A PROJECT REPORT ON

RISK MANAGEMENT IN A MULTINATIONAL CORPORATION

As part fulfilment of PGDBM 2002-2004

 EXECUTIVE SUMMARY

MNCs are coming up in huge number nowadays. To earn the profits with minimal
amount of risk has been a matter of concern for the investors. For this purpose
management of risk is a very crucial factor.

Pertaining to this context, this project has been undertaken with an objective to
study the risk management strategies that can be used by MNCs.
The various risks faced by the MNCs have been mentioned and the ways to
manage them have been depicted in the project.

Exchange Rate Risk is one of the Major risks faced by MNCs. A Case Study on
MNC named LTCM has been included in the project to understand what kind of
problems and tensions exist and faced by the company on change in the
exchange rates. Very important to learn from it is the way in which LTCM came
back to a stable and comfortable position
 INDEX

PARTICULARS Page Nos

INTRODUCTION 2
THE CONCEPT OF RSIK 6
MANAGING TRANSLATION EXPOSURE 15
FOREIGN EXCHANGE RISK AND ECONOMIC EXPOSURE 23
ECONOMIC CONSEQUENCES OF EXCHANGE RATE CHANGES 27
FINANCIAL MANAGEMENT OF EXCHANGE RISK 30
CASE STUDY ON MNC--LTCM 31
BIBLIOGRAPHY 39
 INTRODUCTION

What is a Multinational Corporation?

A Multinational Corporation is a large business organization whose operations extend across

international boundaries.

Why a Multinational Corporation?

Ownership Specific Advantages are

Brand names, patents, copyrights, proprietary technology or technological processes, and
marketing and management expertise. Ownership-specific advantages can lead to sustainable
competitive advantages.

Location Specific Advantages

Location-specific advantages include location-specific natural resources, manmade resources,
low taxes; low wage costs, high labor productivity, or state supported monopolies Location-
specific advantages can lead to sustainable competitive advantages.

Market Internalization Advantages

Ownership-specific and location-specific advantages by themselves are not sufficient to ensure
the success of the multinational corporation over local firms. Market internalization (I) advantages
accrue to the multinational corporation as it exploits its ownership- specific advantages in local
and international markets.

The Life Cycle of a Multinational Corporation

Infancy: developing ownership-specific advantages

Growth: seeking new markets
Maturity: milking the cash cow defensive strategies to preserve revenues defensive strategies to
reduce operating costs financial considerations
Decline? Or Renewal?

Foreign Market Entry

• Export entry
Agents/distributors (foreign or domestic) foreign sales branches and subsidiaries
 • Contract-based entry
Licensing and franchising
• Investment-based entry
Foreign direct investments
• Cross-border mergers and acquisitions
Joint ventures
Exporting Through Agents and Distributors:
Advantages
• quick and easy
• low resource commitment
• low cultural costs and risks
• control over production
Disadvantages
• relatively low sales potential
• must overcome quotas and tariffs
• high political risk
• no control over market & distribution channels

Exporting Through Foreign Branches and Subsidiaries

Advantages
• higher sales potential than agent/distributor
• retains control over production
• achieves control over marketing & distribution
Disadvantages
• higher resource commitment
• slower entry than agent/distributor
• still must overcome quotas and tariffs
• high political risk
• higher cultural costs and risks than agent/distributor
Contract Based Entry
Advantages
• quick and easy
• low resource commitment
• low cultural costs and risks
• avoids import and investment barriers
Disadvantages
 • limited fees/royalties on license agreements
• loss of control over production technology
• potential creation of competitors
Investment Based Entry
Advantages
» high sales potential
» potential for lower costs
» diversifies manufacturing base and matches foreign currency costs to revenues
» avoids import quotas and tariffs
Disadvantages
• high resource commitment
• high exit costs
• must overcome cultural differences
• must overcome investment barriers

Foreign direct investment

» relatively slow entry initially but doing very well now
» maintains control over production, distribution, and intellectual property
Cross-border mergers and acquisitions
» relatively rapid entry
» price of entry (acquisition premium) can be high
Cross-border joint ventures
» may avoid investment restrictions
» less exposure to political/cultural risks
» risk losing control of intellectual properties
» risk creating a competitor
 THE CONCEPT OF RISK

What is Risk?

Risk refers to exposure & exposure means the degree to which the company is affected to any
change in conditions.
Accounting Exposure arises from the need, for the purposes of reporting & consolidation, to
convert the financial statements of the foreign operations from the local currencies involved to the
home currency. If the exchange rates have changed since the previous reporting period, this
translation, or restatement, of those assets, liabilities, revenues, expenses, gains, and losses
that are denominated in foreign currency will result in foreign exchange gains or losses. The
possible extent of these gains or losses is measured by the translation exposure figures.

