Business and Management in a global context

Chapter 6
Questions I should be able to answer:

1. Describe the determinants of exchange rates

2. What are the currency exchange rate risks that companies face?
3. What strategies can companies take to mitigate these risks?
4. Assess the role of the international monetary fund (IMF)
5. What are the criticisms faced by the IMF?

Words I looked Definition

up
Foreign Foreign exchange risk is the possibility that unpredicted
exchange risk changes in future exchange rates will have negative
consequences for the firm.

“Hedging” “Hedging” is how a firm insures itself against foreign exchange

risk.

Spot rate A spot transaction is when the exporter and the importer agree
to pay using today’s (on the spot),
Forward rate A forward exchange occurs when two parties agree to
exchange currency and execute the deal at a specific date in
the future, say 30, 60, or 90 days.
Currency Swap A swap is a combination of both SPOT and Forward

Significant Principles Reference in other

chapters

Demand – rise in currency Supply

1.Law of one price 4. Increase in money supply lead to fall
If price is cheaper in one country in currency

2. Increase in interest rate, lead to

increase in demand

3. A rise in productivity and BOP

increase

5. Exchange rate policy (whether its pegged, managed float or float)

6. Investor Psychology

Compiled by Joanne Koo for SIM-UOL L01 and L04.

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1. What determines currency rates?

What is an International currency exchange rates show how much one unit
international of a country’s currency can be exchanged for another country’s
currency currency. They can be
exchange rate? (i) Fixed/ pegged
(ii) Common Currency
(iii) Floating

Without the foreign exchange market, international trade and

international investment on the scale that we see today would
be impossible; companies would have to resort to barter.
The foreign exchange market serves two main functions.
What is the
foreign (i) First is to convert the currency of one country into the
exchange currency of another.
market? (ii) The second is to provide some insurance against foreign
exchange risk, or the adverse consequences of
unpredictable changes in exchange rates.

What are the 4 main ways companies use foreign exchange

main uses of
the foreign 1) First, the payments a company received (for exports etc)
exchange may be in foreign currency.
market? 2) Second, to pay a foreign company for its products received
3) Third, when a company has spare cash to invest in Foreign
funds for short terms in money markets.
4) A company engages in currency speculation in short-term
movement of funds from one currency to another to profit
from shifts in exchange rates.
What Currencies are influenced by economic, political and
determines a psychological factors such as:
currency rate? – relative price differences of similar products
– inflation and monetary supply
– Interest rates
– Productivity of labor
– balance of payments in trade
– investor psychology and confidence

Benefit of Knowing the value of your home currency in relation to different

understanding foreign currencies helps investors to analyze investments priced
exchange rate in foreign dollars.

For example, for a U.S. investor, knowing the dollar to euro

exchange rate is valuable when selecting European
investments. A declining U.S. dollar could increase the value of
foreign investments, just as an increasing U.S. dollar value
could hurt the profitability of your foreign investments.

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 Factors That Influence Exchange Rates
What
determines a Floating rates are determined by the market forces of supply
currency rate? and demand of a currency, which is in turn affected by the
international trade market as well as foreign direct investment.
For example, if the demand for U.S. dollars by Europeans
increases because of trade, this will cause an increase in price
of the U.S. dollar vs the euro.

1) Relative price differences of products can affect the

currency market. According to the purchasing power parity
(PPP) hypothesis, or the “law of one price”, the price of similar
products must be the same in different countries, if there are no
trade barriers. If the price of the latest iPhone 7 model costs
US$700 in the US while it costs US$850 in China, more people
will buy US$ causing the price of US$ exchange rate to
appreciate.

2) Monetary supply and inflation - amount of money in

circulation. During the financial crisis of 2008/9, the Bank of
England adopted a loose monetary policy (increased money
supply) to stimulate domestic demand, which caused a
depreciation of the pound against the euro. A loose monetary
policy by the government can lead to higher inflation and
depreciation of the currency in relation to the currencies of
trading partners.

3) Higher interest rates (from foreign countries) offer a higher

return on investment. Countries offering a higher return relative
to other countries will attract foreign capital and cause exchange
rate to appreciate.

The recent increase in US interest rates and the increase in

acquisition of US Companies by PRC companies have caused
an increase in demand for US dollars and US exchange rate.

