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Exchange Rate Risk The continuing globalization of business and securities markets, deregulation of some of the worlds financial markets, and tax reform have led to the creation of numerous innovative corporate financing tools. Additionally, foreign currency exchange rates have become increasingly volatile in the financial markets. Management of foreign exchange risk has become a more challenging task. The newly developed instruments also pose new risks to management. Therefore, it is essential for accountants and financial analysts, who are providers of information that is useful to management and investors, to understand how these new devices are being applied. According to contemporary context, the series of chaotic devaluations in many countries has demonstrated, exchange currency risk can become a major challenge for corporate treasurers.
Underlying economic stresses may not become apparent until the crisis actually erupts, and by then it is too late to salvage much. Some companies have tried to avoid the issue by attempting to do business only in U. S. dollars. That, however, may only disguise currency risk. Export sales out of the U.
S. to local distributors may be billed and paid in dollars. If sales are done on open account, foreign exchange risk becomes credit risk. The local distributors or customers pay their customers in local currency. A sudden, massive devaluation of the local currency may mean that the distributor will not be able to generate enough local currency from its customers to cover its dollar payables to the U. S.
exporter. The distributors subsequent default on its bills to the exporter will have the same bottom line impact for the exporter - a significant loss that resulted ultimately from foreign exchange volatility. The purpose of this paper is to examine how US multinational enterprises (MNEs) manage their foreign exchange risks in the existing uncertain and volatile financial environment. It explores the concepts applied by management, the objectives followed, and how management has organized this important function of multinational financial management. Being static and historically oriented, accounting exposure has often been criticized in that its measurement of foreign exchange gains and losses does not reflect the real impact of foreign exchange rate fluctuations on the firm and hence the resulting foreign exchange gains and losses are purely of a paper nature (Glaum, 66). Thus, it is argued, accounting exposure management is not a useful concept to be a basis for corporate exchange risk management.
MNEs are required to determine their functional currencies before adopting the appropriate method for translating their financial statements. The functional currency is defined as the currency of the primary economic environment of the entity. If the US dollar is the functional currency, the temporal method must be applied and the effect of the foreign exchange gains and losses is shown in the income statement. On the other hand, if the foreign currency is the functional currency, the current rate method should be used and the resulting foreign exchange gains and losses are deferred and reported in the stockholders equity section of the balance sheet. The study of Duangploy and Gray (1998) revealed that the majority of the MNEs used the current rate method.
As a result, foreign exchange gains and losses are most likely merged in the stockholders equity section rather than an income statement. Further, with the adoption of SFAS 52, the emphasis has now shifted from translation exposure to transaction exposure management. The study of Collier (1990) was on the behavior of American and British MNEs in terms of transaction risk and translation risk with the emphasis on the extent of risk neutrality. His study supported the concept that translation exposure management was of lesser concern than transaction exposure management.
Kohn emphasized that economic exposure management is the most relevant concept to be applied in foreign exchange management. Economic exposure management focuses on foreign exchange-induced changes in future cash flows. Economic exposure takes into account the competitive situation of the company; it makes evident what effects rate changes can have on its future costs, revenues, and profits. It would include anticipated customer orders and vendor purchases that are denominated in foreign currencies. This concept, according to Kohn, is consistent with what is generally accepted as being the primary objective of corporate management, that is, maximization of the economic value of the firm (Kohn, 71). Glaum argues that the tools which are available for the strategic management of foreign exchange risk are the companys choice of products and markets, the restructuring of its sourcing and production locations, and changes in its longer-term financial policies, etc. (Glaum, 69).
Financial policies are particularly well suited, since operational policies are expensive and changes take time. Specific examples of operational approaches to exposure management are useful to illustrate the wide diversity of such responses. One company had set up a factory in Ireland in order to get into the European market, to take advantage of a tax holiday, and obtain grants when the Irish plant was built. This was not a currency decision. A second company located overseas production where the demand for the companys output dictated. Rather than shopping the world for the cheapest sourcing price, they seek a single source that will furnish quality material which they can sell in a quality product for a good return.
One company tried to have its sourcing denominated in the same currency in which it would be selling the product. This is an example of the financial technique as opposed to the operational method of controlling foreign exchange risk. Among the companies that used both financing and operational means, there are those which attempted to match their cost base with their revenue base in the same currency. They have also used financial means to manage economic exposure. Another company tried to source and price in the local currencies and to borrow only in local currencies. Current literature establishes that a crucial element in the financial strategy of any MNE is the decision on the degree of centralization of the treasury function.
Griffiths and Greenfield claimed that centralized treasuries generally function most efficiently, while decentralized treasuries often ignore the natural hedges created by different foreign currency positions (Griffiths, 26). In agreement with the literature perspective on the organization of exchange risk management, the results of the study, which surveyed 36 MNEs indicate that 22 of 36 companies are highly centralized, five have a low degree of centralization, and nine are completely decentralized. For companies with a low degree of centralization, the reasons discovered during survey were: In the main places where they have foreign currency exposure, foreign managers have ex officio representation on the committees that manage day-to-day exposure. They have decentralized management with centralized policy setting and monitoring. The foreign branches make currency decisions within limits set by headquarters. The empirical study of Khoury and Chan (1999) on 17 companies in 1998 revealed that forward contracts were rated as the most familiar and often used hedging instruments.
This was due primarily to the cost of hedging and the high degree of flexibility. Although futures are similar to forward contracts in which the commitment represents an obligation rather than a right, trading is done in an auction market. Futures are daily marked to market and margins are required of all traders. Options represent the right to buy and sell a foreign currency. Griffiths and Greenfield assert that options are the least speculative form of hedging. Unlike forward contracts, options have an upfront cost-premium which varies according to duration of the contract interest rate differentials and currency volatility (Griffiths, 25).
A swap is a financial transaction in which two counterparts agree to exchange streams of payments over time (Shapiro, 152). Swaps could be perceived as a series of forward contracts. Corporate financial managers can transform an obligation in one currency to one in another currency by signing a contract. By doing so, they can raise money at a very reasonable cost.
Liquidity, flexibility, and certainty about costs are the three most important considerations in choosing a hedging contract. The results of numerous studies indicate that neither size nor number of foreign operations dictate the type of hedging instrument to be used. Bibliography M. Glaum. The Management of Foreign Exchange Risk in UK Multinationals: An Empirical Investigation. Accounting and Business Research (Winter): 3 - 13, 1997 Duangploy, O. , Gray D.
An Empirical Analysis of United States Multinational Corporate Practice in Evaluating and Controlling Overseas Operations. Accounting and Business Research (Fall), 1998 Collier, P. The Management of Currency Risk: Case Studies of US and UK Multinationals. Accounting and Business Research (Summer), 1990 Kohn, K.
Managing Foreign Exchange Risk Profitably. Columbia Journal of World Business (September), 1990 Griffiths S. H. , Greenfield P. S. Foreign Currency Management: Part I Currency Hedging Strategies. Journal of Cash Management (July/August), 1996 Khoury, S.
J. , Chan H. K. Hedging Foreign Exchange Risk: Selecting the Optimal Tool. The International Finance Reader.
Ed. Robert W. Kolb, Florida: Kolb Publishing Co, 1999 Shapiro, A. C. 1989. Multinational Financial Management, 11 th edition, Allyn and Bacon, London, 1998
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Research essay sample on Foreign Exchange Foreign Currency
