Managing Financial Risks in International Trading PART 2
Additionally, an MNE also suffers from operating risk which results from changes in the company’s future operating cash flows due to unexpected changes in the foreign currency exchange rates
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4. Managing Operating risk
Additionally, an MNE also suffers from operating risk which results from changes in the company’s future operating cash flows due to unexpected changes in the foreign currency exchange rates (Eiteman, et al, 2012). Taking Coca-Cola and Pepsi as examples, half of their revenue were from overseas customers, but in the last quarter of 2014, both of them reported a drop in revenue mainly due to a sharp appreciation of the U.S. dollar (Figure 1) (AP, 2015). Actually, many other companies, such as Avon Products, Yum Brands, BMO Private Bank, etc., also complained of less-than-expected earnings due to a strong U.S. dollar in the last quarter of 2014. Analyses showed that in the beginning of that quarter, companies in the S&P 500 index were optimistically projecting an averaged profit growth of 11%, but they eventually presented a growth rate just about 7% (AP, 2015). Clearly, volatile exchange rates could hurt MNEs’ revenue and profits and hence their assets and liabilities would be less than projected (Lessard and Lightstone, 1986). Most interestingly, many MNEs view the situation as unavoidable but it is actually the operating risk that requires attention. In general, the operating risk is dynamic and subjective because it varies with an MNE’s projection of future operating cash flows and the future currency exchange rates. In this case, many companies did not foresee a strong surge of the U.S. dollar in the winter of 2014; therefore, they received less than expected profits when earnings were all converted to the U.S. dollar at the end of that quarter. The management of operating risk is very important to an MNE’s business because it directly affects the company’s operations and earnings. Unfortunately, when the future is concerned, nothing can be certain. If companies rely on an accurate projection of the future foreign currency exchange rate to deal with the operational risk, the chance of avoiding risk and minimizing loss is obviously low.
In another example, if one American MNE gets nearly half of its total revenue from overseas operations and has forecasted that the U.S. dollar will depreciate in the coming years, the MNE will be able to predict its earnings and plan for its future operations in the next few years. However, if the U.S. dollar suddenly appreciates and reverses the expected depreciation trend, the overseas revenue and cash flows will be reduced after being converted to the U.S. dollar, which is very likely to create negative effects on the MNE’s profitability. Furthermore, such an operating risk is potentially large to an MNE due to various overseas subsidiaries and foreign currencies involved. In other words, the unexpected impact could generate destructive effects on an MNE’s global operations.
To manage the operating risk, the key task is to minimize the impact of the unexpected changes in exchange rates on the MNE’s expected cash flows and expected earnings. Optimal options are to diversify operations and financing. The company can diversify sales, locations of production, raw material supplies, and financing sources. These are the strategic approaches that can be deployed by an MNE. The benefits are to diversify cash flows from more than one financial market in more than one currency and to have more flexibility to actively or passively react to impacts caused by unexpected changes in exchange rates while the company can also profit from changes in the global competitive condition.
Practically, there are four proactive policies commonly adopted for managing operating risks. The first policy is to match currency cash flows. The approach is to offset anticipated exposure by acquiring the same currency denominated debt so as to result in a continuous same currency receipt of payment and outflow. For instance, a U.S. company expects to earn considerably in the last quarter of a year from the Japanese market and to receive Japanese yen after three months. The company can make short-term borrowing of a projected amount of Japanese yen from a Japanese bank in the beginning of the quarter and make payments of principal and interest on debt after receiving Japanese yen from sales in that quarter. In other words, no matter how the currency exchange rate fluctuates in that quarter, the company has already secured the projected revenue and converted that amount to the U.S. dollar early in the beginning of that quarter. This policy is most preferable for relatively stable and predictable cash flows and it can be exercised through regular operations.
The second policy is the risk-sharing contractual agreements. This is to share the long-term cash flow exposures between buyers and suppliers and is to be arranged through contractual agreements. Buyers and suppliers will then share or split the impact caused by a sudden change of currency movement. For instance, Ford purchases parts from Mazda, a Japanese company, every month. If Ford lost due to unexpected change of currency exchange rate, it would imply a gain to Mazda, and vice versa. Furthermore, such a situation will continue to happen as long as the supplier-buyer relationship remains. Therefore, it is reasonable to have both companies share loss and gain due to changes of exchange rate together for a long term. Practically, a contract agreement can be established to let Ford bear the transaction risk when the Japanese yen exchange rate with respect to the U.S. dollar stays in a bearable range, but when the exchange rate jumps out of this range both companies will share the loss evenly. This approach does not completely remove unexpected losses but it certainly reduce the amount.
The third policy is to establish back-to-back loans, or referred as parallel loans, between two companies in different countries. In this case, they arrange to borrow each other’s currency for a specific period of time. Then, at maturity, they will return the borrowed currencies to each other. For instance, MNE A in the U.K. lends pounds to a U.K. subsidiary of MNE B in the U.S., while MNE B lends U.S. dollars to a U.S. subsidiary of MNE A. The amount is calculated so that the quantity received by one subsidiary is equivalent to the level received by another subsidiary but in different currencies. Therefore, it would like MNE A in the U.K. providing funds to its subsidiary in the U.S., while MNE B in the U.S. offers fund to its subsidiary in the U.K. Later, at the end of the debt period, each subsidiary will pay principal and interest to another subsidiary’s parent MNE with earnings received locally. In other words, each MNE will receive expected earnings after a period of time from its overseas subsidiary without worrying about currency exchange losses. Such a cross-border indirect financing can take place without involving the currency exchange and hence creates a covered hedge against exchange loss. However, this policy is difficult to exercise because it is not easy to find matching MNEs in different countries with corresponding subsidiaries that could generate matching earnings.
