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Question: Assess different types of foreign exchange exposure faced by the MNC. Identification and measurement of these risks

04 Oct 2022,3:40 PM

 

Assess different types of foreign exchange exposure faced by the MNC. Identification and measurement of these risks
Evaluate the structure of international financial markets and institutions and the range of instruments traded therein.

The most popular way for international expansion is for a local firm to acquire foreign companies. One of the most benefits for international expansion is global distribution capability that helps expanding the market share.

There are different implications of running a company that is within or outside of the European Union. If you were the head of a firm based in the United States, please answer the following questions, providing the rationale behind your answers:

Would you seek to acquire a company within the European Union or outside of it? Why?
Describe the advantages and disadvantages of the choice you made.
Describe the advantages and disadvantages inherent in the option you did not choose.
Explain why an MNC may invest funds in a financial market outside its own country.
Explain why some financial institutions prefer to provide credit in financial markets outside their own country.

Expert answer

 

Different types of foreign exchange risk exposure faced by the MNC. Identification and measurement of these risks:

 

1. Transaction risk exposure: This arises when an MNC undertakes transactions in foreign currencies. For example, an MNC may have to make payments in foreign currencies for its imports or receive revenues in foreign currencies from its exports. These payments and receipts are exposed to changes in foreign exchange rates. An appreciation of the home currency against the foreign currency would lead to a loss on the transaction, while a depreciation of the home currency would lead to a gain.

 

2. Translation risk exposure: This arises when an MNC's financial statements are prepared using a different accounting currency than the functional currency (the currency in which most of its transactions are denominated). For example, an MNC may prepare its financial statements in US dollars even though most of its transactions are denominated in euros. This exposure is due to changes in exchange rates between the accounting currency and the functional currency. An appreciation of the functional currency against the accounting currency would lead to a translation gain, while a depreciation of the functional currency would lead to a translation loss.

 

3. Economic risk exposure: This arises when an MNC's cash flows are affected by changes in economic conditions in foreign countries. For example, an MNC whose revenues are derived from exports to Europe will be affected by changes in economic conditions in Europe. A recession in Europe would lead to a decline in demand for the MNC's products, and this would lead to a decline in its cash flows.

 

 

4. Political risk exposure: This arises when an MNC's operations are affected by political conditions in foreign countries. For example, an MNC whose factories are located in a country that is experiencing political unrest may find it difficult to obtain raw materials or ship its products out of the country. This could lead to a decline in its cash flows.

 

The best way to identify and measure these risks is to use hedging instruments such as forwards, options, and swaps. These instruments can help to offset the potential losses that an MNC might incur due to changes in foreign exchange rates.

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