International business is facilitated by markets that allow flow of funds between countries in different currencies. Multinational corporations are involved in international trade and receive and pay in various currencies. MNCs must constantly monitor exchange rates because their cash flows are highly dependent on them. The risk faced by these companies due to exchange rate movements after having already entered into financial obligations is called exchange rate risk. Such exposure to fluctuating exchange rates can lead to major losses for the firms.
Exchange rate fluctuations cannot be forecast with accuracy. However, using various techniques, the amount of exposure can be measured and minimized. Exchange rate fluctuations can be broadly categorized into three types:
Transaction exposure arises when a firm’s contractual cash flows are affected by fluctuations in exchange rates of the currencies in which they are designated. Transaction exposures can have a great impact on the profits of the company. Transaction exposures are always easily identifiable and quantifiable because the exact amount of the account payable or account receivable is known and certain. The firm must identify the degree of exposure and choose an appropriate hedging technique to hedge part or all of the exposure. When a perfect hedge is not available, alternative hedging techniques like leading and lagging, cross-hedging and currency diversification’s are used.
Operating exposure, or economic exposure, measures the change in the present value of the firm resulting from any change in expected future operating cash flows caused by an unexpected change in macro economic variables — interest rates, inflation, GDP growth rate, Capital Flows, Exchange Rate and others. All transactions that cause transaction exposure cause economic exposure. In addition, other businesses that do not require conversion of currencies can also cause economic exposure. Purely domestic companies can also cause economic exposure. Economic exposure can be managed by balancing the sensitivity of revenue and expenses to exchange rate fluctuations. Typically, an MNC restructures its operations which could involve shifting of sources of costs and revenues to other locations to match cash inflows and outflows in foreign currencies. By restructuring, the firm is developing a long-term solution for economic exposure. In contrast, hedging of transaction exposure deals with each transaction separately.
Translation exposure or accounting exposure measures the potential losses or gains that would appear on the consolidated financial statements of a firm following a change in exchange rates. An MNC creates its financial statements by consolidating the statements of all its individual subsidiaries’ financial statements. A subsidiary’s financial statement is usually measured in its local currency. For purposes of consolidation, the financial statement must be converted into the currency of the parent company. The translations of the financial statements are therefore subject to exchange rate fluctuations. For eg. an MNC headquartered in USA might have operations in UK, India and Philippines. This means that the conversion rates of Euro profits, rupee profits and peso profits are of paramount importance. Translation exposure is dependent on the proportion of the business of the foreign subsidiaries to the parent company, the locations of the foreign subsidiaries and the accounting methods used by the subsidiaries. Such exposures can reduce the MNC’s earnings and may also lead to decline in the price of its stocks. MNCs use forward contracts and other methods to hedge translation exposures.