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A PROJECT REPORT ON RISK MANAGEMENT IN A MULTINATIONAL CORPORATION As part fulfilment of PGDBM 2002-2004

Risk Mgmt - MNC

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Page 1: Risk Mgmt - MNC

A PROJECT REPORT ON

RISK MANAGEMENT IN A MULTINATIONAL CORPORATION

As part fulfilment of PGDBM 2002-2004

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EXECUTIVE SUMMARY

MNCs are coming up in huge number nowadays. To earn the profits with minimal

amount of risk has been a matter of concern for the investors. For this purpose

management of risk is a very crucial factor.

Pertaining to this context, this project has been undertaken with an objective to

study the risk management strategies that can be used by MNCs.

The various risks faced by the MNCs have been mentioned and the ways to

manage them have been depicted in the project.

Exchange Rate Risk is one of the Major risks faced by MNCs. A Case Study on

MNC named LTCM has been included in the project to understand what kind of

problems and tensions exist and faced by the company on change in the

exchange rates. Very important to learn from it is the way in which LTCM came

back to a stable and comfortable position

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INDEX

PARTICULARS Page Nos

INTRODUCTION 2

THE CONCEPT OF RSIK 6

MANAGING TRANSLATION EXPOSURE 15

FOREIGN EXCHANGE RISK AND ECONOMIC EXPOSURE 23

ECONOMIC CONSEQUENCES OF EXCHANGE RATE CHANGES 27

FINANCIAL MANAGEMENT OF EXCHANGE RISK 30

CASE STUDY ON MNC--LTCM 31

BIBLIOGRAPHY 39

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INTRODUCTION

What is a Multinational Corporation?

A Multinational Corporation is a large business organization whose operations extend across

international boundaries.

Why a Multinational Corporation?

Ownership Specific Advantages are

Brand names, patents, copyrights, proprietary technology or technological processes, and

marketing and management expertise. Ownership-specific advantages can lead to sustainable

competitive advantages.

Location Specific Advantages

Location-specific advantages include location-specific natural resources, manmade resources,

low taxes; low wage costs, high labor productivity, or state supported monopolies Location-

specific advantages can lead to sustainable competitive advantages.

Market Internalization Advantages

Ownership-specific and location-specific advantages by themselves are not sufficient to ensure

the success of the multinational corporation over local firms. Market internalization (I) advantages

accrue to the multinational corporation as it exploits its ownership- specific advantages in local

and international markets.

The Life Cycle of a Multinational Corporation

Infancy: developing ownership-specific advantages

Growth: seeking new markets

Maturity: milking the cash cow defensive strategies to preserve revenues defensive strategies to

reduce operating costs financial considerations

Decline? Or Renewal?

Foreign Market Entry

Export entry

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Agents/distributors (foreign or domestic) foreign sales branches and subsidiaries

Contract-based entry

Licensing and franchising

Investment-based entry

Foreign direct investments

Cross-border mergers and acquisitions

Joint ventures

Exporting Through Agents and Distributors:

Advantages

quick and easy

low resource commitment

low cultural costs and risks

control over production

Disadvantages

relatively low sales potential

must overcome quotas and tariffs

high political risk

no control over market & distribution channels

Exporting Through Foreign Branches and Subsidiaries

Advantages

higher sales potential than agent/distributor

retains control over production

achieves control over marketing & distribution

Disadvantages

higher resource commitment

slower entry than agent/distributor

still must overcome quotas and tariffs

high political risk

higher cultural costs and risks than agent/distributor

Contract Based Entry

Advantages

quick and easy

low resource commitment

low cultural costs and risks

avoids import and investment barriers

Disadvantages

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limited fees/royalties on license agreements

loss of control over production technology

potential creation of competitors

Investment Based Entry

Advantages

» high sales potential

» potential for lower costs

» diversifies manufacturing base and matches foreign currency costs to revenues

» avoids import quotas and tariffs

Disadvantages

high resource commitment

high exit costs

must overcome cultural differences

must overcome investment barriers

Foreign direct investment

» relatively slow entry initially but doing very well now

» maintains control over production, distribution, and intellectual property

Cross-border mergers and acquisitions

» relatively rapid entry

» price of entry (acquisition premium) can be high

Cross-border joint ventures

» may avoid investment restrictions

» less exposure to political/cultural risks

» risk losing control of intellectual properties

» risk creating a competitor

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THE CONCEPT OF RISK

What is Risk?

