Management Of Currency Fluctuations

As a Multi National Company (MNC), our company operates in a number of foreign countries and as a result of this, the company’s monetary transactions occur in a variety of different currencies ($, Euro, Yen). In this occasion we need periodical currency exchanges between our domestic currency and all the other currencies that we have invested. These periodical currency exchanges brings an important problem with it as none of the currencies are stable and they always gain or lose value against each other, and this unstable situation is very risky for all MNCs because, as an example, if a currency is depreciating against our local currency that means all our cash earned in this currency is losing its value and on the other hand if we are planning to invest in another currency, appreciation of this currency means that our investment will cost much more than we expected. This is called the “currency risk”.

Currency changes can be forecasted and there are various forecasting types to get information about the currency changes in the future but all these methods are not precise enough to fully protect the company, so the companies have to manage their exposure to currency fluctuations. There are three types of exposure to currency fluctuations;

-Transaction Exposure: A company’s cashflow in a foreign currency is always under effect of currency fluctuations. To measure the transaction exposure there are two steps;

1. Determining the net amount of cashflows in each foreign currency :

The company has to determine the net amount of cash inflows because there may be cases which different subsidiaries can have equal inflows and outflows of the same currency which will make that currency’s risk negligible. So by projecting the net cashflows of each currency we will be aware of the amount of cash we have in each currency but this information alone does not mean anything as the transaction risk also depends on the volatility of the currency. As an example we may have lot much more net cash flows in Euros but if Yen’s volatility is higher than Euro’s then we may have more risk in Yen rather than Euro.

2. Determining the risk of exposure to those currencies :

As it is mentioned above, to determine the risk, we have to know the variability of the currencies which can be found by the calculating the standard deviation of the foreign currency;

- Economic Exposure: The effect of currency fluctuations over the company’s present

cashflow is called the economic exposure. This means even if the company’s all transactions are in their local currency, their income will be effected of currency fluctuations because these fluctuations will cause transaction exposure on the customers of the company all over the world and it may direct them to buy less or much from the company and of course our company will be effected by this kind of exposure.

- Translation Exposure: This is the type of exposure which MNCs will face while creating their

financial statements, since they have to translate each subsidiary’s financial statement to the domestic currency. So exchange rate movements will surely effect the financial statement of the company.

As stated above our company is subject to all three types of currency risks and we have to manage such risks to protect our company’s earnings. While managing risks, each type of risk exposure has to be concentrated on seperately.

Management of Transaction Exposure: There are mainly three steps for this ;

- Identifying net transaction exposure: Every subsidiary has to send its cashflow and they are consolidated in a centralised part. By that way, the net expected exposure in each currency is identified.

- Adjusting the invoice policy: In this step the company has to decide whether to hedge the exposure or not. Although there is an exposure the company may decide not to hedge according to the situation, because expenditures of hedging may be equal to the risk or there may be offsetting transactions which will then zero the exposure.

- Hedging technique decision: If the company decides to hedge, then it has to select the appropriate hedging technique by comparing the cashflows expected from each technique. Possible hedging techniques are stated as below;

1. Futures Hedge: This type of hedge entitles the company to buy or sell a specified amount in a specified currency for a specified price on a specified date .

2. Forward Hedge: This type is very similar to future hedge but it is usually applied to larger transactions and in forward hedges the company has an option to specify the exact amount it needs . The decision for a forward contract is given by looking at the expected cost of hedged payables.

3. Money Market Hedge: Two differents procedures are followed to hedge payables or receivables;

-Payables: When the firm has a payment in the future it can convert the money immediately to the specified currency and deposit it into a bank account. In this ocasion the company has to convert a discounted money since the money which is put into the bank will have the surplus interest when the payment time comes and the money will not be affected of currency fluctuations.

- Receivables: To hedge the receivables the company should borrow the money which will be received in a period of time and convert it to its own currency immediately so the receivable can be used to repay the borrowing.

4. Currency Option Hedge: The all three hedging types were obliging the company to buy or sell the specified amount which prevents the company to take advantage of the currency changes if the currency movements go favourably. In currency option hedge the company just has the right to buy or sell the specified amount so the company may decide not to use the option if the present market value of the currencies make the company better off.

Hedging decisions are given by considering all hedging options together. For our company’s payment of 30.000.000 Yen which is due in twelve months time we have to consider all options including not to hedge, In this case our options are; 1)Forward hedge, 2) Money market hedge, 3) Option hedge, 4) No hedge

- Forward Hedge: Spot rate of japanese yen is 0,0048Ð'Ј and the forward rate is 0,005Ð'Ј so the hedging cost will