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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.
Other types of exchange rate risks are translation risk and so-called hidden risk. The translation risk relates to cases where large multinational companies have subsidiaries in other countries. On the financial statement of the whole group, the company may have to translate the assets and liabilities from foreign accounts into the group statement. The translation will involve foreign exchange exposure. The term hidden risk evolves around the fact that all companies are subject to exchange rate risks, even if they don’t do business with companies using other currencies. A company that is buying supplies from a local manufacturer might be affected of fluctuating foreign exchange rates if the local manufacturer is doing business with overseas companies. If a manufacturer goes out of business, or experience heavy losses, it will affect all the companies it does business with. The co...
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A UK exporter invoicing US$1,000,000 in January for payment in June.
January: US$1.40 £714,286
February: US$1.50 £666,667
Loss on transaction: £47,619 (£714,286 - £666,667)
i. A company borrows £100,000 from a bank at 8% interest rate.
£100,000 X 1.08 = £108,000
ii. 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.
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