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“Exchange rates are the amount of one country’s currency needed to purchase one unit of another currency (Brealey 1999, p. 625)”. People wanting to exchange some money for their vacation trip will not be too much bothered with shifts if the exchange rates. However, for multinational companies, dealing with very large amounts of money in their transactions, the rise or fall of a currency can mean getting a surplus or a deficit on their balance sheets. What types of exchange rate risks do multinational companies face?
One type of exchange risk faced by multinational companies is transaction risk. If a company sells products to an overseas customer it might be subject to transaction risk. If a UK company is expecting a payment from a US customer in June and the invoice was made in January, the exchange rate is bound to have changed during the period. If the deal was worth £1,000,000 and the american dollar compared to pound sterling weakened from US$1.40 in January to US$1.50 in June, the UK company would loose £47,619 (Appendix A).
Economic risk is another type of exchange risks companies have to consider when dealing globally. Changes in exchange rates are bound to affect the relative prices on imports and exports, and that will again affect the competitiveness of a company. An UK exporter dealing with companies in the US would not want the US$ to depreciate, because it would make the exports more expensive for the US market, thus the company will loose business...
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.... A company borrows £2,000,000 in 1998, with a fixed interest rate of 8%, payable annually for a 5 year period.
Fixed annual interest, 8%: £2,000,000 X 0.08 = £160,000
New annual interest, 6%: £2,000,000 X 0.06 = £120,000
Annual loss, 6% vs. 8%: £160,000 - £120,000 = £40,000
http://www.expedia.com, 22/11/2000, http://www.expedia.com/pub/Agent.dll
Brealey, Richard A., Marcus, Alan J., Myers, Stewart C. 1999, Fundamentals of Corporate Finance, 2nd edn, Craig S. Beytien, USA.
Howells, Peter., Bain, Keith 2000, Financial Markets and Institutions, 3rd edn, Henry King Ltd., Great Britain.
Ritter, Lawrence R., Silber, William L., Udell, Gregory F. 2000, Money, banking, and Financial Markets, 10th edn, USA.