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A multinational corporation operating in a foreign country is highly exposed to exchange risks when generating its revenue and settling expenses. Currency fluctuations occur because not all currencies are tied to dollar.

This study aims at analyzing the foreign exchange aspect that affects the financing for the newly developed MNC bank and the possible options of mitigation.

The exchange foreign exchange plays a vital in the trade of a country, which determines the economic status of a country (Drabek et al, 2013). Therefore, the government keeps monitoring the foreign exchange fluctuations of a country to ensure business do not trade at a worse off. The foreign exchange affects the profitability of a business, the investors’ portfolio and the growth of a business as a whole. The foreign exchange can affect the financing ability of business especially foreign corporations in a variety of ways.

For instance, the business will not borrow money from a foreign economy with high interest. This is because the business will incur massively in terms of loan recovery by the lender.

Foreign currency risk

Also known 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 currency other than that of the base currency of the company (Drabek et al, 2013). The risks also exist between a subsidiary and a parent business. In this case, the risk occurs when the subsidiary reports its transaction in a local currency other than the reporting currency of the parent. The risk is that the currency rate may fluctuate between the transactions may lead to increase in prices due to the speculation of approaching inflation.

There are different types of exposures that affect the financing of a business in a foreign country for example economic exposure, transaction exposures and contingent exposures. Transaction exposures occur when the business procures items whose payment is depended on the exchange. The economic exposure is the fluctuation in the foreign exchange due to economic factors such as inflation. Translation exposure refers to currency due to converting the local currency into the reporting of a given business. Contingent exposure arises due to those factors surrounding the business whose outcome can result into cash outflow from the, for instance a pending court case may be passed against the business leading to compensation payment by the business.

Despite all the exposures facing the business, there exists various method of managing or mitigating such risk such as:

Hedging the currency risk

This is a technique of putting a group of assets in a portfolio to offset each other in terms of their rising and falling prices. If the price portfolio of assets’ portfolio increases, the business stands at a chance of gaining. 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 mitigate itself against currency risks. For transaction exposures, the company can use hedging strategies tools such, 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 above strategies careful to reduce the purchase cost. This will involve flexibility of supply chain in terms of procuring, developing strong research and development and product differentiation.

For the case of translation exposures, the International Financial Reporting Standards (IFRS) gives procedure of revising the transaction of the company to determine the value of foreign exchange translation gain or loss. The statement of financial position is the 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 securities mainly having a maturity period of less than a year. The trade is 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. This tool provides the firm with the short source of finance.

Financial derivatives

These are financial instruments whose pay off relies on foreign exchange rate of more than one currencies. Foreign exchange derivatives are commonly used for arbitrage and speculative motive as well as hedging for currency risks.

Forward contract

This is an agreement between two or more parties to sell and buy an asset in future at the price determined today (Drabek et al, 2013). A forward contract is usually a speculative motive way of hedging for risks. If buyer of an asset expects the currency rate will increase in future he or she may lock-in a forward contract with the seller of the asset. If the asset price happens to increases, then the buyer of the asset makes profit while the seller suffers losses and vice versa.

Options

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 locks-in an option contract and agrees to buy the asset at a specified date.

Swaps

This refers to an agreement between two parties to exchange cash flow generated by an instrument of one party for those of other party’s instrument (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 un-conducive for business financing operations (Drabek et al, 2013). For instance, high business taxation and strict penalties increases the cost borrowing hence high cost of financing business operations.

Effects of inflation and interest rate on exchange rate

Inflation is generally a persistent increase in prices of the commodities 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 to bring inflation down to normal. During inflation times, the local currency usually depreciates against the foreign currency and vice versa. Therefore, to restore the situation back to normal the regulatory authority increases the interest rate to reduce inflation and to appreciate the local currency relative to the foreign currency. Therefore, exchange rate is 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.