rewrite under 30%

The purpose of this study is to analyze the foreign exchange aspect that affects the financial activities of the newly developed MNC bank and the possible measures of mitigation.

Foreign exchange plays an important role in the trade of a country by determining the economic status of a country (Drabek et al, 2013). In relation to the above the government keeps monitoring the foreign exchange fluctuations of a country to ensure that business does not trade at a worse off point. Foreign exchange impacts the rate of profitability of a business, the investors’ portfolio and the growth of an entire business. The foreign exchange affects the financing ability of businesses especially foreign corporations in a variety of ways.

For instance, the business will not borrow money from a foreign economy with high interest but also will incur massively in terms of loan recovery by the lender. The high interest will be to disadvantage of the borrowing country.

Foreign currency risk

Can also be referred to as the exchange rate risk or the foreign exchange risk. The financial risk is present when the financial dealing of a business is denominated in a foreign currency rather than that of the base currency of the company or a country (Drabek et al, 2013). The risks exist between a subsidiary form of business and a parent form of business. In this case, the danger occurs when the subsidiary reports its transaction in a local currency instead of reporting the currency of the parent. The danger is that the currency rate may fluctuate between the transactions and this may lead to increase in prices because of the speculation of approaching inflation.

There are different types of exposures that affect the financial activities of a business in a foreign country. Some of these exposures include; economic exposures, transaction exposures and contingent exposures. Transaction exposures can occur when the business obtain items whose payment is depended on the exchange rate. The economic exposure involves the changes in the foreign exchange due to economic factors such as inflation. Translation exposure refers to currency conversion to the local currency into the reporting of a given business. Contingent exposure arises due to those factors which surrounds the business whose outcome can result into cash outflow from the business. For example, a pending court case may be ruled against the business leading to compensation payment by the business.

Despite all the exposures facing the business, there still exists various methods of managing or mitigating such risk. These methods include;

Hedging the currency risk

This is a technique involves putting together a group of assets in a portfolio to offset each other in terms of their increasing and decreasing of prices. If the price portfolio of assets’ portfolio rises, the business stands at a chance of earning a profit. Hedging involves investing in more than one type of financial assets for example stock and bonds.

A multinational company can use the various hedging tools to protect itself against currency risks. For transaction exposures, the company can use hedging strategies tools like, money markets and foreign exchange derivatives that include futures, forward contracts, swaps and options.

For the economic exposures, the company may apply some of the hedging strategies above in order to reduce the purchase cost carefully. This will involve adjustments in the supply chain in terms of procuring, developing strong research and development and product differentiation.

As for translation exposures, the International Financial Reporting Standards (IFRS) gives the relevant procedure of revising the transaction of a company in determining the value of foreign exchange translation either gain or loss. The statement of financial position is updated from the historical to current statement of financial position (Wang, 2011). The MNC can use the following hedging instruments

The money market

This is a market for borrowing short-term loans mainly having a maturity period of less than a year. The trade involves over the counter or wholesale business. The various money market instruments include commercial papers, repurchase agreement, and certificate of deposits, banker’s acceptance and treasury bills. These tools provide the firms with the short source of finance to run their activities..

Financial derivatives

These are financial measurements whose pay off depends on foreign exchange rate of more than one currencies. Foreign exchange derivatives are commonly used for taking advantage of the differences in prices of two markets and speculative motive as well as hedging for currency risks.

Forward contract

This is an agreement between two or more parties which are to be involved in selling and buying an asset in the future at the price determined today at the current market (Drabek et al, 2013). A forward contract is usually a speculative motive way of hedging for risks. If a buyer of an asset hopes that the currency rate will raise in future he or she may seal a forward contract with the seller of the asset. If the asset price happens to raises, then the buyer of the asset makes profit while the seller suffers losses and vice versa.

Options

An option is a contract that gives the buyer the right but not the obligation to buy or sell an underlying asset or instrument at a specified contract’s strike price (Wang, 2011). A call is a specific type of an option that gives the owner a right to buy a specified asset at a specific price. To hedge for currency risk, the buyer seals an option contract and agrees to buy the asset at a specified date.

Swaps

This refers to an agreement between two parties which exchange cash flow generated by an instrument or asset of one party for those of other party’s instrument or asset (Beck et al, 2009). There is uncertainty of cash flows hence the contract itself is tool for hedging for the risk. Swaps are commonly used to hedge for interest rate risks.

Effects Government regulations on financing

Strong state laws and regulations are nonconductive for business financing operations (Drabek et al, 2013). For instance, high business taxation and strict penalties will increase the cost of borrowing hence high cost of financing business operations.

Effects of inflation and interest rate on exchange rate

Inflation is generally a constant increase in prices of the products and services in an economy (Beck et al, 2009). The monetary policy maker examines the inflation and the interest rate to regulate the proper functioning of the economy. For example, the higher the inflation, the higher the interest rate will be required so as to bring the inflation rate down to normalcy. During inflation times, the local currency usually depreciates against the foreign currency and vice versa. Therefore, the situation needs be restored back to being normal. This implies the regulatory authority increases the interest rate to reduce inflation and to appreciate the local currency relative to the foreign currency. In conclusion, the exchange rate can be viewed as a function of interest rate and the prevailing inflation level in the economy regardless of the country.

References

Wang, L. (2011). Foreign direct investment and urban growth in China. Burlington, VT:

Drabek, Z., & Mavroidis, P. C. (2013). Regulation of foreign investment: Challenges to international harmonization. Singapore: World Scientific Publishing Company.

Beck, T., Demirgüç-Kunt, A., & Levine, R. (2009). Financial institutions and markets across countries and over time: Data and analysis.