In the world of corporate business Multi national companies (MNC’s) play a pivotal role. Owing to the limitation of the system, these companies are exposed to the volatility of the exchange rate changes. Myth of MNC’s possessing huge profit margins, cheap labor, and access to economical raw materials although some what true, but there is also a huge financial risk these companies have to bear.
MNCs generally deal in two or more than two currencies. If there are changes in the value of those currencies, companies are liable to gain profit if the change is positive.
On the other hand, if the change is negative companies would get exposed. This is an example of companies getting exposed to currency changes, but there are also variables like interest rates, commodity prices and equity prices.
Companies, which dwell in such an environment, have always been managing these risks. Initially these efforts were uncoordinated and ad hoc. Nowadays, financial risk management is a complete science and is taken very seriously by corporations.
Vulnerabilities which corporations face in the world of finance, due to exchange rates constitute foreign exchange exposures. They are also termed as “currency exposures”. Our deliberation would be on three currency exposures namely Translation, Transaction, and Operational exposures.
It measures the change in the value of a deal from the time it was signed to the time transactions actually take place due to change in exchange rates. Companies which deal in international trade face the risk of currency exchange rates changing after a legal binding has been achieved.
This variation will cause a lot of loss to the effected firm. This form of exposure is of short term in duration because the effects stay there till the transaction of the binding happens. Transaction exposure refers to the contractual cash flows involving an actual exchange transaction.
Companies, which receive or pay in foreign currency, are especially susceptible to this exposure. These companies have different reporting currencies. If there is a change in the foreign and the reporting currency it will affect the amount of reporting currency in the transaction. A company with net receivables in a foreign currency is prone to losses in transaction if the foreign currency weakens in the exchange rate. Conversely, a company with net liabilities in a foreign currency will gain in the same situation.
This exposure deals with the estimation of change in the value of a firm, due to an expected cash flow change, incurred due to an un expected change in exchange rates (Change in prices, increase/decrease in sales volume etc).
The extent to which the future trading of a corporation or its assets and liabilities may be affected by an unexpected change in its operating environment is known as Operating Exposure. Operating exposure relies heavily on the relative pricing. If there is a change in the relative pricing because of any change in the exchange rate, the operating change in the cash flow is referred to as economic exposure (operating exposure). The definition of operating exposure caters for the value of assets as well as flow of cash that is expected.
It is the change in the owner’s capital due to translation of foreign currencies to a single one. Whenever a company’s assets, debts, loans and income will change in its amount because of change in the exchange rate is known as Translation Exposure. This is a particular phenomenon for corporations, which have their denomination in foreign currency. Responsibility lies heavily with the accountants, which save the firm from this exposure by giving a consolidated statement in the financial sheet. They also utilize cost accounting procedures. In many cases this exposure is recorded in the statements of the company as gain or a loss after an exchange rate.
Translation exposure exists when the financial statements of a foreign branch must be translated into the currency in which the parent firm is operating, so they can be incorporated into the parent company’s financial sheets by consolidation, equity or the combination method. Translation exposure is also referred as accounting exposure. The root of this exposure is the difference in exchange rates between the time of consolidation and there effect in the value of the company’s assets and liabilities which are abroad.
An exposed item is the one that is law bided by accounting rules to be translated according to the current exchange rates or the rate of the consolidation date. An unexposed item is bided by the exchange rate at which that item was acquired. A company with assets that are exposed surplus then the liabilities in a foreign land is vulnerable to translation losses from decrease in the value of the foreign currency between two financial years. The situation would be the same if the liabilities were more and there is an appreciation in the foreign currency.
Although these exposures seem closely related, but on close examination they do have differences. Differences maybe in the definition as well as the their area of effect. Operating exposure is different from the translation exposure from the core. It involves giving a predetermined value to all the future cash flows, and then it measures fluctuations in the exchange rate on all operational cash flows, whether a transaction has taken place or not.
Translation exposure has their profits and losses either directly on the cash flow or indirectly on the stockholders equity, financial assets, whereas transaction exposure has direct bearing on the cash flow.
In terms of effect Transaction exposure is of short term whereas Translation and Operating exposure have long-term effects. There is also a significant difference in the area that these exposures encompass. Transaction exposure is limited to the particular deal, which has taken place. On the other hand, translation exposure focuses on a wider spectrum like Stockholders equity, liabilities, and assets which ever have to be converted in to a single currency. Operating exposures encompass the widest of the spectrum, assets, all future cash flows, liabilities and there effect is the longest. Understandably there are a variety of factors, which can influence the operating exposures, like cost of raw material, pricing, and the volume of sales.
