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CHALLENGES IN FORECASTING

EXCHANGE RATES BY MULTINATIONAL


CORPORATIONS
IN GLOBAL FINANCE ERA

AU TH O R 1 - M R . S C . M I L O R AD S TAM E N O V I C
AU TH O R 2 - P R O F.D R TATJ AN A C V E TK O V S K I
AU TH O R 3 - P R O F. D R D I N K O P R I M O R AC
INTRODUCTION

Among all differences between MNCs and domestic companies,


most important one is that MNC have operations worldwide
one of the most important financial issues is dealing with
exchange rates and its forecasting
MNC needs to predict future currency movements in order to
create environment for decision making process
Cash flow predictions are closely related to exchange rates
predictions
Financial decisions are based on forecasting exchange rate
Reporting of financial statements is obligation of MNC that
needs to be accomplished per regulatory requirements
(influenced by exchange rates/investment decisions)
WHEN MNC NEED TO
FORCAST EXCHANGE RATE
Academic model of IRP, IFE or PPP lead to very strong
explanation of exchange rates movements (Madura, Fox 2011)
In practice, theoretical forecasting abilities are not superior;
actually, those abilities are on low level of forecasting accuracy
Purchasing power parity, Interest rate parity and International
Fisher Effect effect are able to show approximately 10% of
changes/variation into exchange rates (Madura J., Fox R, 2011)
there is problem with underestimated extreme situations and its
influence on exchange rate variations
small movements can be predicted, but large movements
cannot be predicted with high level of certainty
MNCs will much more appreciate forecasting of high
movements (long term forecasting)
SIX BASIC CONCEPTS
Madura and Fox are relaying on six basic concepts when some
Multinational corporation is interested in forecasting future exchange
rates:
Hedging decision
Short term financing decision
Short term investment decision
Capital budgeting decision
Earnings assessment
Long term financial decision
Three main types of exchange rate risks
(Madura,Fox, 2007)

Transaction risk, cash flow risk that deals with the effect of exchange
rate moves it influence to receivables (export contracts), payables
(import contracts), or repatriation of dividend.

Translation risk, balance sheet exchange rate risk exchange rate


moves to the valuation of foreign subsidiary, and in turn it affects
parent company balance sheet.

Economic risk, risk to the firm present value of future operating cash
flows from exchange rate movements, Economic risk influence on
exchange rate on revenues (domestic sales and exports) and
operating expenses (cost of domestic inputs and imports).
HEDGING DECISION
Hedging decision is closely related to revealing potential risks which may
influence on exchange rate (Papaioannou, 2006)
In practice, chosen hedging strategy mostly depends on frequency of
certain type of risk and the size of the MNC (Papaioannou M, 2006).

HEDGING TRANSACTION RISK


Transaction risk is often hedged strategically or tactically in order to prevent
earnings and cash flows related to the firm views on future exchange rate
movements
When using tactical hedging, transaction currency risk from receivable and
payable transactions is based on short-term period.
When firm is using strategically hedging, then firm is considering procedures on
long term basis.
HEDGING
TRANSLATION RISK
Translation risk can be hedged on none systematically basis, mainly in
cases of avoiding shock effect on net assets.
risks are mainly related to long term exposure on foreign market. Example
could be debt structure of foreign subsidiaries. (Papaioannou M, 2006)
Hedging translation adjustment is used as method for minimizing adverse
reactions of exchange rates on net income and cash flows (Bandopadhaya,
et al, 2010)

HEDGING ECONOMIC RISK


Economic risk is very difficult to be measured - it measures potential impact
on the present value from one hand and cash flows from the other.
E.g. When inflation rate is followed by exchange rate excursions due to
PPP and MNC have subsidiary which is facing inflation above expected
inflation rate - competitiveness of the firm can be found as a result of
adjustment of exchange rate that is not in line with PPP
SHORT TERM
FINANCING
DECISION
Most of companies and especially MNCs use short term
financing decisions
Main reason is in reaching access to additional funding.
Decision should be brought on management level and all
managers should be informed about potential risks of this type
of decision making.
In addition, maximization of value of MNC is expected outcome
of use of short term financing decisions (Madura J., Fox R, 2007).
Short term investment
decision

Short term decision is protecting need of Multinational


corporations to have new investments that exceeds cash in
short period of time.
Ideal situation will be adjustment of exhibiting of high interest
rates and strengthening of respective value over time
investment (Madura J., Fox R, 2011).
CAPITAL BUDGETING
DECISION
Capital budgeting decision need to be brought in order to
investigate investments- especially foreign direct investments.
MNC have to take in account that there will be changes of
exchange rates when referring to specific currency.
Analysis of capital budgeting can be managed only in case
when all cash flows are estimated and translated to parent
company in local currency.
Capital budgeting technique also allows MNC to find best
possible solution for further investments.
EARNINGS
ASSESSMENT
Multinational corporation parent company need to make
decision whether earnings from their subsidiary will be further
invested to foreign country or earnings will be sent back to
parent company.
Main reason for such decision-making activity is related to
exchange rate fluctuations and it could be observed trough
translation of earnings into parent company.
As an outcome, result should be evaluated with measured
earnings from foreign investment country (Madura J., Fox R, 2011).
Long term financial
decision
MNC financial decision is mostly defined by the interest rates
Cost of long term investment is based on percentage change in
exchange rate on currency during loan duration (and on quoted
interest rate).
In practice, bonds denominated in foreign currencies have lower
yields in U.S. corporations mainly consider issuing bonds in these
currencies.
There should be noted that this is not always case.
E.g. Multinational Corporations as Disney, Hewlett Packard and
IBM, issued bonds n Japanese yen in order to capitalize because
yen has lower interest rate.
There is no guarantee that that the bond will be less worth then
U.S. dollar bond that is denominated (Madura J., Fox R, 2007).
RISKS ON SIDE OF MNC
RELATED WITH EXCHANGE
RATE VARIATION AND
EXCHANGE RATE MANAGEMENT