Risk refers to exposure & exposure means the degree to which the company is affected to any

change in conditions.

Accounting Exposure arises from the need, for the purposes of reporting & consolidation, to

convert the financial statements of the foreign operations from the local currencies involved to the

home currency. If the exchange rates have changed since the previous reporting period, this

translation, or restatement, of those assets, liabilities, revenues, expenses, gains, and losses

that are denominated in foreign currency will result in foreign exchange gains or losses. The

possible extent of these gains or losses is measured by the translation exposure figures.

TRANSLATION EXPOSURE:

Alternative Currency Translation Methods:

Companies with international operations will have foreign currency denominated assets and

liabilities, revenues and, expenses. However, because home country investors are interested in

the home currency values, the foreign currency balance sheet accounts and income statement

must be assigned HC figures. Financial statements of an MNC’s overseas subsidiaries must be

translated from local currency to home currency prior to consolidation with parent’s financial

statement.

If currency values change, foreign exchange translation gains or losses result. Translation

Exposure is simply the difference between exposed assets and exposed liabilities. Such gains or

losses are of accounting nature, i.e no cash flows are necessarily involved.

Current/Noncurrent Method:

With this method all the foreign subsidiary’s current assets and liabilities are translated into home

currency at the Current Exchange Rate. Each Noncurrent asset or liability is translated at its

Historical Exchange Rate, i.e. at the rate in effect at the time the asset was acquired or the

liability incurred.

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The income statement is translated at the Average Exchange Rate for the period, except for

those revenues and expense items associated with the Noncurrent assets or liabilities. Items

such as depreciation expense are translated at the same rate as the corresponding balance

sheet items.

Monetary/ Non Monetary Method:

The monetary/non monetary method differentiates between monetary assets and liabilities and

non monetary or physical assets and liabilities. Monetary items are translated at the current

rate and non monetary items are translated at historical rates.

Income statements are translated at the average exchange rate during the period except for

revenue and expense items related to non monetary assets and liabilities. The latter, primarily

depreciation expense and cost of goods sold, are translated at same rate as the corresponding

balance sheet items. As a result the cost of goods sold may be translated at a rate different from

that used to translate sales.

Temporal Method:

Under the Temporal Method, inventory is normally translated at the Historical Rate, but it can be

translated at current rate if the inventory is shown on the balance sheet at the market value. The

choice of exchange rate translation is based on the type of asset or liability in the monetary/non

monetary method; in the temporal method, it is based on the underlying approach to evaluating

cost.

Income statement items are normally translated at an average rate for the reporting period.

However, cost of goods sold and depreciation and amortization charges related to balance sheet

items carried at the past prices are translated at historical rate.

Current Rate Method:

The current rate method is the simplest; all balance sheet and income items are translated at

current rate. Under this method, if a firm’s foreign currencies denominated assets exceed its

foreign currency denominated liabilities, devaluation must result in a loss and revaluation must

result in a gain.

TRANSACTION EXPOSURE:

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Companies often include transaction exposure as part of their accounting exposure. Transaction

Exposure stems from the possibility of incurring foreign exchange gains or losses on

transactions already entered into and denominated in a foreign currency.

A company’s transaction exposure is measured currency by currency and equals the difference

between contractually fixed future cash flows and outflows in each currency. Some of these

unsettled transactions, including foreign currency denominated debt and accounts receivable, are

already listed on the firm’s balance sheet. But other obligations, such as contracts for future sales

or purchases are not.