[The current (spot) exchange rate will be influenced by the

interest rates offered on investments in both countries (e.g. on
government bonds). Forward exchange rates, the price of a
currency 30, 60, 90 or 120 days in the future, are also
influenced by relative price differences by market participants’
expectations about the interest rates then prevailing.]

4) Productivity and balance of payments- A rise in a country’s

productivity improves its competitive position and tends to lead
to a rise in the demand for, and value of, its currency. A country
experiencing a current account surplus will see its currency
appreciate in value, while a country experiencing a current
account deficit will see its currency depreciate.

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 5) Investor psychology.
Short term movements are also influenced by investor
psychology. The bandwagon effect – investors moving as a herd
in the same direction at the same time – can occur. Example,
during the 1997 Asian Financial Crisis, to minimise their
exposure, many South Koreans exchanged the Korean won for
US$ as a safe haven, hastening the depreciation of the won.
Sometimes, intervention by the government can stop a
bandwagon effect from starting, but not always.

Governments in some markets can intervene to influence

currencies, e.g. in August 2015, the PRC government devalued
the Yuan to make its exports more competitive viz-a-viz the US
dollar even though China enjoys a current account surplus in its
trade with the US. President Donald Trump has called China a
“currency manipulator”. Consequently, several governments
including the South-east Asian governments which adopt a
managed float, e.g. Singapore, relative to the Chinese Yuan
devalued their currency as well.

Foreign Foreign exchange risk is the possibility that unpredicted

exchange risk changes in future exchange rates will have adverse
consequences for the firm.

Companies are exposed to 3 types of foreign exchange

exposure
a) Transaction Exposure – risk caused by fluctuating
exchange rate per transaction
b) Translation Exposure – risk at the end of financial year
when financial statements are consolidated and reconciled back
to home country. Once a year, and “paper loss/gain”
c) Economic Exposure – future earning power affected by
unexpected changes e.g. natural disasters.

• Transaction exposure is the extent to which the income from

What are the individual transactions is affected by fluctuations in foreign
risks that exchange values. Investors and businesses exporting or
businesses face importing goods and services or making foreign investments
in exchange have an exchange rate risk which can have severe financial
rate? consequences.

For example an American firm such as Wal-Mart which

maintains its low-cost advantages from made-in-China products,
but selling them in the US, stems at least in part from the
Chinese government’s policy to peg its yuan at a favourable
level against the dollar. As a result, if the yuan appreciates, Wal-
Mart’s low-cost advantage may be eroded, since its cost may
increase.

Compiled by Joanne Koo for SIM-UOL L01 and L04.

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 • Translation exposure or “accounting risk” occurs when the
foreign subsidiary of a firm maintains financial statements in a
foreign currency and has to consolidate assets and liabilities in
foreign currencies to the reported financial statements of
consolidated entity in home country (HQ). Foreign exchange risk
also exists when it is translated but not converted into the
reporting currency. It may result in a “paper” loss.

It is not of immediate concern until the balance sheet is drawn

up usually end of financial year. For instance, McDonald's saw
sales in Europe increase in 2011, but the yearly profits were
actually down as a result of a weakening euro.

• Economic exposure is the extent to which a firm’s future

international earning power is affected by unexpected changes
in exchange rates, e.g. natural disasters such as earthquakes,
war, or change in government in the host country which can
result in change in taxes.

What can firms do?

How can firms
manage the 3
types of From a resource-based perspective, a firm needs to build
exchange rate capabilities in treasury and foreign currency management.
risks? MNEs have four options to counteract their currency exposure.
i. Operational approach
ii. Strategic Hedging
iii. Diversification
iv. Financial market instruments

Transaction (a) Transaction risk from payment made or received in foreign

risk currency for companies who do cross-border trade or
investments.
i. Operational Approach
Invoicing exports and accept payment only in home currency
or US$. Insist imports be invoiced in its home currency.
Pros Cons
 Shift the entire exchange  Non-payment by a foreign
risk to the other party. buyer who may find it
 In the case of a US impossible to meet U.S.
exporter, it reduces the dollar-denominated
potential financial losses payment obligations due
due to devaluation of the to a significant devaluation
foreign currency against of the local currency
the U.S. dollar. against the U.S. dollar.
 Convenient, especially if  Export opportunities lost in
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 the other country does not
have an internationally
trade currency. Exports/
imports can be priced with
a neutral currency like US.
the first place because of
a “payment in U.S. dollars
only” policy.
 Firms must price exports
in local currency to drive
exports.