TRANSLATION EXPOSURE:

Alternative Currency Translation Methods:

Companies with international operations will have foreign currency denominated assets and
liabilities, revenues and, expenses. However, because home country investors are interested in
the home currency values, the foreign currency balance sheet accounts and income statement
must be assigned HC figures. Financial statements of an MNC’s overseas subsidiaries must be
translated from local currency to home currency prior to consolidation with parent’s financial
statement.

If currency values change, foreign exchange translation gains or losses result. Translation
Exposure is simply the difference between exposed assets and exposed liabilities. Such gains or
losses are of accounting nature, i.e no cash flows are necessarily involved.

Current/Noncurrent Method:

With this method all the foreign subsidiary’s current assets and liabilities are translated into home
currency at the Current Exchange Rate. Each Noncurrent asset or liability is translated at its
Historical Exchange Rate, i.e. at the rate in effect at the time the asset was acquired or the
liability incurred.
The income statement is translated at the Average Exchange Rate for the period, except for
those revenues and expense items associated with the Noncurrent assets or liabilities. Items
such as depreciation expense are translated at the same rate as the corresponding balance
sheet items.

Monetary/ Non Monetary Method:

The monetary/non monetary method differentiates between monetary assets and liabilities and
non monetary or physical assets and liabilities. Monetary items are translated at the current
rate and non monetary items are translated at historical rates.

Income statements are translated at the average exchange rate during the period except for
revenue and expense items related to non monetary assets and liabilities. The latter, primarily
depreciation expense and cost of goods sold, are translated at same rate as the corresponding
balance sheet items. As a result the cost of goods sold may be translated at a rate different from
that used to translate sales.

Temporal Method:

Under the Temporal Method, inventory is normally translated at the Historical Rate, but it can be
translated at current rate if the inventory is shown on the balance sheet at the market value. The
choice of exchange rate translation is based on the type of asset or liability in the monetary/non
monetary method; in the temporal method, it is based on the underlying approach to evaluating
cost.

Income statement items are normally translated at an average rate for the reporting period.
However, cost of goods sold and depreciation and amortization charges related to balance sheet
items carried at the past prices are translated at historical rate.

Current Rate Method:

The current rate method is the simplest; all balance sheet and income items are translated at
current rate. Under this method, if a firm’s foreign currencies denominated assets exceed its
foreign currency denominated liabilities, devaluation must result in a loss and revaluation must
result in a gain.

TRANSACTION EXPOSURE:
Companies often include transaction exposure as part of their accounting exposure. Transaction
Exposure stems from the possibility of incurring foreign exchange gains or losses on
transactions already entered into and denominated in a foreign currency.

A company’s transaction exposure is measured currency by currency and equals the difference
between contractually fixed future cash flows and outflows in each currency. Some of these
unsettled transactions, including foreign currency denominated debt and accounts receivable, are
already listed on the firm’s balance sheet. But other obligations, such as contracts for future sales
or purchases are not.

MANAGING TRANSACTION EXPOSURE:

A transaction exposure arises whenever a company is committed to a foreign currency

denominated transaction. Since the transaction will result in a future foreign currency cash inflow
or outflow, any change in the exchange rate between the time the transaction is entered into and
the time settled in the cash will result in cash will lead to change in rupee amount of the cash
inflow or outflow. Protective measures to guard against transaction exposure involve entering into
foreign currency transactions whose cash flows exactly offset the cash flows of the transaction
exposure.

These protective measures include using forward contracts, price adjustment clauses, currency
options, and borrowing or lending in the foreign currency.

Techniques for managing Transaction Exposure

1. Forward Market Hedge:

In a Forward Market Hedge, a company that is long on a foreign currency will sell the
foreign currency forward, whereas a company that is short on a foreign currency will buy
the currency forward. In this way the company can fix the rupee value of the future
currency cash flows.
 The true cost of hedging:

The true cost of hedging of a transaction can’t be calculated in advance as it depends on

the future spot rate, which is unknown at the time the forward contract has been entered
into. The traditional method of calculating the cost of a forward contract is however not
the right method as it does not measure the opportunity cost. Specifically the cost of a
forward contract is usually measured as its forward discount or premium.

Infact, in an efficient market, the expected cost of a forward contract must be zero.
Otherwise, there would be an arbitrage opportunity.

2. Money Market Hedge:

An alternative to a forward market hedge is to use the Money Market Hedge. A money
market hedge involves simultaneous borrowing and lending activities in two different
currencies to lock in the rupee value of a future currency cash flow.