The major distinction of the operating exposure is that, whereas Translation and Transactional exposures are limited to the individual corporation, but economic exposure has to cater for the effects of the exchange rate on its competitors.
Another major difference once comparing accounting and operating exposure is that the former represents an exposure, which has happened, and latter caters for future exposure.
Foreign exchange exposures measure the profit margin, net cash flow, and the market value of a firm to vary according to the change in the exchange rates.
Measurement of transaction exposure is fairly easy. It is measured from currency to currency. The amount of the contractually fixed list is calculated. The final payment according to the latest exchange rate for the currency in which the amount has to be paid is calculated. The exposure is the difference between the two.
Measuring of the operating exposure is a tedious task and requires a lot of planning. Measurement of the operating exposure requires that we analyze and forecast corporations future transaction exposures together with the future exposures that the corporations competitors and to be competitors will face. Let us assume that a company A has X number of transactions from its present and future dealings abroad. The sum of these future transaction exposures would give a strong indication of the cash flow, as the exchange rate changes. Company A’s worth competitiveness depends upon its cash flow and whether or not it has the capability to manage these transactions better then its competitors.
Operating exposures takes into account the long term goal of the firm. It measures two types of cash flows:
Operating cash flow constitutes payments for services, goods, and rent. It also includes payments of royalties, license fees, and management fees.
These are payments for the inter company loans and liabilities. They also include payment of stockholder equity.
Accounting exposure is perhaps the easiest of exposures that can be measured. For measuring the current exchange rate should be known, then the difference between the local and the reporting currency is calculated.
Corporations possessing individual investor’s money are viable to exposure by fluctuations in all kinds of financial retailing, as a natural by-product of their financial activities. Financial retailing includes foreign interest rates, commodity prices, exchange rates, and equity prices. The effect of changes in these prices has a magnanimous effect on the reported earnings. Its common knowledge companies reporting reduced or enhanced financial statements owing to fluctuating commodity prices or gain due to favorable exchange rates.
Hedging in the general sense is a company entering or creating a transaction, whose sensitivity to fluctuation in financial retailing offsets their vulnerability in their core business. Hedging involves a lot of planning and by no means is an easy exercise. Another major reason for hedging the exposure of the firm to its financial risk is to increase or sustain the competitiveness of the corporation.
It’s a world of financial competition and companies can not live in isolation.. they compete with other corporations domestically as well as internationally, especially between companies that produce similar products in the global market. Take the example of a pharmaceutical company that has its competition with domestic firms and also competes with other international pharmaceutical companies.
Simple hedging techniques can render a company to effectively close in a deal or transaction at a predetermined exchange rate and minimize the risk of transaction profits and losses between the signing of transaction and the settlement date.
To elaborate a US company was due for payment of 10 million pounds on May 1. Constant fluctuation of exchange rate was a problem which company was likely to face. Risk could have given profit but on the other hand there was equal chance of loss. To alleviate this problem the company decided to hedge a forward contract with the bank for the conversion of 10 Million pounds at a fixed rate of 1.7$/pound. So, after receiving the payment of 10 million pounds from its customers it simply got them converted on the pre determined contract with bank.
Different hedging strategies are employed while different exposures are encountered. Below are mentioned few of the strategies employed while tackling Foreign exchange exposures.
Hedging of Transaction exposure
There are various ways of protecting against a transaction exposure including clauses in the contract, which keep prices fixed, forward contracts, various currency options etc.
Following are the methods by which translation exposure can be effectively curtailed.
Hedging of operating exposure is far more important for a firm’s long health then transaction and translation exposure combined.
It is the era of “globalization” and international products are available at our doorsteps. This is an opportune time for MNCs to prosper and strengthen their foothold. Consumers are also benefiting equally from this competitive environment, in terms of better quality of products and cheap prices.
Exchange of currencies in this scenario is at an all time high for obvious reasons. Effect of these currency transactions is creating anomalies in the form of exposures. In places, where there are dealings in millions these exposures gain enormous importance. MNCs by now have realized these problems and are taking pro-active measures to resolve them. Those companies which have not given exposures there due importance will suffer and lag behind in this financial world.
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