Multinational Finance
Essential summary
The two main topics in multinational finance are foreign exchange (FX) and treasury. In terms of the former, MNEs monitor their positions at all times to avoid the kinds of adverse currency movements that can wipe out profits. Tracking a group’s innumerable positions is extremely difficult, however, explaining why most MNEs spend large sums on information systems centralising currency data. As for MNEs’ treasury operations, the key here is their ability to access capital for both short and long-term purposes. When times are tough, acquiring finance can be crucial to a company’s expansion and even survival. Like labour or materials, funding is a key input in an MNE’s production process.
Foreign exchange
The only MNEs that avoid direct foreign exchange (FX) risk are those who operate entirely in their home currency. And even so, they still face indirect risk because of the way currency movements affect their international rivals’ competitiveness.
For the vast majority of MNEs, currency risk is a permanent phenomenon. The main questions then become how this risk manifests itself; where it originates; and what might be done about it.
The concept of exposure
By definition, the vast majority of MNEs engage in FX simply because they incur costs and/or generate revenues in multi-currency environments as a matter of course. On top of this, there are certain commodities like oil or rubber (or complex goods like aeroplanes) where the US dollar is globally recognised as the standard currency of transaction. This automatically creates FX exposures for non-dollar-based companies trading in these sectors.
In general, an MNE is exposed to FX risk under the following conditions:
Its assets and/or liabilities are denominated in several currencies.
A gap exists between its assets and liabilities in any one currency. Prices vary for the currencies in question — reflecting in turn whether a currency is pegged to a fixed rate set by the government or (as has overwhelmingly become the case since the 1970s and the end of the gold standard) if its price floats and reflects continuous trading between market participants.
Where a firm has more assets than liabilities in a given currency (a “long” position), the risk is that the currency falls in value before the assets can be sold. Where a firm has more liabilities than assets in a given currency (a “short” position), the risk is that it rises in value before the liabilities can be acquired. Thus, regardless of a firm’s currency of origin, it is exposed to FX price variations if its various positions are not equal to zero at all times.
Sources of FX exposure
“Transactional” exposures are incurred through value chain activities. These are MNEs’ main FX risks and can occur regularly or sporadically.
Commercial risk arises when an MNEs is paid in foreign currency, increasing its long exposure.
Operational risk occurs when it makes payments in a foreign currency, increasing its short exposure.
Most MNEs manage the FX exposures that their various international subsidiaries accumulate on a net basis. This means calculating exposures by offsetting long vs short positions in any one currency.
Non-transactional FX risks
Translation risk happens when FX variations affect an MNE’s conversion of foreign assets or liabilities into its home currency. This includes dividends repatriated to headquarters, foreign currency loans and the valuation of foreign assets.
Speculative risk. MNEs are free to decide what percentage of their currency risk they want to offset and may reason that in-house treasury specialists are as competent at trading as the banking counterparts onto whom they currently offload their FX risk.
Economic risk is encountered when long-term adverse currency trends mean that it is no longer possible for the MNE to operate profitably and/or competitively in the countries where it incurs assets or liabilities.
Note as well an indirect economic risk when a competitor gains advantage by producing in a country with a weakening currency or selling into a country with a strengthening currency.
Managing foreign exchange risk
When an MNE fears that an adverse currency movement will have lasting effects, reconfiguring its entire global value chain is a viable (albeit costly) option. Immediate exposures, on the other hand, tend to be dealt with through short-term financial hedging.
“Natural" hedging
The most strategic response for MNEs that continuously accumulate assets in a weak currency and/or liabilities in a strong currency is to change their overall configuration to even out these exposures. One natural hedge involves adding to their revenue base in a currency they are short, for instance by expanding sales in the countries where that currency is used. The other natural hedge involves increasing their cost base in a currency they are long, for instance by running operations or buying from suppliers in the countries where it is used. By going long against shorts and short against longs, they reduce their overall exposure. The problem, of course, is that all these FX-driven changes take time and are very costly (especially where FDI is involved).
Short-term financial hedging
Where MNEs have no long-term view on a currency’s strength, they can offset any exposure they face by “hedging” it through the FX markets. This involves a new transaction creating new exposures diametrically opposed to the original FX risk. That way, if the worst-case scenario happens and damages the MNE’s original “underlying” position, the loss will be offset by the profits from the hedge. Of course, if the FX market moves and the original exposure ends up making a windfall profit, it is the hedge that will lose money. In both cases, the MNE will have fixed its ultimate FX price the day it transacts the hedge, for as long as this cover lasts (see Figure 10.1).
Unlike long-term structural reconfigurations of an MNE’s value chain, short-term hedges do not prevent initial exposures from reappearing once a hedge matures, with the possibility that the new hedge will be transacted at a worse rate. Moreover, recurring short-term hedges increase transaction costs because the market-maker with whom the MNE transacts always seeks remuneration for its willingness to accept the risk by buying at below-market and selling at above-market prices. Having said that, it is also possible that once one hedge matures, the next will be at a better rate. Above all, short-term financial hedges are quicker and cheaper than huge structural reconfigurations.
Since financial hedging reduces the short-term volatility of earnings, analysis here necessarily centres on the risk attitudes revealed through MNEs’ different policies in this respect. Some treat FX as a simple cost item and may be more willing to pay hedging-related transaction costs to reduce their risk. MNEs in this category are typified by their greater aversion to earnings volatility and by the fact that they define their role more narrowly as simply making and selling the products they
Figure 10.1 MNE FX hedging.
Multinational finance 117 offer. However, there are other MNEs who treat FX as a profit source and prefer to maintain some risks unhedged. This reflects both their willingness to assume different kinds of international risk — including FX-related — as well as their confidence that they can predict future currency market movements. This confidence tends to be based on either a short-term “technical” reading of market sentiment (using charts to estimate whether traders are optimistic “bulls” or pessimistic “bears”) or else on longer-term “fundamental analysis” assessing the fair value of a currency based on indicators such as purchasing power parity or else macro-economic aggregates like inflation, growth and the trade balance.