ii. Strategic Hedging Approach

Strategically structuring the business in a way that revenues
and expenses match in the same currencies. Involve big FDI
and sourcing decisions.
When Europe took on the Euro, Toyota in 1998 set up new
factory in France instead of expanding its UK operations as
France is in the Euro zone.
If Toyota receives a major export order from France, it may
order some components parts in France. Toyota uses euros
received for its export order of cars to pay for imports of
components.
Pros Limitations
Once the structures are in This method requires long
place, the risks are balanced. term structures involving
Useful also for managing managers from functional
translation exposure. areas such as production,
marketing and sourcing in
addition to those from
finance.

Currency risk
diversification iii. Diversification Approach
approach Working with a number of different currencies and offset loss
in some regions by gains in others.
E.g. a European firm selling to a wide range of countries in
2008 may have experienced substantial losses on its orders
from Greece but made gains on orders to Asia.
Pros Limitations
Having a truly international Aim here is to manage risks.
company can help with this Gains made in one country
as, theoretically, losses made can be eroded as well if there
when one currency falls will are exchange rate losses in
be recovered when another another country.
rises.

iv. Currency hedging in the following instruments:

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  spot exchange rates
 forward exchange rates, and
 currency swaps.
Spot exchange
rate
d) Currency hedging in spot rate (today’s rate)

When two parties agree to exchange currency and execute the

deal immediately (on the spot), the transaction is referred to as a
spot exchange. Thus, when a British tourist in Singapore goes
to a bank to convert her pounds into dollars, the exchange rate
is the spot rate for that day.

(i) A spot transaction is when the exporter and the importer

agree to pay using today’s (on the spot), exchange rate and
settle within two business days. Spot rates change continually,
often on a minute-by-minute basis

Pros
No capital outlay and potential for capital gain if home currency
rises in value
Cons
Forward Potential for capital loss if home currency falls in value.
exchange
(ii)A forward exchange occurs when two parties agree to
exchange currency and execute the deal at a specific date in the
future, say 30, 60, or 90 days.

Example, A US importer has to pay the Japanese laptop

company ¥200,000 per laptop in 30 days time. At the exchange
rate of $1 = ¥120, this is about $1,667.
However, if Yen appreciates to $1 = ¥95, then in 30 days’ time,
he will pay $2,105 for the same ¥200,000.

The US importer can sign a forward contract to lock in an

exchange rate (today) for a fixed time period, say 30 days at $1
= ¥110 and agree to buy or sell at this specified price on a future
date (30 days) irrespective of what the actual exchange rate will
be then. If the estimates are correct, this can be a beneficial
approach. Some businesses will also purchase currency in
advance if they know that they will be making big purchases and
are concerned about volatility.

In our example, $1 bought more yen with a spot exchange than

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 with a 30-day forward exchange indicates foreign exchange
dealers expected yen to appreciate in the next 30 days. Of
course, the opposite can also occur.
This is a similar effect as buying insurance.

Pros
Beneficial for companies
as a third party e.g.
financial institution bears
the risk
Cons
Bank fees can be costly.
Counterparty risk if the financial
institution goes bankrupt
Underlying transaction does not
take place as expected and future
revenues or expenses do not
realise. E.g. oil price and airlines

Currency Swap A currency swap is the simultaneous buy and sell of a given
amount of foreign exchange for two different time periods.
A swap is both SPOT and Forward rates for firms buying and
selling in foreign currency.

(This example is for your understanding. No need to describe in

exam how swap works.)
Example, Johnson and Johnson (J&J) both sells to and buys
from Japan.
Time 1 J&J buy parts from suppliers in Japan and pays in ¥.
Time 2 J&J sells medical equipment to customers in Japan who
pay in Yen ¥ but J&J factory in US needs US$ (expenses in
US$)
A swap is both SPOT and Forward rates for firms buying and
selling in foreign currency.
J&J create a 1 month Swap,
• Sell US$ for Yen on SPOT and simultaneously
• Buy US$ and Sell Yen on a 1 Month (1M) forward.
J&J purchase Yen reliably, reduces risk and has US $ for
domestic transactions in the meantime.

Pros
Elimination of transaction exposure, two deals can be covered
Cons
Loss of capital gain if exchange becomes higher than in the
deal.

