risk exposure

There are three types of exchange rate risk exposure:-

Translation exposure

Transaction exposure

Economic exposure

Translation exposure

A company which has assets and firms in other countries is subject to translation exposure. Translation exposure results due to the fact that a parent company must merge all operations of its subsidiaries into its own financial statements. Because a foreign subsidiary's assets are carried on its books in a foreign currency, it is imperative to convert the foreign values into domestic currency to combine with the parent's assets. During the translation process, results in gains and losses occur due to the fluctuating exchange rates. Since this type of exposure is related to assets and liabilities in balance sheet, it is sometimes referred to as accounting exposure (Bhola, 2008).

The main issue related to the translation of foreign asset values has to do with whether the accurate exchange rate to use is the historic rate of exchange that existed at the time when asset was acquired or the current exchange rate (Bhola, 2008).

Transaction exposure

It is the risk of losses or gains which occurs when a company engages in trade transactions in which the currency of the transaction is foreign to the company; i.e., denominated in a foreign currency. It is the type of exchange rate risk that is managed by various ways like forward contracts, futures, options and money market hedges (Cuckee, 2009).

Economic exposure

It is the risk which is associated with revenues, costs and demand for goods as foreign exchange rates fluctuates. Economic exposure is often called “operating exposure” since it refers to the risk to operations. An example would be a devaluation of a foreign currency which makes product relatively more expensive. So, it would be less competitive in the foreign country (as well as locally), resulting in lower sales and lower profits (Cuckee, 2009).

There is no perfect hedge, but in order for a company hedge against economic exposure, there are actions that a company may take to help offset the risks over longer period of time.

Production Management

• Sourcing of products: Diversify the source of materials. If you are manufacturing in an overseas country that witness's devaluation, then some of the loss of profits and sales from your products which becomes comparatively more expensive is offset by the fact that some of the costs have become less expensive, because they are now bought from country with weaker currency.

• Shifting production: As sales drop due to a currency becoming more expensive, production can be shifted to countries where a weaker currency results in lower costs, again shielding your profit margin, although the sales will decline (Bhola, 2008).

Marketing Management

• Geographic diversification: If sales become weak in one country, they can increase in another because of change in currency values.
• Market segmentation: High-end (luxury) segment or low-end (economy).
• Profit margin versus market share.
• Differentiation of product: It helps make product less vulnerable to changes in price (Bhola, 2008).

Financial Management

• Arrange financing: So that a drop in sales from a weaker currency, is offset by servicing costs with cheaper debt (Cuckee, 2009).

Recommendations to the G20 Summit

Need for Restructuring Dysfunctional Terms of Trade

In order to save the world from a lingering depression, international trade should be restructured from its current disparaging role of preempting domestic development toward a new constructive role of supplementing it. The nearly two-year-old crisis in financial markets has been shaped by unwarranted debt denominated in a fiat dollar, whose issuer has for decades failed to live by discreet rules of monetary and fiscal discipline, and the solution to a debt-infested financial catastrophe is mistakenly deemed to be merely shifting massive private sector debt into public sector debt by spending future taxpayer money to protect zombie financial institutions from bankruptcy. This move toward saving the decrepit institutions from free market capitalism in spite of protecting the severely injured global economy will only aggravate and extend the current financial crisis into a decade-long worldwide economic depression.

USA, whose fiat currency has the unfair advantage of being the dominant reserve currency for international trade, damages the economic and political sovereignty of independent nations. When international trade is denominated in fiat dollars, the US essentially imposes a global tax on all trade worldwide, whether or not the US is a direct participant in the transaction or it takes place within US jurisdiction. Foreign investment denominated in dollars, direct or indirect, goes only to projects that can earn dollars, and not to where target nation needs most for domestic development. Foreign investment then serves the foreign investor mainly, and only peripherally the target nation. That's why both foreign trade and foreign investment at levels beyond augmenting domestic development are objectionable and the G20 should seek other methods of economic development.

Breaking Free from Dollar Supremacy

Dollar supremacy precludes non-dollar economies from financing domestic development with sovereign credit denominated in their own currencies and compel them to rely on foreign capital denominated in dollars. Also, exporting economies are in actual, shipping real wealth created by low wages and environmental abuse to nations which have unearned sources for dollars. The dollar-denominated trade surplus earned by exporting nations can't be spent in domestic economy without first converting it to local currency. But such conversion will create inflation since wealth behind the new local currency has already been shipped to the importing nations.

Therefore the exporting nations, while ravenous for capital, have to invest the dollars which they earn from environmental abuse and low wages back into the dollar economy, allowing the importing economies to get more dollars to import more. Capital from the dollar economy is in actual debt from the exporting economies. However such debt will go back to the lending economies as foreign capital to devote to the export sector in a cruel circle. Dollar supremacy is in essence the setting for a free transfer of wealth from poor countries to the rich countries. This free transfer of wealth harms workers in both poor and rich countries by keeping wages less through cross border wage arbitrage. Low wages then create overfilling unsupported by enough demand in every economy.