3. Risk Shifting:

A company can avoid its transaction exposure altogether if the other company allows its
price of the sale to be in the home currency. This practice does not however eliminate the
risk; it simply shifts the risk from the seller to the buyer. Despite the fact that this form of
risk shifting is a zero sum game, it is common in international business. Firms typically
attempt to invoice the exports in strong currencies and imports in weak currencies.

Is it possible to gain from Risk Shifting? Not if one is dealing with informed customers or
suppliers.
Eg Consider a GE- Lufthansa deal. If Lufthansa is willing to be invoiced in dollar (Home
currency for GE) for the turbine blades, this must be because Lufthansa calculates that
its Euro equivalent cost will be no higher than what it had originally agreed to pay.

4. Pricing Decisions
 The top management sometimes fails to take anticipated rate changes into account when
making operating decisions, leaving financial management with the essentially impossible
task, through purely financial operations of recovering a loss already incurred at the time
of the initial transaction.

For eg. If GE priced Lufthansa’s order of turbine blades at $10 million and then, because
Lufthansa demands to be quoted a price in Deutsche Marks, converts the dollar price to
Deutsche Mark quote of DM 25 million, using the spot rate of DM 1 = $ 0.40.

In reality the quote is worth only $9.57 million even though it is booked at $ 10 million
because that is the risk free price that GE can guarantee for itself by using the forward
market. If the GE management wanted to sell the blades for $ 10 million, it should have
set a DM price of 1000000/ 0.3828 = DM 26.12 million. Thus GE lost $ 430,000 the
moment it signed the contract. This loss is not an exchange loss; it is a loss due to
management inactiveness.

The general rule on credit sales overseas is to convert between the foreign currency
price and the home currency price by using the forward rate not the spot rate. If the home
currency price is high enough, the exporter should follow through with the sale.

In the case of a sequence of payments to be received at several points in time, the

foreign currency price should be a weighted average of the forward rates for delivery on
those dates.

5. Exposure Netting:

Exposure netting involves offsetting exposure in one currency with exposures in the
same or another currency, where exchange rates are expected to move in such a way
that losses on the first exposed position should be offset by gains on the second currency
exposure. This portfolio approach to hedging recognises that the total variability or risk of
a currency exposure portfolio should be less than the sum of the individual variability’s of
each currency exposure considered in isolation. The assumption underlying exposure
netting is that the net gain or loss on the entire currency exposure portfolio is what
matters, rather than the gain or loss of any individual monetary unit.
 In practice exposure netting involves one of the three facilities:

• A firm can offset a long position in a currency with the same position in that same
currency.
• If the exchange rate movements of the two currencies are positively correlated,
then the firm can offset a long position in one currency with a short position in the
other.
• If the currency movements are negatively correlated, then the short or long
positions can be used to offset each other.

6. Currency Risk Sharing:

Currency risk sharing can be implemented by developing a customized hedge contract

imbedded in the underlying trade transaction. This hedge contract typically takes the form
of a price adjustment clause, whereby a base price is adjusted to reflect certain exchange
rate changes. For eg. The price can be set at any amount, but both the parties should
share the currency risk below a neutral zone. The neutral zone represents the currency
range in which the risk is not shared.

7. Foreign Currency Options:

In many circumstances a firm is uncertain whether the hedged foreign currency inflow or
outflow will materialize. This uncertainty has important consequences for the appropriate
hedging strategy.

Taking the above example, GE would like to guarantee that the exchange rate does not
move against it between the time it bids and the time it gets paid, should it win the
contract. The danger of not hedging is that its bid will be selected and the Deutschemark
will decline in value, possibly wiping out GE’s anticipated profit margin. For Eg. If the
forward rate on April 1st for delivery December 31st falls to DM 1 = $0.36, the value from
the contract will drop from $9.57 million to $9 million, for a loss of $ 570,000.

The apparent solution for GE is to sell the anticipated DM 25 million receivable forward
on January 1st. However, if GE does that and loses the bid on the contract, it can cancel
the forward contract.
 Until recently, GE or any company that bid on a foreign contract in a foreign currency was
not assured of success would be unable to resolve its foreign exchange risk dilemma.
The advent of Currency Options has changed all that. Specifically, the solution to
managing its currency risk in this case is for GE, at the time of its bid, to purchase an
option to sell DM 25 million on December 31st. Suppose, that on January 1st, GE can buy
for $100,000 the right to sell Citibank DM 25 million on December 31st at a price of Rs
0.3828 per Deutschemark. If it enters into this option contract with Citibank, GE will
guarantee itself a minimum price ($9.57 million) should its bid be selected, while
simultaneously ensuring that if it lost the bid, its loss would be limited to the price paid for
the option contract (the premium of $100,000). Should the spot price of the DM on
December 31st exceed $0.3828, GE would let its option contract expire unexercised and
convert the DM 25 million at the prevailing spot rate.