Currency Option
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 More flexible than the forward contract as it gives the purchaser
of the option the right, but not the obligation, to buy or sell a
certain amount of foreign currency at a specified price within the
specified time frame.
Example:
A Singapore exporter who sells to European customers, buys an
option to sell 100,000 Euros at an exchange rate of 1€ =
SGD$1.50 in three months.
If at maturity, the spot exchange rate of the euro is below the
exchange rate, the exporter will exercise this option and receive
SGD$150,000.
However, if the spot rate moves to 1€ = SGD$1.70, he will not
exercise his option but sell his Euros in the SPOT market, where
he will receive SGD$170,000
The option protects the exporter against adverse moves in the
currency market without removing the benefits of favourable
movements.
Pros of Option
Elimination of transaction exposure
Flexible
Potential for capital gain if home currency rises in value
Cons
Premium fees to banks paid up front for option
Inflexible in size and timing of contract
• Options can be more expensive than forward contracts
especially in highly volatile market, but very useful
because of flexibility. When the amount and timing of
future cash flow is certain, companies prefer to use
forward contract.
(b) Translation (b) Translation risk exposure
risk exposure Some analysts are of the view that translation risk has no cash
flow impact and over time, the situation heals itself and is only a
paper loss.
Strategy:
It can be reduced through a strategic hedge. A firm matches its
assets denominated in a given currency with its liabilities in the
same currency.
Pros Limitations
Once the structures are in This method requires long
place, the risks are balanced. term structures involving
Useful also for managing managers from functional
areas such as production,
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 translation exposure. marketing and sourcing in
addition to those from
finance.
Unrealistic for smaller firms
without operations overseas.
(c) Economic exposure
the extent to which a firm’s future international earning power is
affected by unexpected changes in exchange rates, e.g. natural
disasters such as earthquakes, war, or change in government in
the host country which can result in change in taxes.

Strategy:
To deal with economic exposure, a company can distribute
productive assets to countries with less currency risks when
assessing the risk analysis of any investments. They can
implement centralised control, establish good reporting system
to monitor the firm’s exposure and ensure each sub-unit adopts
the correct mix of tactics and strategies. The company can also
produce monthly foreign exchange reports to be used as the
basis for hedging strategies.

Pros of such a strategy is that paying attention to currency risks

will result in choosing an attractive country for FDI. Limitations is
that sometimes political shocks cannot be predicted and that
such hedging can be costly.

2016 ZA and ZB
‘Given the wide variety of cross-border activities that international firms are
engaged in nowadays, it is inevitable that they are exposed to exchange rate
risks.’ Therefore:
(a) Explain the three different types of foreign exchange risk to which
international firms are exposed. (6 marks)
(b) Describe the strategies that international firms can employ to manage their
exchange rate risks. (14 marks)
(c) What are the factors that influence a currency’s exchange rate? (5 marks)

Examiner’s commentary

(a) The three are transaction exposure, translation exposure and economic
exposure. These should be discussed not just listed.
(b) Many strategies are possible but expect mention of strategic hedging, risk
diversification, currency hedging, and currency swap. Candidates could
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 choose to talk about these in depth with illustrative examples or a more broad
range of strategies.
(c) The factors include relative price differences, inflation and monetary supply,
interest rates, productivity and balance of payments, investor psychology,
bandwagon effect. We expected a discussion of these and not just bullet
points.

International currency exchange rates show how much one unit of a currency can be
exchanged for another currency. Currency exchange rates can be (i) floating, i.e.
they change continually based on a multitude of factors, or they can be (ii) pegged
(or fixed) to another currency, in which case they still float, but they move in tandem
to a reference country and the exchange rate between that currency and other
currencies is determined.

Knowing the value of your home currency in relation to different foreign currencies
helps investors to analyze investments priced in foreign dollars. For example, for a
U.S. investor, knowing the dollar to euro exchange rate is valuable when selecting
European investments. A declining U.S. dollar could increase the value of foreign
investments, just as an increasing U.S. dollar value could hurt the profitability of your
foreign investments.

Factors That Influence Exchange Rates

Floating rates are determined by the market forces of supply and demand of a
currency, which is in turn affected by the international trade market as well as foreign
direct investment. For example, if the demand for U.S. dollars by Europeans
increases because of trade, this will cause an increase in price of the U.S. dollar in
relation to the euro.

