Foreign Exchange Risk Management In Multinational

Corporations Finance Essay

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23 Mar 2015

Corporations (MNCs)

Introduction:
Globalisation has had economic, cultural, technological and political effects. Over the
last few decades the increase in globalisation has led to rapid growth in several
industries around the world and it has also had a strong influence on the flexibility of
firms. Hundreds of new MNCs have emerged globally due to the liberalisation of trade
and capital markets. MNCs are not limited to the big firms with huge investments like
Coca Cola, Nike and Shell, due to advances in technology and liberal markets many
small firms operate internationally to maximise their profits. This growth has
highlighted the various risks faced by MNCs operating in different countries. One such
risk is the financial risk involved with the foreign currency exchange markets. Most of
the time MNCs deal in more than one national currency and hence the changes in the
foreign exchange rates can have an adverse effect on the firms' profits. This paper
discusses the various foreign exchange risks faced by multinationals around the globe
and the necessary steps taken to manage these risks. A study on the Malaysian MNCs
has also been covered in the paper.

Foreign Exchange Risks:

Foreign Exchange risks also known as exposures can be termed as an agreed, projected
or contingent cash flow whose scale is not certain at the moment. The magnitude
depends on the value of the changes in the foreign exchange rates which in turn
depends on various variables such as the interest rate parity, purchasing power parity,
speculations and government policies on exchange rates.

According to G.Shoup (1998), a company has exposure if there is a currency mismatch

in some aspect of the business such that a shift in foreign exchange rates, nominal or
real, affect its performance either positively or negatively. These exposures may be
classified into three different categories:

Translation exposure

Transaction exposure
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Economic exposure

Translation Exposure; this is the net asset/liability exposure in the home currency of
the MNC. In other words, it is the profit gained or loss incurred in translating foreign
currency financial statements of foreign subsidiaries of the MNC into a single currency
which it uses in its final reports (Yazid & Muda, 2006). In essence, translation risk can
be defined as the effect of exchange rates on the figures shown on the parent company's
consolidated balance sheet. Although this exposure does not affect the shareholder's
equity, it does influence the investors due to the changing values of the assets or
liabilities. (Shoup, 1998)

Transaction Exposure; it is a risk associated with a transaction that has already been
contracted. It is as a result of unexpected changes in foreign exchange rates affecting
future cash flows which the MNC has already committed itself to. Usually MNCs enter
an international contractual obligation, the payment or receipt of which is expected on a
future date, hence any change in the foreign exchange rate during that period will
expose the MNC to transaction risks. Transaction risks can be easily identified and thus
get more attention from the financial managers. (Eiteman, Stonehill, & Moffett, 2007)

Economic Exposure; this is the most complex risk as it not only involves the known cash
flows but also future unknown cash flows, hence also termed as a hidden risk. It is a
comprehensive measure of a company's foreign exchange exposure and therefore
sometimes termed as a combination of translation and transaction exposure.
Identifying economic risks involves measuring the change in the present value of the
company resulting from any changes in the future operating cash flows of the firm
caused either by adverse or desirable change in the exchange rate. (Eiteman, Stonehill,
& Moffett, 2007). As Dhanani (2000) noted, economic risk can be viewed as the
consequence of long-term exchange rate fluctuations on a firm's predicted cash flows
and as the cash flows linked to the risk are not certain to materialize, the risk is hard to
identify. Economic exposure to a MNC may last for a long duration making it difficult to
be quantified and hence limiting the use of possible management techniques. (Shoup,
1998)

Foreign Exchange Risk Management

Foreign exchange risk management is a process which involves identifying areas in the
operations of the MNC which may be subject to foreign exchange exposure, studying
and analysing the exposure and finally selecting the most appropriate technique to
eliminate the affects of these exposures to the final performance of the company.
(Shoup, 1998)

Risks involving short term transactions can be dealt with using financial instruments
but long term risks often require changes in the operations of the company. As in the
case of translation exposure the MNC can have an equal amount of exposed foreign

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currency assets and liabilities. By doing so the company will be able to offset any gain or
loss it may have due to changes in the exchange rates of that currency, also known as
balance sheet hedging. (Eiteman, Stonehill, & Moffett, 2007)