There are two types of options available to manage exchange risk. A put option, such as
the one which is appropriate to GE situation, gives the buyer the right, but not the
obligation, to sell a specified number of foreign currency units to the option seller at the
fixed rupee price, up to the option’s expiration date. Alternatively, a call option is the right,
but not the obligation, to buy the foreign currency at a specified rupee price up to the
expiration date.

A call option is valuable, for example, when a firm has offered to buy a foreign
asset, such as another firm, a t a fixed foreign currency price, but is uncertain
whether its bid will be accepted. By buying a call option on the foreign currency,
the firm can lock in a maximum rupee price for its tender offer, while limiting its
downside risk to the call premium in case the bid is rejected.

Currency options are valuable risk management tools in other situations as well.
Conventional transaction exposure management says you wait until your sales are
booked or your orders placed before hedging. But, if a company does that, it faces
potential losses from exchange rate movements because the foreign currency price
doesn’t necessarily adjust right away to changes in the value of the rupee. As a matter of
policy, to avoid confusing customers and sales people, most companies don’t change
their price list every time the exchange rate changes. Unless and until the foreign
currency price changes, the unhedged company may suffer a decrease in its profit
margin. Because of the uncertainty of anticipated sales or purchases, however, forward
contracts are an imperfect tool to hedge the exposure.
.

MANAGING TRANSLATION EXPOSURE

Firms have three available methods for managing their translation exposure:

• Adjusting fund flows

• Entering into forward contracts
• Exposure netting
The basic hedging strategy for reducing translation exposure uses these methods.
Essentially, the strategy involves increasing hard cash (likely to appreciate) assets and
decreasing soft currency (likely to depreciate) assets, while decreasing hard currency
liabilities and increasing the soft currency liabilities. For example, if devaluation appears
likely, the basic hedging strategy would be executed as follows: borrowing, delay
accounts payable, and sell the weak currency forward.
Despite their prevalence among firms, however, these hedging activities are not
automatically valuable. If the market already recognizes the likelihood of currency
appreciation or depreciation, this recognition will be reflected in the costs of the various
hedging techniques. Only if the firm’s anticipations differ from the market’s and are also
superior to the markets then can hedging lead to reduced costs? Otherwise, the principle
value of hedging would be to protect a firm from unforeseen currency fluctuations.

Funds adjustment:

Most techniques for hedging impending local currency devaluation reduce local currency
assets or increase local currency liabilities, thereby generating local currency cash. If
accounting exposure is to be reduced, these funds must be converted into hard currency
assets. For example, a company will reduce its translation loss if before local currency
devaluation it converts some of its local currency cash holdings to the home currency.
This conversion can be accomplished, either directly or indirectly, by means of various
fund adjustment techniques.
Funds adjustment involves altering either the amounts or the currencies or both of the
planned cash flows of the parent and/or its subsidiaries to reduce the firm’s local currency
accounting exposure. If an local currency devaluation is anticipated, direct funds
adjustment methods include pricing exports in hard currencies and imports in the local
 currency, investing in hard currency securities, and replacing hard currency borrowings
with local currency loans. The indirect methods include, adjusting transfer prices on sale
of goods between affiliates; speeding up the payment of dividends, fees, and royalties;
and adjusting the leads and lags of intersubsidiary accounts. The latter method, which is
one of the most frequently used by multinationals, involves speeding up the payment of
intersubsidiary accounts payable and delaying the collections of intersubsidiary accounts
receivable. These hedging procedures for devaluations would be reversed for
revaluations.

Depreciation Appreciation

Sell the local currency forward Buy the local currency forward
Reduce levels of local currency cash and Increase levels of local currency cash and
marketable securities marketable securities.
Tighten credit(reduce local currency receivables) Relax local currency credit terms
Delay collection of hard currency receivables Speed up collection of soft currency receivables
Increase imports of hard currency goods Reduce imports of soft currency goods
Borrow locally Reduce local borrowing
Delay payment of accounts payable Speed up payment of accounts payable
Speed up dividend and fee remittances to parent Delay dividend and fee remittances to parent and
and other subsidiaries other subsidiaries.
Some of these techniques or tools may require considerable lead time and as is the case
with transfer price once they are introduced, they cannot be easily changed. In addition,
such as transfer price, fee and royalty, and dividend flow adjustments fall into the realm
of corporate policy and are not usually under the treasurer’s control. It is, therefore,
incumbent on the treasurer to educate other decision makers about the impact of these
tools on the costs and management of corporate exposure.

Although entering forward contracts is the most popular coverage technique, leading and
lagging of payables and receivables is almost as important. For those countries in which
a formal market in local currency forward contracts does not exist, leading and lagging
and local currency borrowing are the most important techniques. The bulk of international
business, however, is conducted in those few currencies for which forward markets do
exist.