Firstly, relative price differences of products can affect the currency market.
According to the purchasing power parity (PPP) hypothesis, or the “law of one price”,
the price of similar products must be the same in different countries, if there are no
trade barriers. If the price of the latest iPhone 7 model costs US$700 in the US while
it costs US$850 in China, more people will buy US$ causing the price of
US$ exchange rate to appreciate.

Second, monetary supply and inflation, which is the amount of money in circulation
affects the exchange rate. During the financial crisis of 2008/9, the Bank of England
adopted a loose monetary policy to stimulate domestic demand, which caused a
depreciation of the pound against the euro. A loose monetary policy (e.g.
government ) can lead to higher inflation and depreciation of the currency in relation
to the currencies of trading partners.

Third, higher interest rates can offer lenders a higher return on investment. Countries
which offer a higher return relative to other countries will attract foreign capital and
cause exchange rate to appreciate. The recent increase in US interest rates and the
increase in acquisition of US Companies by PRC companies have caused an
increase in demand for US dollars and US exchange rate. [The current (spot)
exchange rate will be influenced by the interest rates offered on investments in both
Compiled by Joanne Koo for SIM-UOL L01 and L04.
11
countries (e.g. on government bonds). But forward exchange rates, the price of a
currency 30, 60, 90 or 120 days in the future, are also influenced by relative price
differences by market participants’ expectations about the interest rates then
prevailing.]

Fourth, productivity and balance of payments. A rise in a country’s productivity

improves its competitive position and tends to lead to a rise in the demand for, and
value of, its currency. A country experiencing a current account surplus will see its
currency appreciate in value, while a country experiencing a current account deficit
will see its currency depreciate.

Fifth, investor psychology. Short term movements are also influenced by investor
psychology. The bandwagon effect – investors moving as a herd in the same
direction at the same time – can occur. Example, during the 1997 Asian Financial
Crisis, to minimise their exposure, many South Koreans exchanged the Korean won
for US$ as a safe haven, hastening the depreciation of the won. Sometimes,
intervention by the government can stop a bandwagon effect from starting, but not
always.

The above describes the economics and psychology in determining exchange rates.
However, the markets for some currencies are heavily influenced by governments,
e.g. in August 2015, the PRC government devalued the Yuan to make its exports
more competitive viz-a-viz the US dollar even though China enjoys a current account
surplus in its trade with the US. President Donald Trump has called China a
“currency manipulator”. Consequently, several governments including the South-east
Asian governments which adopt a managed float, e.g. Singapore, relative to the
Chinese Yuan devalued their currency as a result.

2. What risks does an international business face from exchange rate

fluctuations?

An exchange rate is the rate at which one currency is converted into another.
Foreign exchange risk is the financial risk which occurs when unpredicted changes
in future exchange rates have adverse consequences for the company. Exchange
rates influence the profitability of trade and investment deals because an adverse
shift in the value of a currency can turn a deal that had appeared to be profitable into
a bad choice.

However, while private investors only have their own savings to worry about if they
fail to manage this risk appropriately, businesses face angry shareholders and a
drop in share value - as well as a drop in profits.

Companies need to protect themselves against three types of foreign exchange risk:
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12
• Transaction exposure is the extent to which the income from individual
transactions is affected by fluctuations in foreign exchange values. Investors and
businesses exporting or importing goods and services or making foreign investments
have an exchange rate risk which can have severe financial consequences. For
example an American firm such as Wal-Mart which maintains its low-cost
advantages from made-in-China products, but selling them in the US, stems at least
in part from the Chinese government’s policy to peg its yuan at a favourable level
against the dollar. As a result, if the yuan appreciates, Wal-Mart’s low-cost
advantage may be eroded, since its cost may increase.

• Translation exposure or “accounting risk” occurs when the foreign subsidiary of

a firm maintains financial statements in a foreign currency and has to consolidate
assets and liabilities in foreign currencies to the reported financial statements of
consolidated entity in home country (HQ). Foreign exchange risk also exists when it
is translated but not converted into the reporting currency. It may result in a “paper”
loss. It is not of immediate concern until the balance sheet is drawn up usually end
of financial year. For instance, McDonald's saw sales in Europe increase in 2011, but
the yearly profits were actually down as a result of a weakening euro.

• Economic exposure is the extent to which a firm’s future international earning

power is affected by unexpected changes in exchange rates, e.g. natural disasters
such as earthquakes, war, or change in government in the host country which can
result in change in taxes.