The fourth policy is to make cross-currency swaps. This is similar to the back-to-back loans but through a swap dealer. For instance, one firm in the U.K. regularly acquires loans in pounds while making exports to the U.S. The firm can swap its loans in pounds to an American firm that makes sales to the U.K. with loans in the U.S. dollar. Later, the U.K. firm can use its earned U.S. dollars to pay for loans in the U.S., while the U.S. firm can use its earned pounds to pay for loans in the U.K. Clearly, this approach also avoids currency exchange risks. Fortunately, the cross-currency swaps can be accomplished through an international bank which is the swap dealer that could allocate matching firms in different countries and process all needed paper work. The difficulty behind it is much lower than that of the back-to-back loans.
Overall, the above-stated four policies offer a possibility to reduce the impacts of the operating risk. However, it is not like dealing with transaction risk which handles only a limited quantity of foreign currency at stake for a definite number of transactions. Operating risk often deals with a huge quantity of sales and earnings of one quarter, at least. Therefore, the cost to hedge the operating risk would not be trivial. In other words, many MNEs may not be willing to trouble themselves with the complexity and the financial burden in tackling the operating risk. For that reason, many MNEs still suffer with this risk (AP, 2015). In addition, without converting all foreign cash flows to the parent MNE’s currency, operating risk does not really result in a loss or gain to the MNE until the day that consolidated financial statements are created and negative impacts to the MNE’s profit outlook and credit rating are realized. Therefore, some U.S.-based MNEs may ignore operating risk when they have decided to hide overseas earnings from the U.S. government. In addition, besides financial operations in the global market, MNEs have another option to broaden its risk-management efforts through internal financial managements among parent and foreign subsidiaries (Grant and Soenen, 2004).
Supply and demand of foreign currency affect the daily floating of the foreign currency exchange rate. However, the occurrence of certain financial or political event could cause sudden fluctuation of the currency exchange rate, such as a boost of the U.S. dollar demand after an increase of the U.S. interest rate. MNEs heavily rely their earnings from overseas sales. Therefore, they are constantly exposed to the transaction, translation, and operating risks when making international trades.
The transaction risk occurs when an MNE has confirmed a foreign deal and is expecting to receive foreign currency after the deal. The MNE may lose after the received foreign currency is exchanged to the U.S. dollar when the amount is compared with the receivable U.S. dollar at the time of confirming the deal. Forward hedge contracts, option hedge contracts, and money market hedge contracts are commonly used to minimize losses embedded in the transaction risk. In principle, an MNE could acquire an equivalent amount of the expected revenue in the U.S. dollar in the early stage of the deal through a loan or a protective option. Later, the MNE could pay back loan or exercise option by using the received foreign currency and hence avoid losses caused by the transaction risk.
The translation risk happens when the value of a subsidiary’s assets, liabilities, and other financial items are translated from foreign currency to the U.S. dollar. The effort may affect the level of the translated value and cause the MNE’s consolidated financial statements to show an unexpected loss due to unexpected changes of foreign currency exchange rates at the time of translation. The translation is needed to present the MNE’s effort on generating profits and on holding an acceptable credit rating, but the associated risk may cost the company to present undesired results. A balance hedging approach, which is to adjust subsidiary’s exposed liabilities to maintain a balance with the exposed assets, has been adopted by many MNEs. In the process, the cost of foreign debt determines the overall costs of the effort. However, since many U.S.-based MNEs are hiding their overseas profits from the IRS, they have directly avoided the translation risk.
The operating risk happens when an MNE’s expected sales and earnings after a period of time are not reached due to changes of exchange rate in that period. The loss can be substantial when the fluctuation is considerably large. Four proactive policies includes matching currency cash flows, taking risk-sharing contractual agreements, establishing back-to-back loans, and making cross-currency swaps. They can be deployed to minimize the impact of the operation risk. Except for the risk-sharing approach, other policies are similar to the hedge approach by first borrowing a quantity of foreign currency which is equivalent to the projected revenue in the early stage of the expected period, and then by paying back the debt with the earned foreign currency at the end of the period. The major problem associated with the tackling of the operation risk is cost because the level of expected revenue over a certain period would not be a trivial amount. Therefore, the total cost would not be a small amount if efforts are taken to handle risks associated with many different subsidiaries.
In general, foreign currency exchange happens when trading across borders is taking place. A lag between the time of contracting and the time of executing the trade is accompanied with a difference in the foreign currency exchange rate at these two time steps. In other words, companies involved in the trading may not be able to receive the expected amount of money after the currency exchange. This risk will be enlarged with the expansion of the difference in the exchange rate, the size of the money involved, and the length of time interval. Furthermore, the characteristics and the impact of the risks turn toward different directions when the issue relates the earnings of subsidiaries with the parent MNE. Therefore, the transaction, translation, and operating risks are distinguished in along with different tackling approaches. Details are outlined clearly in this article but it also reveals that concerns of cost involved in taking necessary steps may hamper companies’ interest on investing in needed actions. For this reason, many multinational enterprises still suffer with abrupt changes of exchange rates. In the meantime, many U.S.-based MNEs take great efforts on minimizing their tax burden by avoiding to transfer subsidiaries’ earnings back to the parent companies. Such an action ironically helps to minimize MNEs’ financial risks associated with the currency exchange.
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