Evaluating alternative hedging mechanisms:

Ordinarily, the selection of funds adjustment strategy cannot proceed by evaluating each
possible technique separately without risking sub optimization; for example, whether or
not a firm chooses to borrow locally is not independent of its decision to use or not to use
those funds to import hard currency inventory. However, where the level of forward
contracts that the financial manager can enter into is unrestricted, the following two stage
methodology allows the optimal level of forward transactions to be determined apart from
the selection of what funds adjustment techniques to use. Moreover, this methodology is
valid regardless of the manager’s attitude toward risk.

• Compute the profit associated with each funds adjustment technique on a covered
after tax basis. Transactions that are profitable on a covered basis ought to be
undertaken regardless of whether they increase or decrease the firm’s accounting
exposure. However, such activities should not be termed as hedging; rather they
involve the use of arbitrage to exploit market distortions.
• Any unwanted exposure resulting from the above stage can be corrected in the
forward market. This is the stage of selection of an optimal level of forward
transactions based on a firm’s initial exposure, adjusted for the impact on exposure of
the decisions made in the above stage. Where the forward market is non existent, or
where the access to it is limited, the firm must determine both what techniques to use
and what their appropriate levels are. In the latter case, a comparison of the net costs
of funds adjustment technique with the anticipated currency depreciation will indicate
whether or not the hedging transaction is profitable on an expected value basis.

Designing a hedging strategy:

Management’s objectives will largely determine its decision about the specific hedging
techniques and strategy to pursue. These objectives, in turn should reflect management’s
view of the world, particularly its beliefs about how the markets work. The quality or value
to the shareholders, of a particular hedging strategy is, therefore related to the
congruence between those perceptions and realities of the business environment.

Here we assume that the basic purpose of hedging is to reduce exchange risk, where
exchange risk is that element of cash flow variability that is due to currency fluctuations.
Underlying the selection of a definition of exchange risk based on market value is the
assumption that management’s primary objective is to maximise the value of the firm.
Hence, the focus id on cash flow effects of the currency changes.

In operational terms, hedging to reduce the variance of cash flows translates into the
following exchange management goal:
 To arrange the firm’s financial affairs in such a way that however the exchange rate may
move in the future, the effects on home currency returns are minimized.
This objective is not universally subscribed to, however, instead many firms follow a
selective hedging policy designed to protect against anticipated currency movements.
But, if financial markets are efficient, firms cannot hedge against expected exchange rate
changes. Interest rates, forward rates, and sales contract prices should already reflect
currency changes that are anticipated, thereby offsetting the loss reducing benefits of
hedging with higher costs. In the case of Mexico, for instance, the one year forward
discount in the futures market was close to 100% just before the peso was floated in
1982. The unavoidable conclusion is that a firm can protect itself only against unexpected
currency changes.

Even shifting funds from one country to another is not a costless means of hedging. The
net effect of speeding up remittances while delaying receipt of inter company receivables
is to force a subsidiary in a devaluation prone country to increase its local currency
borrowings to finance additional working capital requirements. The net cost of shifting the
funds, therefore, is the cost of local currency loan minus the profit generated from the use
of the funds.

Reducing the level of cash holdings to lower exposure can adversely affect a subsidiary’s
operations, while selling local currency denominated marketable securities can entail an
opportunity cost. A firm with excess cash or marketable securities should reduce its
holdings regardless of whether devaluation is anticipated. Once cash balances are at
minimal level, however any further reductions will involve real costs that must be weighed
against the expected benefits.

Risk shifting by invoicing exports in the foreign currency and imports in the local currency
may cause the loss of valuable sales or may reduce a firm’s ability to extract concessions
on import prices. Similarly, tightening credit may reduce profits more than costs.

Cost of the basic hedging techniques:

Depreciation Costs
Sell the currency forward Transaction costs: difference between forward
and future spot rates
Reduce levels of local currency cash and Operational Problems: opportunity costs(loss of
marketable securities higher interest rates on local currency securities)
Tighten credit (reduce local receivables) Loss of sales and profit
Delay collection of hard currency receivables Cost of financing additional receivables
Increase imports of hard currency goods Financing and holding costs
Borrow locally Higher interest rates
Delay payments of accounts payable Harm to credit reputation
Speed up dividend and fee remittances to parent Borrowing costs if funds are not available or loss
and other subsidiaries of higher interest rates if local currency securities
must be sold
Speed up payment of intersubsidiary accounts Opportunity cost of money
payable
Delay collection of intersubsidiary accounts Opportunity cost of money
receivable
A company can benefit from the abovementioned techniques only to the extent that it can
estimate the probability and timing of the devaluation more accurately than the general
market can. Attempting to profit from foreign exchange forecasting, however, is
speculating rather than hedging. The hedger is well advised to assume that the market
knows as much as he or she does. Those who feel that they feel have superior
information may choose to speculate, but this activity should not be confused with
hedging.