In dealing with economic exposures efficiently, a MNC may have to diversify either its
finance or its operations. It can diversify its operations by either moving to locations
where the cost of production is low, or having a flexible supplier policy, or changing the
target market for its products and the types of products it deals in. As it can be
illustrated from the 1994 example of Toyota, when a strong Yen made Japanese exports
to US more expensive, it decided to shift its production from Japan to US, where it
achieved comparatively lower costs of production, enabling it to compete in the US car
market. (Eun & Resnick, 2007)

The management of transaction exposures may either involve hedging using special
techniques or applying pro-active policies. The pro-active policies commonly used
include (Eiteman, Stonehill, & Moffett, 2007):

Matching currency cash flow

Risk sharing agreements

Back to back loans

Currency swaps

Lead and Lag payments

Use of re-invoicing centres

Hedging is the act of protecting a pre-existing position in the spot market by trading in
derivative securities; that is guarding of existing assets from future losses. According to
Eiteman et al (2007), hedging is the taking of a position, acquiring a cash flow, an asset
or a contract that will rise or fall in value and hence offset a fall or rise in value of an
existing position. Several studies on this issue have emphasized that MNCs have a
higher probability of facing exchange rate volatility in their operations as they expand
their involvement throughout the world. Therefore, the extensive use of various
hedging techniques by most companies has been widely recognized to ensure the
company's overall interests, cash flows and equity are safeguarded. Some of the most
commonly used hedging techniques include:

Forward market hedge

Money market hedge

Options market hedge

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Forward market hedge; this is the case where the MNC in the forward contract has a
legal obligation to buy or sell a given amount of foreign currency at a specific future date
which is known as the contract maturity date at a price agreed upon at present. (Nitzche
& Cuthbertson, 2001)

Money market hedge; under this hedging technique, the transaction exposure can be
hedged by lending and borrowing in the local and foreign markets. For instance a MNC
may borrow in a foreign currency to hedge the amount it expects to receive in that
currency at a later date and similarly it could lend to hedge payables in a foreign
currency. By doing so, the MNC will be matching its assets and liabilities in the same
currency. (Eun & Resnick, 2007)

Options market hedge; this is a technique used by a MNC which gives it the right but not
the obligation to buy or sell a specific amount of foreign currency at a specific price, by
or on a specific date. Although not a widely used tool, it can be useful when a MNC is
uncertain about the future receipt or payments of foreign currency. (Nitzche &
Cuthbertson, 2001)

Hedging helps in reducing the risks involved in international transactions and also
improves planning capability. By hedging a MNC can ensure its cash flow does not fall
below a necessary minimum, particularly in cases where there is a tendency of a
company to run out of cash for necessary investments (Eiteman, Stonehill, & Moffett,
2007). A very good example would be that of Merck, a pharmaceutical company.
Kearney and Lewent (1993) identified that Merck was one of the pioneers to have used
hedging to ensure that its key investment plans could always be financed, which in their
case was the research and development aspect of their business. Mathur (1982) came to
the conclusion that, to decrease the negative outcomes caused by fluctuations of foreign
exchange rate on earnings and cash flows, most companies employ a hedging program.
He also noted that a formal foreign exchange management policy is more common
among larger firms. According to Bartov et al (1996), if MNCs do not institute a hedging
program, they are more likely to be exposed to risks which may result in substantial
losses.

Despite its advantages, hedging does not increase the company's expected cash flows, on
the other hand it uses up the company resources in the process (Eiteman, Stonehill, &
Moffett, 2007). According to G.Shoup (1998), unless there are clear defined objectives,
safeguards in place and clear communication at every level of management, a hedging
program may turn into a disaster. As the chairman of Zenith Electronic Corporations,
Jerry K Pearlman once said, "It is a, damned if you do and damned if you don't
situation." (Shoup, 1998, p15.)