Siam Cement in 1997 had $4.2 billion debt denominated in foreign currencies and
hedged none of it. When the Thai baht sharply depreciated against the US$ in July
1997, Siam Cement had to absorb $517 million loss, which wiped out all the profits it
made during 1994-1996

MNE subsidiary managers in certain countries may believe that there are lucrative
opportunities to expand production.

However, if these countries suffer from high currency risks, it may be better for the
company, as a whole, to curtail such expansion and channel resources to other
countries whose currency risks are more manageable.

This can be anticipated by company when it is looking at future cash flow or sourcing
of parts and components or where to locate its investments.

It requires the company to distribute productive assets to various locations so that

the company’s financial well-being is not severely affected by changing exchange
rates.
Reducing economic exposure also requires companies to be sure that assets are not
concentrated in countries where likely rises in currency values will mean significant
increases in the prices of the goods and services produced.

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13
3. Establish how a firm and its management can respond to exchange rate
risks in international business.

Exchange rate risk is a financial risk that exists when a financial transaction is
denominated in a currency other than that of the base currency of the company. The
risk is that there may be an adverse movement in the exchange rate of the
denomination currency in relation to the base currency before the date when the
transaction is completed.

Investors and businesses exporting or importing goods and services or making

foreign investments have face different types of risk mentioned in (2) which can have
severe financial consequences; but steps can be taken to manage (i.e., reduce) the
risk.

What can firms do?

From a resource-based perspective, in addition to striving for excellence in

operations and marketing, a firm’s capabilities in currency management may make
or break them. MNEs have four options to counteract their currency exposure.

(a) Transaction risk arises from payment made or received in foreign currency for
companies who do cross-border trade or investments.

Firstly, an operational approach is for an US exporter to shift the entire exchange risk
to the other party by invoicing its exports and to only accept payment in home
currency and insisting that imports also be invoiced in its home currency. This will
reduce the potential financial losses due to devaluation of the foreign currency
against the U.S. dollar.

The Cons of this approach is the non-payment by a foreign buyer who may find it
impossible to meet U.S. dollar-denominated payment obligations due to a significant
devaluation of the local currency against the U.S. dollar. Export opportunities may
also be lost in the first place because of a “payment in U.S. dollars only” policy.
Firms must realise that if it wishes to drive exports, it may need to price its exports in
local denominated currency.

Secondly, Strategic Hedging or strategically structuring the business in a way that

revenues and expenses match in the same currencies.

This usually involves big FDI and sourcing decisions which was what Toyota did in
1998 by deciding to set up its new factory in France instead of expanding its UK
operations as France is in the Euro zone. If Toyota receives a major export order
from France, it may order some components parts in France. Toyota will then use

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14
the euros received for its export order of cars to pay for its own imports of
components.

However such a method requires long term structures that involves managers from
many functional areas (such as production, marketing and sourcing) in addition to
those from finance.

Thirdly, a firm could look into currency risk diversification by reducing risk exposure
through working with a number of different currencies and offset loses in some
regions by gains in others. Having a truly international company can help with this
as, theoretically, losses made when one currency falls will be recovered when
another rises.

E.g. a European firm selling to a wide range of countries in 2008 may have
experienced substantial losses on its orders from Greece but made gains on orders
to Asia.

Fourthly, a firm may manage its risk by using financial market instruments such as
the use of hedging in the spot rate, a forward contract or via swaps.
(i) A spot transaction is when the exporter and the importer agree to pay using
today’s exchange rate and settle within two business days.

(ii) The firm can also lock in an exchange rate for a fixed period of time by setting up
a forward contract, or agreements to buy or sell at a specified price on a future date.
If the exposure estimates are correct, this can be a beneficial approach. Some
businesses will also purchase currency in advance if they know that they will be
making big purchases and are concerned about volatility.

Given the unpredictable nature of exchange rates, it seems natural that firms that
deal with transactions in foreign currencies would engage in currency hedging as it
would have a similar effect as buying insurance.

(b) Translation risk exposure

Some analysts are of the view that translation risk has no cash flow impact and over
time, the situation heals itself and is only a paper loss.
It can be reduced through the use of a strategic or balance sheet hedge. A firm
matches its assets denominated in a given currency with its liabilities in the same
currency.