Under some circumstances, it is possible for a company to benefit at the expense of the
local government without speculating. Such circumstance would involve the judicious use
of market imperfections and/or existing tax asymmetries.

Centralization V/s Decentralization:

In area of foreign exchange risk management, there are good arguments both for and
against centralization. Favouring centralization is the reasonable assumption that local
treasurers want to optimize their own financial and exposure positions, regardless of the
overall corporate situation. For example, a multi billion dollar US consumer goods firm
that gives a free hand to its affiliates in deciding their hedging policies. The firm’s local
treasurer’s ignored the possibilities available to the corporation to trade off negative &
positive currency exposure positions by consolidating exposure worldwide.

A further benefit of centralized exposure management is the ability to take advantage,

through exposure netting, of the portfolio effect discussed previously. Thus, centralization
of exchange rate risk management should reduce the amount of hedging required to
achieve a given level of safety.
Once the company has decided on the maximum currency exposure it is willing to
tolerate, it can then select the cheapest option worldwide to hedge its remaining
exposure. Tax effects can be crucial at this stage both in computing the amounts to
hedge and the costs involved, but only headquarters will have the required global
perspective. Centralized management is also needed to take advantage of the before tax
hedging cost variations that are likely to exist among subsidiaries because of market
imperfections.

All these arguments for centralization of currency risk management are powerful. Against
the benefits must be weighed the loss of local knowledge and the lack of incentive for
local managers to take advantage of the particular situations that only they may be
familiar with. Companies that decentralize the hedging decision may allow local units to
manage their own exposures by engaging in forward contracts with a central unit at
negotiated rates. The central unit may or may not lay off these contracts in the market
place.

FOREIGN EXCHANGE RISK AND

ECONOMIC EXPOSURE
The most important aspect of foreign exchange risk management is to incorporate currency
change expectations into all basic corporate decisions. In performing this task, the firm must
know what is risk? However, there is a major discrepancy between accounting practice and
economic reality in terms of measuring Exposure, which is the degree to which a company is
affected by exchange rate changes.

The economic theory focuses the impact of the exchange rate on future cash flows.; that
is, Economic Exposure is based to the extent to which the value of the firm as
measured by the present value of the expected cash flows will change when exchange
rate changes.
Specifically, if PV is the present value of the firm, then the firm is exposed to a currency
risk if:
Change in PV/ Change in Exchange Risk is not equal to Zero
Where, Exchange risk is defined as the variability in the firm’s value that is caused by
uncertain exchange rate changes. Thus, exchange risk is viewed as the possibility that
currency fluctuations can alter the expected amounts or variability of the firm’s future
cash flow.
Economic exposure can be separated into two components:
• Transaction Exposure
• Operating Exposure
Transaction exposure stems from the exchange gains or losses on foreign currency
denominated contractual obligations. Although transaction exposure is often included
under accounting exposure it is more properly a cash flow exposure and hence, part of
economic exposure. However, even if the company prices all its contracts in the home
currency or otherwise hedges its transaction exposure, the residual exposure, longer
term operating exposure still remains.

Operating Exposure arises because currency fluctuations can alter a company’s future
revenue and costs, that is, its operating cash flows. Consequently, measuring a firm’s
operating exposure requires a longer term perspective, viewing the firm as an ongoing
concern with operations whose cost and price competitiveness could be affected by
exchange rate changes.

Thus the firm faces operating exposure the moment it invests in servicing a market
subject to foreign competition or in sourcing goods or inputs abroad. This investment
includes new product development, a distribution network, foreign supply contracts, or
 production facilities. Transaction exposure arises later on, and only if the company’s
commitment leads it to engage in foreign currency denominates sales or purchases.

The measurement of economic exposure is made specifically difficult because it is

impossible to assess the effects of an exchange rate change without simultaneously
considering the impact on cash flows of the underlying relative rates of inflation
associated with each currency. The Real Exchange Rate is defined as the Nominal
Exchange Rate adjusted for changes in the relative purchasing power of each currency
since some base period.

