“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.
A letter of credit If companies are unable to access this facility it would lead to exporter reluctant to sell their goods to any unfamiliar party and obstruct international trade. A letter of credit enable two unfamiliar parties to complete a transaction by removing payment default risk. It enables the importer to abscond from making a payment in advance to the exporter and gives the exporter comfort that they will be paid for their goods. It minimise their credit risk, as it is a guarantee payment will be met from a bank. From a bank perspective a letter of credit is a contingent liability until it is presented for payment.
When a country imports more than it exports, there will be pressure on that country's currency to devalue. However, if the trade deficit is offset by inflows of capital( for investment purposes), the country can continue to run the trade deficit without having to devalue. When a government devalues its currency, it is often because the interaction of market forces and policy decisions has made the currency's fixed exchange rate weak. In order to nourish a fixed exchange rate, a country must have sufficient foreign exchange reserves, often dollars, and be willing to spend them, to purchase all offers of its currency at the established exchange rate. When a country is unable or unwilling to do so, then it must devalue its currency to a level that it is able and willing to support with its foreign exchange reserves.
Events such as currency crisis can pose a threat to the stable cash flows of a multinational firm. A firm can benefit from or be harmed by the fluctuations in exchange rate, depending on whether it is an exporter or importer. However most firms are concerned with lowering their cashflow variability rather than try to be on “the right” side of the trade. While firms usually hedge the foreign exchange risk, such severe and difficult to predict events can exceed their hedging capacity and cause damage to firms’ operations. According to Adler and Dumas (1984), a firm can hedge currency exposure perfectly if exposure of future cash-flow is known.
Executive Summary Eiteman et al (2003) contend that Hedging is undertaken by the firms in the market to cover their exposure to fluctuation in exchange rates. Stulz (1996) assert that the prime reason for a firm resorting to hedging is that it wants to ensure reduction in such events that may result in financial distress to the firm. Due to such financial distress, a firm may incur losses due to exchange rate fluctuations. In this context, Leland (1998) also supported the view of Stulz (1996) by showing that through hedging current the debt capacity of the firm may increase which would result in increase in value of the firm through higher interest tax shields. Thus hedging is an effective method through which the firm may be able to cover its exposure and it may increase value of the firm also although the topic relating to hedging and its impact on value is of intense debate among various thinkers.
A high value currency is a sign that a country has a good economy, as it shows that people want to invest in the country by buying its currency. If an economy is in trouble people will usually try and sell its currency, which pushes its value down. However, if a currency’s value is too high it can affect a country’s exports, since products made there become too expensive for people to buy abroad, which can damage the economy. The Forex market mainly exists because of the need to ease or facilitate currency exchange. There is a need to exchange currencies because one country’s currency is not accepted in another.
The exchange rate movement can be favorable or unfavorable to the company. Many multinational companies wish to hedge against the exposure of transaction risk which can has potential effect to the company cash flows in order to minimise the loss on foreign exchange rates. The degree of exposure of Tobago Berhad to the transaction risk is dependent on the size of the transaction, the hedge period which is the time period before the expected cash flows occurs, and the anticipated volatility of the exchange rates during the hedge... ... middle of paper ... ...st it main competitor and thereby lose the competitive position in the exports market. The customers will prefer to purchase the product of it main competitor with relatively cheaper price than Tobago Berhad. (Kaplan Financial Limited, 2012) Works Cited Investopedia.
Fixed Exchange Rate System refers to a system where the country's exchange rate is tagged to the official exchange rate of another country’s currency. This is meant to maintain a country's currency value within a tight range. It is also commonly known as a pegged exchange rate (Investopedia, 2015). The key issue is the central banks’ propensity to fix the value of its currency below the market clearing value, due in part to the incapability to obtain the market clearing exchange rate. Thus, there will be an excess demand for the foreign currency which will lead to a balance of payment deficit (Samarasiri, 2010).
International Business is a lucrative prospect in today’s climate, but transactions performed with foreign currencies, will incur considerable risk with the fluctuation of not only the currencies traded in but also the world economy. So what is a business to do to protect oneself from financial risks? Hedging is one way to protect oneself and one’s assets; but what exactly is hedging? According to Investopedia; a hedge is "investing to reduce the risk of adverse price movements in assets." It 's an insurance policy to mitigate risk and offset changes within whatever market you choose to invest.
Thus, the import surplus increases demand of foreign currencies the demand of the dollar drops and cause dollar devaluation. Although the United Stated was facing a trade deficit and current account deficit, it enjoyed a prosperous economy at the same time. So maybe external deficits better are sustainable as long as they make no adverse effect, but on the contrary, it coincides with a period of prosperity. The disparity of the economic growth between the United ... ... middle of paper ... ...vestors find the United States an attractive investment destination and that brings higher rate of income comparing to any other place because of its openness, scope and liquidity of capital. Also, the role of dollar as prime currency of the investment and transaction in the world makes the United States a great place for foreigner to invest their capitals (Karczmar, 2004).