Risk related with exchange rate variation:


A common types of exchange rate risk relates to the effect of
unexpected exchange rate changes on the value of the firm
are following (Papaioannou M, 2006)
Direct result of un-hedged exposure
Indirect loss in the firms cash flows, assets and liabilities,
net profit, in turn, its stock market value from a exchange rate
move
MEASURMENT OF
EXCHANGE RATE RISK
Measuring of currency risk may appear difficult, at least with regards
to translation and economic risk. (Papaioannou M, 2006)
Transaction exposure is related to cash flow risk. Cash flow will
further influence on transaction accounts on side of receivables i.e.
export contracts or potentially dividends repatriation. Changing of
exchange rate in currency of denomination will further result in direct
transaction exchange rate risk for company. (Papaioannou M, 2006)
According to Bandopadhaya, et all (2010), two methods are
commonly used for measuring exposure of transactions (2):

1. Net translation exposure measurement


2. Value at risk measurement (VAR)
NET TRANSLATION
EXPOSURE MEASUREMENT
This type of risk measuring is used when MNC need to make consolidation from
inflows and outflows in foreign subsidiary on currency by currency basis according
(Bandopadhaya, et all, 2010).
Advantage of this method is in fact that MNC will be able to identify expected net
positions in foreign currency for observed following periods.
After net currency flow is determinated, it can be used as a whole or as a range
for specific currency.
Afterwards MNC need to consider ratio between all currencies and to compare
with currencies variability and with correlations among currencies Bandopadhyaya,
et al, 2010).
VALUE AT RISK
VaR does not show what happens to exposure
(100-z)% point of confidence worst case
scenario. Because of that, companies often use
risk management methods such as stop loss or
they put some operational limits.
VAR calculation depends on three
parameters (Papaioannou M, 2006):
1. Estimated time for position duration, typically 1 day
2. The confidence level when estimated is planned to
be done. Usually it is around 95-99%
3. Currency that is used for VAR denomination
VALUE AT RISK

For VaR calculation there are many different models, but


most used ones are following :

1. The Historical simulation assumes that currency returns


on companies foreign exchange position will have the same
distribution as previous was
2. The Variance covariance model assumes that currency
returns on previous position and also that the change of value
is linearly dependent on all returns
3. Monte Carlo simulation assumes that future currency
returns will be randomly distributed
EXCHANGE RATE
FORCASTING
Main approaches of forecasting foreign exchange rates are
(Madura J., Fox R, 2011):

1. Fundamental approach
2. Technical approach
3. Market based
4. Mixed
EXCHANGE RATE
FORCASTING
For operation of measuring translation gains and losses and also
translation operating exposure MNC need to make accurate
estimation of future exchange rates.
In a case of Hedged position, there is option in which such situation
could lead to losses in future if exchange rates are constantly differ
from forecasted ones.
If analysis is based on empirical results, we can say that
results are not still on satisfactory level according to numerous
literatures.
General opinion is that spot exchange rate is random-walk and
structural exchange rate models are not able to forecast this
simple random-walk model.
CONCLUSION
MNCs need to monitor and forecast foreign exchange in order
to have clear assessment in regards of their current and future
business conditions.
Without sophisticated analyzing of exchange rate movements,
MNC will be completely out of data which are of outmost
importance for its strategic business activities.
In this paper there is described relation between decision of
management for investments, loans, hedging, budgeting on
short and long run on one side and further measuring of
specific risk exposure of MNCs.
Also, in paper are displayed systems for risk measurement
which are highly important for resolving this specific risk issue.
CONCLUSION
MNC management is at high pressure in order to bring appropriate
determination of future currency fluctuation.
As most of economics literature states, long term and short term
forecasting needs to be done with different analyzing techniques with
usage of different models but long term forecasting is something that
is not so reliable for decision making processes.
In managing risks, MNC often use hedging strategies, and specific
hedging strategy depends from respective situation.
Hedging strategies becomes very complicated because they are
developed to address transaction, translation and also economic risk.
As these risks are something that influence all companies (not
considering size of companies) - there is increased number of users of
hedging strategies and there is higher demand for hedging protection
and also greater variety of hedging instruments (Papaioannou M, 2006).
THANK YOU!

Milorad Stamenovic
m.stamenovic@rocketmail.com
+381 63 273 978