E = n X {(1+ fi)/ (1+fd)}

Where,
E = the real exchange rate (home currency per one unit of foreign currency) at time t;
n = the nominal exchange rate (home currency per one unit of foreign currency) at time t;
fi = the amount of foreign inflation between times 0 and t;
fd = the amount of domestic inflation between time 0 and t

Importance of Real Exchange Rate

The distinction between the nominal exchange rate and real exchange rate is important
because of their vastly different implications of exchange risk. A dramatic change in the
nominal exchange rate accompanied by an equal change in the price level should have
no effects on the relative competition positions of domestic firms and their foreign
competitors and, therefore, will not alter real cash flows. Alternatively, if the real
exchange rate changes it will cause relative price changes; changes in the ratio of
domestic goods’ prices to the prices of the foreign goods. In terms of currency changes
affecting the relative competitiveness, therefore, the focus must not be on nominal
exchange rate changes, but instead on changes in the purchasing power of one currency
relative to another.

Inflation and Exchange Risk

Let us assume that the relative prices remain constant and we look only at the effect of
general inflation. This condition means if the inflation rate is 10%, the price of every good
in the economy rises by 10%. Let us also assume that all goods are traded in a
competitive world market without any transaction costs, tariff’s, or taxes of any kind.
Given these conditions the economic theory tells us that the law on one price must
prevail. That is, the price of any good, measured in a common currency, must be equal in
all countries.
If the law of one price holds and if there is no variation in the relative prices of goods or
services, then the rate of change in the exchange rate must be equal to the difference
between the inflation rates in the two countries. The implications of a constant real
exchange rate, that is, the purchasing power parity (PPP) holds. Purchasing power parity
does not imply that exchange rate changes will necessarily be small or easy to forecast.
If a country has high and unpredictable inflation, then the country’s exchange rate will
also fluctuate randomly.
However, without relative price changes, a multinational company faces no real operating
exchange risk. As long as the firm avoids contracts fixed in foreign currency terms, its
foreign cash flows will vary with the foreign rate of inflation. Because the exchange rate
also depends on the difference between the foreign and the domestic rates of inflation,
the movement of exchange rate exactly cancels the change in the foreign price level,
leaving real cash flows unaffected.

The above conclusion does not hold if the firm enters into contracts fixed in terms of the
foreign currency. For example, debt with fixed exchange rates, long term leases, labour
contracts, and rent. However, if the real exchange rate remains constant, the risk
introduced by entering into fixed contracts is not exchange risk; it is inflation risk.

Real Exchange Rate Changes and Exchange Risk:

A decline in the real value of a nation’s currency makes its exports and import competing
goods more competitive. Conversely, an appreciating currency hurts the nation’s
exporters and those producers competing with imports.
The economic impact of a currency change on a firm depends on whether the exchange
rate change id fully offset by the difference in inflation rates or whether the real exchange
rate and, hence relative prices change. It is this relative price changes that ultimately
determine a firm’s long run exposure.

A less obvious point is that a firm may face more exchange risk if nominal exchange
rates do not change.
 THE ECONOMIC CONSEQUENCES OF
EXCHANGE RATE CHANGES

Transaction Exposure:
Transaction exposure arises out of the various types of transactions that require
settlement in foreign currency. For example, cross border trade, borrowing and lending in
foreign currencies, and the local purchasing and sales activities of foreign subsidiaries.
The items already on firm’s balance sheet, such as loans and receivables, capture some
of these transactions. However, a detailed transaction exposure report must also contain
a number of off balance sheet items as well, including future sales and purchases, lease
payments, forward contracts, loan repayments, and other contractual or anticipated
foreign currency receipts and disbursements.

In terms of measuring economic exposure, though, a transaction exposure report, no

matter how detailed, has a fundamental flaw; the assumption that local currency cost and
revenue streams remain constant following an exchange rate change.

The assumption does not permit an evaluation of the typical adjustments that consumers
and firms can be expected to undertake under conditions of currency change. Hence,
attempting to measure the likely exchange gain or loss by simply multiplying the
projected predevaluation local currency cash flows by the forecast devaluation
percentage will lead to misleading results. Given the close relationship between nominal
exchange rate changes and inflation as expressed in purchasing power parity, measuring
exposure to a currency change without reference to the accompanying inflation is also a
misguided task

