments and instead opts for operational exchange rate exposure hedging techniques. Specifically, it uses the holding technique whereby it holds the minimum stock levels possible in all of its foreign countries (Friberg, 2015). This way, the risks associated with liability occurring from currency exchange rates fluctuating to the disadvantage of the Japanese yen are minimized.[Click Essay Writer to order your essay]
In sum, exchange rate fluctuations create a lot of uncertainty for multinational companies. The economic and financial risk associated with overseas operations has a huge bearing on the performance of an organization and cannot be ignored. Financial risks associated with foreign operations have minimal bearing on an organization and are in most cases ignored. However, transactional and operational risks exist both in the long and short run and have a great impact on expected future cash flows. Operational hedging techniques against economic risks are better and more beneficial to financial hedging techniques. Toyota, which relies on operational hedging against exchange rate uncertainty, has been able to overtake GM, which solely uses financial hedging techniques.
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Treanor, S., Simkins, B., Rogers, D., & Carter, D. (2014). Does operational and financial hedging reduce exposure? Evidence from the U.S. airline industry. Financial Review
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