In 1984, Lufthansa a German airline company placed a major purchase order for
airlines from an American firm. The financial managers at Lufthansa had forecasted a
stronger dollar in the days to come and therefore locked up the German Duetsche mark
against the American dollar. Due to an unfavourable effect, a weak dollar, in one year
Lufthansa lost around US$150 million and half of the financial managers' team lost
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their jobs (Shoup, 1998). In another instance, two years later in 1986, the chairman of
Porche found himself unemployed as he had engineered the company into a dependence
on the US market for 61% of its revenue without hedging against a downturn in US$, as
a result forcing Porche to suffer major financial losses. (Shoup, 1998)

According to a study by Marshall (2000), the trend in the objectives of managing

foreign exchange risks was quite similar between the UK and US multinationals who
gave significant importance to certainty of cash flow as well as minimising fluctuations
in earnings. On the other hand, a higher number of Asian multinationals managed these
risks to minimise fluctuations in their earnings. The trend observed is summarised in
Figure 1 below.

Figure 1: "Foreign exchange risk management in UK, USA and Asia Pacific
multinational companies" by Andrew P Marshall, Journal of Multinational Financial
Management, 2000.

Belk and Glaum (1990) undertook a study which involved investigating several UK
MNCs. The study revealed that although majority of the companies considered
translation exposure to be important, not all were prepared to hedge this risk actively.
On the other hand transaction exposure was given most importance in the management
of foreign exchange risks. The level of hedging the transaction exposure varied between
the companies investigated, some hedged totally while others did so partially. The study
also seemed to show that the size if the MNC influenced its involvement in foreign
exchange risk management, the larger the company the higher the propensity.

In another study carried out by Makar and Huffmann (1997), it was found that there is
a linear relationship between the amount of foreign exchange derivatives employed and
the degree of foreign currency exposure in US MNCs.

Foreign Exchange Risk Management in Malaysian Multinational

Corporations (MNCs)
During the financial crisis of 1997, most Malaysian MNCs suffered foreign exchange
losses due to currency fluctuations, thus leading to the increased involvement of
Malaysian MNCs in foreign exchange risk management (Yazid & Muda, 2006). It can be
seen that before the financial crisis fewer MNCs considered hedging their foreign
exchange risks to be vital, as the General Manager of the Malaysian Monetary Exchange
Bhd indicated that local MNCs were very passive and reactive in managing their
financial risks (New Strait Times, 30 May 1998: 11). A similar statement was given by
the then Minister for International Trade and Industry, Rafidah Aziz, which implied
that MNCs should manage their foreign exchange risks well (New Strait Times, 3 July
1998). A very good example of the losses suffered would be that by Malaysian Airline
System (MAS), MAS lost around M$400 million in the first half of 1998 because of its
foreign debt of about M$3.16 billion. Yazid and Muda (2006) studied 90 out of the then
113 MNCs listed under the Bursa Malaysia. The main objectives cited by MNCs in this
study relating to the foreign exchange risk management were to minimise the following;
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Losses on operational cash flow

Cash flow fluctuations

Losses on consolidated balance sheet

Losses on shareholders' equity

Business uncertainty

Foreign exchange risk to a comfortable level

According to Yazid and Muda (2006), Malaysian MNCs became very proactive in
managing their foreign exchange risks during the financial crisis and once the crisis was
over, the priority attributed to foreign exchange risk management decreased slightly but
not to the point it was before the crisis. This has been illustrated as a summarised result
of the survey shown in table 1.

Objectives

Before

During

Current
Minimise Losses on operational cash flow

Minimise Cash flow fluctuations

Minimise Losses on consolidated balance sheet

Minimise Losses on shareholders' equity

Minimise Business uncertainty

Minimise Foreign exchange risk to a comfortable level

Table 1 (Yazid and Muda, 2006)

Note: The results are based on five-point progressive Likert scale (1 is the least
important; 5 is the most important)

Large MNCs in Malaysia are more likely to get involved in foreign exchange risk
management compared to smaller firms or firms with relatively lesser operations
outside Malaysia. This trend seems to be consistent with other MNCs around the globe
(Yazid et al, 2008). Majority of the Malaysian MNCs centralise their foreign exchange
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risk management and it can be said that foreign exchange risk management in Malaysia
is still at its 'infant stage' in comparison to other MNCs in the west. Their management
practices are very informal and no proper documented policies can be found in regard
to foreign exchange risks. Although the use of hedging tools is on a steady rise amongst
the Malaysian MNCs, the objectives behind their involvement remain uncertain (Yazid
and Muda, 2006).

