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Essay Questions:

1. Why does MNC’s hedge?

The Multinational Corporations are involved in business activities across many

countries resulting in transactions having exposure to the changes in the financial prices.

The fluctuations in the interest rates, exchange rates, equity prices, and commodity prices

affect the reported earnings adversely. Therefore, companies tend to seek for those

transactions whose sensitivity to the movement in financial prices counterbalanced the

sensitivity of their main business to such changes. This making of the transaction’s nature

to lower their sensitivity to the fluctuations in the market is termed as hedging.

Multinational companies adopt hedging to absorb the fluctuations or to dissolve

the changes in the financial prices, which may affect their core business adversely. An

investor would buy a stock of a company to get advantage for the management of that

company, and not from that country’s falling currency. Multinational companies also use

this to improve their competitiveness. Moreover, Multinational companies also adopt this

process in order to reduce their costs of funding and to lower their prices in the markets

that have the potential to be of strategic importance in the future.

The competition also forces Multinational companies to adopt and use hedging. If

some major companies are adopting risk management and are engaged in a

comprehensive hedging process, then its pushes and puts substantial pressure on the other

companies which have not adopted any hedging process to go for it. The main reason is

the difference it creates in the cost of the funding and subsequently the pricing in the
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market among the companies who have and who have not adopted risk management

strategies. (Madura, 2014)

2. Discuss the theories that attempt to explain changes in the foreign exchange price.

How well do these theories hold up in the real world?

Portfolio Balance approach is one of the theories which explains the process of

exchange rate determinations with the argument that the exchange rate is a function of the

relative supplies of foreign and domestic bonds. The theory of international Fisher Effect

suggests that a specific currency exchange rate will decrease as compared to the other

currency provided the its inflation rate and interest rate is higher than the other country’s

currency. However, it is evident that in some periods the Fisher effect does not hold true.

The foreign short-term investments may get to have a higher return then what is

achievable locally. However, there is a risk of the denomination of the currency against

the home currency causing a lower return than the domestic investment in security even

with the showing of high interest rate.

The absolute form of purchasing power parity is the theory, which shows and

explains the way inflation differentials affect the exchange rates. According to this

theory, the prices of any two products in different countries should be equal if measured

in same currency. The Interest Rate Parity Theory suggests that the forward rate

(premium or discount) is equal to the difference in the interest rate between the two

concerned currencies.

The purchasing power parity is another theory, which suggests that the exchange

rate will adjust according to the time to reflect the difference in the inflation rates of the
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two countries, making the purchasing power of the consumers same for the domestic as

well as foreign goods. The relative form of the Purchasing power parity theory suggests

that the rate of price changes of the products should be to some extent similar, provided

the costs of transportations and the trade barriers are not different. However, Purchasing

Power Parity is used and considered as a valuable concept, in the real world there is

sufficient evidence of significant deviation from the theory. (Madura, 2014, pp. 242-261)

3. Which exchange rate forecast technique should the MNCs use?

Multinational corporations requires forecasting for exchange rates in order to

make decisions for hedging receivables, payables, capital budgeting, short and long term

financing and investments. The most used forecasting techniques are the technical

forecasting method, fundamental forecasting method, the market based forecasting

method, and mixed forecasting model. Each model of forecasting has its own criteria and

limitations and results in different forecasts based on its different forecasting criteria.

Moreover, it also depends upon the nature of the business and the market for choosing the

most favorable forecasting method. The accuracy of the results of these forecasting

models is limited because of the constantly changing exchange rates.

These methods of forecasting can be evaluated by comparing the results of these

forecasts with the actual values of currencies. To have a fair and meaningful result, these

comparisons should be conducted in different periods. Accuracy and bias are the two

criteria, which can be used to evaluate the performance of the forecasting methods.

As it is nearly impossible to forecast future exchange rates in these constantly

changing markets with perfect accuracy, Multinational Corporations can use a specified
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interval around their estimate point forecast for better results. The interval around the

point estimate can be created from the current exchange rate volatility, the implied

figures of the standard deviation of the currency option prices, or the past time series of

volatility. This can be a better method to use for the forecasting of the exchange rates for

the Multinational corporations. Moreover, it also depends upon the nature of the business

and the market for choosing the most favorable forecasting method. (Madura, 2014, pp.

271-302)

References:

Madura, J. (2014). International Financial Management. Cengage Learning.