(c) Economic exposure

To deal with economic exposure, MNEs must pay attention to currency risks in
addition to the risk analysis of any investments. They can examine both long-term
movements such as PPP and balance of payment, and short term fluctuations such
as interest rate changes and investor mood swings.
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15
Pros of such a strategy is that ignoring currency risks will result in otherwise
attractive country having a devaluation in the future. Limitations is that sometimes it
cannot be predicted and that such hedging whether through strategic or specialists in
banks can be costly.
Company can distribute productive assets to countries with likely rises in currency
values. Implement a system of centralised control to ensure that each subunit
adopts a correct mix of tactics and strategies
– Forecast future exchange rates
– Establish good reporting systems so that the central finance function
can regularly monitor company’s exposure position.
– Produce monthly foreign exchange exposure reports that can be used
as the basis for hedging strategies
– Risk diversification by working with different currencies. Offset gains in
some regions with losses in some regions.
– Use financial instruments such as hedging and currency swap.

However there are costs and risks such as bank fees, counter party risks and
uncertainty in the underlying business transaction.

Costs and Risks

Hedging costs can be quite high if a firm wants to hedge over long time periods,
unusual contract length or in less traded currencies.

Next, counterparty risk - the risk that the bank, with which the firm has a hedging
contract, goes bankrupt. Usually this possibility is seen as remote. But in 2008,
when Lehman Brothers went bankrupt, some businesses found themselves with
claims that they could not realise.

Third, there is a possibility that the underlying transaction does not take place as
expected and future revenues or expenses do not realise.
Example, when oil price soared in 2007, many airlines anticipated having to pay a
higher price for fuel in the future. Thus, they expected to need a lot of US$ in the
future and bought them using forward contracts. However, in 2008, the oil price fell,
while demand for air travel slowed. As a result, airlines found that they needed
fewer dollars than expected, but they had entered into forward contracts at a time
when the dollar was relatively expensive, and they had to sell those dollars at a
lower price in the spot market. As a result, Cathay Pacific had to write off $1 billion
while Ryanair, Air France and Southwest also made substantive losses.

Hence in 2008, about 55% of large firms engaged in financial hedging. Among
America’s largest firms, about two thirds do not use financial hedging, including
many large firms, such as 3M, ExxonMobil and IBM as hedging eats into profits,
costing up to half a percentage point of profits. For large firms that have only a small
part of costs and revenues in foreign currencies, it may be viable.
Compiled by Joanne Koo for SIM-UOL L01 and L04.
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But for small firms with a large share of international business, such as Siam Cement,
such a strategy can be fatal.

Compiled by Joanne Koo for SIM-UOL L01 and L04.

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Mind-Map

Compiled by Joanne Koo for SIM-UOL L01 and L04.

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Past exam questions

2022 ZB
‘Currency exchange rate fluctuations can seriously damage an international
business.’ Discuss as follows, using illustrative examples:
a) What factors determine exchange rates? (9 marks)
b) How can an international business reduce the risks from currency exchange rate
fluctuations? (9 marks)
c) Are cryptocurrencies the answer to exchange rate challenges? (7 marks)

2017 ZB
‘Exchange rate management is a very important issue for many international firms
which are engaged in cross-border trade and investment activities.’
a) Explain the determinants of a currency’s exchange rate. (5 marks)
b) Describe, with examples, the three types of exchange rate exposure that
international firms face. (6 marks)
c) How can an international firm reduce its exposure to exchange rate risks? (9
marks)
d) Explain the disadvantages of the strategies identified in part c) above. (5 marks)

2016 ZA and ZB
‘Given the wide variety of cross-border activities that international firms are engaged
in nowadays, it is inevitable that they are exposed to exchange rate risks.’ Therefore:
(a) Explain the three different types of foreign exchange risk to which international
firms are exposed. (6 marks)
(b) Describe the strategies that international firms can employ to manage their
exchange rate risks. (14 marks)
(c) What are the factors that influence a currency’s exchange rate? (5 marks)

2015 Prelim
a) What are the risks of exchange rate fluctuations for firms engaged in international
business? (3 marks)
b) How can an international manager reduce his or her firm’s exposure to currency
exchange rate risks? (10 marks)
c) Explain the disadvantages of the alternatives identified in part (b) above.(7 marks)
d) What are the determinants of a currency’s exchange rate? (5 marks)

Compiled by Joanne Koo for SIM-UOL L01 and L04.

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