The past decade has seen rapid growth of a new segment in the global finance industry,
the Islamic finance sector. To qualify for Islamic foreign exchange hedging, transactions
must involve tangible assets. Malaysia, which is pre-dominantly an islamic country has
highlighted the need of hedging tools which are compliant with Islam. Hence CIMB, a
leading Malaysian bank among others, have introduced an 'Islamic foreign exchange
hedging instrument', which would assist their clients to manage their risks. (Reuters,
2008)

Astro, which is a leading services provider in the Asian entertainment indutry is based
in Malaysia. Being a MNC, foreign transactions are dealt in different foreign currencies
other than the Malaysian Ringgit. Consequently, there is an exposure to foreign
currency exchange risk. Astro uses foreign currency derivatives such as forward
contracts and interest rate swap contracts to hedge currency exchange risks. Forward
contracts are commonly used to limit exposure to currency fluctuations on foreign
currency receivables and payables as well as on cash flows generated from anticipated
transactions denominated in foreign currencies. In 2007 Astro made a loss of RM
137,000 due to foreign exchange fluctuations and henceforth decided to emphasize the
use of hedging techniques. This can be proven by Astro's estimated principal amounts
of outstanding forward contracts which as at 31st January 2009 was RM188,083,636,
whereas at the same time a year before it was at RM 5,109,000. The emphasis on risk
management resulted in a substantial gain of RM 7,680,000 for Astro in the year ended
2008. In addition, as Ringgit Malaysia is Astro's functional currency; all the financial
statements have to be consolidated into this currency. Hence Astro is exposed to
translation risk due to the fluctuating exchange rates. According to Table 2.0, the
significance of the foreign currency risk management is noticeable as Astro experienced
a huge gain in 2008 relative to the loss they suffered in 2007.

Table 2.0: ASTRO; Result of Foreign Exchange Risk Management

Cash Flow due to Operating Activities

RM'000

RM '000

Net Effect of Currency Translation on Cash and Cash Equivalents

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Gain on Realisation of Foreign Forward Contracts

However, hedging of foreign exchange does not always yield a positive result, as
illustrated in the case of AirAsia, one of the leading budget airlines in Asia. AirAsia like
many international airlines used a technique refered to as fuel hedging, this allows the
airline to purchase fuel at a price fixed at an earlier date despite an increase in the fuel
price. During the fuel crisis of 2007-2008 when prices rose to over US$150/barrel,
AirAsia made a significant loss as it had hedged for fuel prices not to exceed
US$90/barrel and as a result AirAsia recorded its first ever full year loss of RM471.7
million for the year ended 31st December 2008, despite achieving a growth of 36.6% in
revenue. This led to the removal of all hedges on fuel prices and AirAisa declared itself
as 'completely unghedged'. Although AirAsia intends to re-introduce fuel hedging in
2011, for now it deals in spot prices for its fuel. (Leong, 2009) (Ooi, 2008)

Conclusion
Multinationals are exposed to various kinds of risks, which includes the foreign
exchange risk. This risk which is as a result of exchange rate volatility is said to have a
pervasive impact on the profitability and certainty of a MNC. Globally, multinationals
face translation, transaction and economic risks due to the frenzied system of floating
exchange rates. To avoid the adverse effects of these risks, multinationals often take
measures which although do not entirely eliminate the losses; they do enable the firms
to minimize the losses. Hedging is very common risk management tool used by
multinationals and has often resulted in positive results when used after a correct
analysis of the exposure is made. Despite its advantages, not all multinationals around
the globe decide to manage their risks in this way. The objectives behind foreign
exchange risk management and the techniques used to manage are seen to differ across
regions.

In the case of Malaysian multinationals, foreign exchange risk management is deemed

to be at a lower level relative to their counterparts globally. Until recently, majority of
the Malaysian multinationals were not actively managing these risks. The Asian
financial crisis in the late 1990's had a significant effect on their stance and the level of
foreign exchange risk management amongst Malaysian multinationals has since
increased considerably.

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