Exhange risk faced by multinational companies. Essay

This essay has a total of 1628 words and 8 pages.

Exhange risk faced by multinational companies.

Exchange Rate Risk.

"Exchange rates are the amount of one country's currency needed to purchase one unit of
another currency (Brealey 1999, p. 625)". People wanting to exchange some money for their
vacation trip will not be too much bothered with shifts if the exchange rates. However,
for multinational companies, dealing with very large amounts of money in their
transactions, the rise or fall of a currency can mean getting a surplus or a deficit on
their balance sheets. What types of exchange rate risks do multinational companies face?

One type of exchange risk faced by multinational companies is transaction risk. If a
company sells products to an overseas customer it might be subject to transaction risk. If
a UK company is expecting a payment from a US customer in June and the invoice was made in
January, the exchange rate is bound to have changed during the period. If the deal was
worth £1,000,000 and the american dollar compared to pound sterling weakened from US$1.40
in January to US$1.50 in June, the UK company would loose £47,619 (Appendix A).

Economic risk is another type of exchange risks companies have to consider when dealing
globally. Changes in exchange rates are bound to affect the relative prices on imports and
exports, and that will again affect the competitiveness of a company. An UK exporter
dealing with companies in the US would not want the US$ to depreciate, because it would
make the exports more expensive for the US market, thus the company will loose business.

Other types of exchange rate risks are translation risk and so-called hidden risk. The
translation risk relates to cases where large multinational companies have subsidiaries in
other countries. On the financial statement of the whole group, the company may have to
translate the assets and liabilities from foreign accounts into the group statement. The
translation will involve foreign exchange exposure. The term hidden risk evolves around
the fact that all companies are subject to exchange rate risks, even if they don't do
business with companies using other currencies. A company that is buying supplies from a
local manufacturer might be affected of fluctuating foreign exchange rates if the local
manufacturer is doing business with overseas companies. If a manufacturer goes out of
business, or experience heavy losses, it will affect all the companies it does business
with. The company might not be able to pay its debts, or fulfill its contracts, and all
the companies it does business with will consequently suffer.



Interest Rate Risk.

Interest can be explained as the "charge paid by a borrower for to lender for the use of a
lender's money (Ritter 2000 p. 598)." The interest rate is simply the percentage of the
sum a borrower has to pay the lender on top of the sum which is being lent for an agreed
period of time. For example, if a company borrows £100,000 from a bank at 8% interest
rate with payment due in 12 months. By the end of the 12 months the company then has to
pay the bank £108,000 (Appendix B, i). What types of interest rate risks do multinational
companies face?

One type of interest rate risks is the transaction risk. Since the interest rates
constantly rise and fall companies often fix their interest rates on loans for long
periods of time. As a result of this the company looses money if the interest rate falls
below their fixed rate during the period the loan is for. For example, in 1998 a company
borrows £2,000,000 for a 5 year period with fixed interest rate of 8% payable annually.
Each year the company then has to pay interest of £160,000. If the interest rate in 2000
falls to 6%, the company is still paying 8% interest, and will consequently "loose"
£40,000 annually.

Other types of interest rate risks are translation risk and economic risk. Translation
risk relates to fact that changes in the interest rates will change the value of financial
assets. If people expect the interest rate to increase, the values of financial assets,
such as bonds and stocks, are likely to decrease. So, stock values are very much
inter-related to the rate of interest. This idea goes hand in hand with the economic risk.
Changes in a country's interest rates affect the whole business environment in that
country. Increased interest rates are likely to make people spend less money, so the
income of companies goes down.



Methods of mitigating exchange rate and interest risk.

A company has lots of options trying to safeguard against interest and exchange rate
risks. The company could do nothing and hope the market evens itself out. Rise of some
country's economy might mean that another country's economy is falling. To avoid being
exposed to exchange rate risk a company might decide to transfer the risk over to its
overseas customer by making the customer pay the exchange rate difference from the date a
deal was being made. The effect of this could be that the company looses its business
partners. However, most companies practice internal hedging to safeguard against exchange
and interest rate risks. A company can buy forwards, which enables a company to freeze the
price at which it buys its currency at the end of the agreed period. For a company buying
from a foreign company, this method will eliminate all exchange risk totally. If a company
has a payment due in two months, it could buy the foreign currency at spot rate straight
away and invest the money until payment due. The company will then be sure to have enough
currency to go through with the payment, plus surplus from the investment. A third method
of hedging is called timing, which means that a company could speed up or delay payments
if they have a hunch on which way the rates are going. This method applies to both
exchange rates and interest rates. Timing is the most risky method of hedging, because
there's no way to predict a future rate with a hundred percent accuracy.

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