Operating exposure:
A real exchange rate change affects a number of aspects of the firm’s operations. Let us
assume dollar to be the home currency here. With respect to dollar appreciation then, the
key issue for a domestic firm is its degree of pricing flexibility; that is, can the firm
maintain its dollar margins both at home and abroad? Can the company maintain its
dollar price on domestic sales in the face of lower priced foreign imports? In the case of
foreign sales, can the firm raise its foreign currency selling price sufficiently to preserve
its dollar profit margin?
 The answers to these questions depend largely on the price elasticity of demand. The
less price elastic the demand, the more price flexibility a company will have to respond to
exchange rate changes. Price elasticity, in turn, depends on the degree of competition
and the location of key competitors. The more differentiated a company’s products are
the less competition it will face and the greater its ability to maintain its domestic currency
prices both at home and abroad. Similarly if most competitors are based in the home
country, then all will face the same change in their cost structure from home currency
appreciation, and all can raise their foreign currency prices without putting any of them at
a disadvantage relative to their domestic competitors.
Conversely, the less differentiated a company’s products are and the more internationally
diversified its competitors are, the greater the price elasticity of demand for its products
will be and the less pricing flexibility it will have. These companies face the greatest
amount of exchange risk.
Another important determinant of a company’s susceptibility to exchange risk is its ability
to shift production and sourcing of inputs among countries. The greater the company’s
flexibility to substitute between home country and foreign country inputs or production,
the less exchange risk will it face. Other things being equal, firms with worldwide
production systems can cope with currency changes by increasing production in a nation
whose currency has undergone a real devaluation and decreasing production in a nation
whose currency has revalued in real terms.
Characteristic Economic Effect of Exchange Rate Changes on MNC’s
Cash Flow Relevant Economic Devaluation Revaluation
Categories Factors impact impact
Revenue Parent company Parent company
revenue impact revenue impact
Export Sales Price Sensitive Demand Increase Decrease
Price insensitive demand Slight increase Slight decrease
Local Sales Weak prior import Sharp decline Increase
competition
Strong prior import Decrease Slight decrease
competition
Costs Parent company Parent company
cost impact cost impact
Domestic Inputs Low Import Content Decrease Increase
High Import content/ Inputs Slight decrease Slight Increase
used in export or import
competing sectors
Imported Inputs Small local market Remain the same Remain the same
Large local market Slight decrease Slight increase
Depreciation Cash flow impact Cash flow impact
Fixed assets No asset valuation Decrease by Increase by
 adjustment devaluation % revaluation %
Financial Management of Exchange Risk

The one attribute that all the strategic marketing and production adjustments have in
common is that they take time to accomplish in a cost effective manner. The role of
financial management in this process is to structure the firm’s liabilities in such a way that
during the time the strategic operational adjustments are underway, the reduction in
asset earnings is matched by the corresponding decrease in the cost servicing of these
liabilities.

One possibility is to finance the portion of the firm’s assets used to create export profits
so that any shortfall in operating cash flows due to an exchange rate change is offset by
a reduction in the debt servicing expenses. For example, a firm that has developed a
sizeable export market should hold a portion of its liabilities in that country’s currency.
The portion to be held in foreign currency depends on the size of loss in profitability
associated with a given currency change. No more definite recommendations are
possible because the currency effects will vary from one company to another.

The implementation of hedging policies is likely to be quite difficult in practice, if

only because the specific cash flow effects of a given currency change are hard
to predict. Trained personnel are required to implement and monitor an active
hedging program. Consequently hedging should be undertaken only when the
effects of the anticipated exchange rate changes are expected to be significant.

CASE STUDY ON
EXCHANGE RATE RISK MANAGEMENT
IN MNC NAMED
LTCM
Barings, the Russian meltdown, Metallgesellschaft, Procter & Gamble, LTCM. These
are all events in the financial markets, which have become marker
buoys to show where it went wrong. The common weakness, in
LTCM’s case, was the misguided assumption that 'its counter party and
the market it was operating in, were performing within manageable
limits.' But once those limits were crossed for whatever reason,
disaster was difficult to head off.
The LTCM fiasco is full of lessons about :
Model risk
Unexpected correlation or the breakdown of historical correlations
The need for stress-testing
The value of disclosure and transparency
The danger of over-generous extension of trading credit
The woes of investing in star quality
And investing too little in game theory.
The latter because LTCM's partners were playing a game up to hilt.

LTCM was unregulated, free to operate in any market, without capital charges and
only light reporting requirements to the US Securities & Exchange
Commission (SEC). It traded on its good name with many respectable
counter parties as if it was a member of the same club. That meant an
ability to put on interest rate swaps at the market rate for no initial
margin - an essential part of its strategy. It meant being able to borrow
100% of the value of any top-grade collateral, and with that cash to buy
more securities and post them as collateral for further borrowing: in
theory it could leverage itself to infinity.

To make 40% return on capital, however, leverage had to be applied. In theory,

stepping up volume doesn’t increase market risk, provided you stick to
liquid instruments and don't get so big that you yourself become the
market.
Some of the big macro hedge funds had encountered this problem and reduced their
BIBLIOGRAPHY

• MULTINATIONAL FINANCIAL MANAGEMENT – ALAN C SHAPIRO

• ICFAI JOURNAL
• JOURNAL ON RISK MANAGEMENT
• BUSINESS INDIA
• MULTINATIONAL FINANCE – KRIT C BUTLER
• WEBSITES ON THE INTERNET