When sellers and buyers are located within the same country, with arrangements denominated in domestic currency, even though with imbalance of payments, free trade is not greedy. But when buyers are located in separate countries from sellers, and trade is denominated in the buyer's fiat currency due to currency supremacy, trade becomes greedy and in favor of the buyer, even if the balance of payments is in favor of the seller. Fundamentally, this is the situation with US-China trade.

2. Why does cost of capital for MNCS differ from that of domestic firms? Explain giving examples. Give your recommendations with the present failures of MNCs to the G20 summit.

There are several factors which affect a company's cost of capital:

1. The size of the company: An MNC that often borrows substantial amounts may receive preferential treatments from creditors, thereby reducing its cost of capital (Madura and Fox, 2007).

2. Access to capital markets: MNC's access to the international capital markets may allow it to obtain funds at lower costs that that paid by domestic firms. The Coca Cola Company's recent annual report said: “Our global presence and strong capital position afford us easy access to key financial markets globally, enabling us to obtain funds at low cost. This posture, coupled with the aggressive management of our mix of short-term and long-term debt, results in an overall lower cost of borrowing” (Madura and Fox, 2007).

3. Diversification: If a firm's cash inflows come from sources globally, those cash flows may be more stable since the firm's total sales will not be influenced by a single economy, which may reduce the probability of bankruptcy and hence reduce the cost of capital (Cheol and Resnick, 2006).

4. Exchange rate risk: An MNC's cash flows can be more unstable than those of a domestic firm in the same industry, if it is exposed highly to exchange rate risk. If foreign earnings are remitted to a British parent company of an MNC, they won't be worth if the British pound is strong against major currencies (Madura and Fox, 2007).

5. Country risk: An MNC having foreign subsidiary is subject to the likelihood that a host country government may seize a subsidiary's asset. This could occur due to factors such as attitude of the host country's government, changes in tax laws and industry of concern. Exxon Mobil has much experience in evaluating the viability of project in foreign countries. If it detects a major change in tax policy or change in government, it adds a premium to the required return of projects (Cheol and Resnick, 2006).

Recommendations to the G20 Summit

Trade Finance

One of the most important problems faced by the global economy currently is the sharp drop in trade across the world - the first diminution in trading in a generation. And in order to overcome this problem, the G20 summit must ensure that proper financial support is provided to the developing countries of the world.

Because exporters from the emerging economies are unable to get credit in the wake of this global financial crisis, so credit guarantee would allow them to continue manufacturing goods at competitive prices and to export them. Consequently, it will create an atmosphere of competitiveness and MNC's will also offer goods at lower prices in their operating countries, allowing them to flourish as well.

Protectionism

The G20 summit should make sure that the tariff or quota on goods imported from overseas should be reduced, so that MNC's can use their diversification advantage and provide the same goods at competitive countries in other countries as well. Worst affected countries in this current economic downturn can benefit from this to the maximum, and get goods at competitive prices from countries like China, India etc. to break this recession.

In addition, any new trade barrier should be removed for a longer period, so that new entrants can also come and offer goods at cheap prices, which will create an atmosphere of competitiveness.

Bibliography

Avon, D. (2008). A close eye on the developing economies. Lecture delivered at the University of Bradford.

Bhola, N. (2008). Foreign Exchange Rate Exposures.

Available at http://www.managementparadise.com/forums/archive/index.php/t-24525.html/ [Accessed 12/7/2009].

Carl Dahlman (2007) “Development Strategies of China and India: What can we learn from the development strategies of these two Giants?” forthcoming in FDI, Technology and Competitiveness. UNCTAD.

Cheol, S. (2006), International Financial Management, Irwin Professional Pub.

Cuckee.com (2009). Types of exchange rate risk exposures.

Available at http://www.cuckee.com/types-of-exchange-rate-risk-exposure-forex-and-finance/ [Accessed 13/7/2009].

Fox (2007), International Financial Management, London: Thomson Learning.

Madura, J. (2007), International Financial Management, London: Thomson Learning.

Nabeshima, K. (2006), China's Development Priorities, London: Thomson Learning.

Available at http://www.flipkart.com/china-development-priorities-shahid-yusuf/0821365096-r7w3f9glj3/ [Accessed 15/7/2009].

Resnick, B. (2006), International Financial Management, Irwin Professional Pub.

Yusuf, S. (2006), China's Development Priorities, London: Thomson Learning.

Available at http://www.flipkart.com/china-development-priorities-shahid-yusuf/0821365096-r7w3f9glj3/ [Accessed 15/7/2009].

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