MANAGING TRANSACTION EXPOSURE:

A transaction exposure arises whenever a company is committed to a foreign currency

denominated transaction. Since the transaction will result in a future foreign currency cash inflow

or outflow, any change in the exchange rate between the time the transaction is entered into and

the time settled in the cash will result in cash will lead to change in rupee amount of the cash

inflow or outflow. Protective measures to guard against transaction exposure involve entering into

foreign currency transactions whose cash flows exactly offset the cash flows of the transaction

exposure.

These protective measures include using forward contracts, price adjustment clauses, currency

options, and borrowing or lending in the foreign currency.

Techniques for managing Transaction Exposure

1. Forward Market Hedge:

In a Forward Market Hedge, a company that is long on a foreign currency will sell the

foreign currency forward, whereas a company that is short on a foreign currency will buy

the currency forward. In this way the company can fix the rupee value of the future

currency cash flows.

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The true cost of hedging:

The true cost of hedging of a transaction can’t be calculated in advance as it depends on

the future spot rate, which is unknown at the time the forward contract has been entered

into. The traditional method of calculating the cost of a forward contract is however not

the right method as it does not measure the opportunity cost. Specifically the cost of a

forward contract is usually measured as its forward discount or premium.

Infact, in an efficient market, the expected cost of a forward contract must be zero.

Otherwise, there would be an arbitrage opportunity.

2. Money Market Hedge:

An alternative to a forward market hedge is to use the Money Market Hedge. A money

market hedge involves simultaneous borrowing and lending activities in two different

currencies to lock in the rupee value of a future currency cash flow.

3. Risk Shifting:

A company can avoid its transaction exposure altogether if the other company allows its

price of the sale to be in the home currency. This practice does not however eliminate the

risk; it simply shifts the risk from the seller to the buyer. Despite the fact that this form of

risk shifting is a zero sum game, it is common in international business. Firms typically

attempt to invoice the exports in strong currencies and imports in weak currencies.

Is it possible to gain from Risk Shifting? Not if one is dealing with informed customers or

suppliers.

Eg Consider a GE- Lufthansa deal. If Lufthansa is willing to be invoiced in dollar (Home

currency for GE) for the turbine blades, this must be because Lufthansa calculates that

its Euro equivalent cost will be no higher than what it had originally agreed to pay.

4. Pricing Decisions

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The top management sometimes fails to take anticipated rate changes into account when

making operating decisions, leaving financial management with the essentially impossible

task, through purely financial operations of recovering a loss already incurred at the time

of the initial transaction.

For eg. If GE priced Lufthansa’s order of turbine blades at $10 million and then, because

Lufthansa demands to be quoted a price in Deutsche Marks, converts the dollar price to

Deutsche Mark quote of DM 25 million, using the spot rate of DM 1 = $ 0.40.

In reality the quote is worth only $9.57 million even though it is booked at $ 10 million

because that is the risk free price that GE can guarantee for itself by using the forward

market. If the GE management wanted to sell the blades for $ 10 million, it should have

set a DM price of 1000000/ 0.3828 = DM 26.12 million. Thus GE lost $ 430,000 the

moment it signed the contract. This loss is not an exchange loss; it is a loss due to

management inactiveness.

The general rule on credit sales overseas is to convert between the foreign currency

price and the home currency price by using the forward rate not the spot rate. If the home

currency price is high enough, the exporter should follow through with the sale.

In the case of a sequence of payments to be received at several points in time, the

foreign currency price should be a weighted average of the forward rates for delivery on

those dates.

5. Exposure Netting:

Exposure netting involves offsetting exposure in one currency with exposures in the

same or another currency, where exchange rates are expected to move in such a way

that losses on the first exposed position should be offset by gains on the second currency

exposure. This portfolio approach to hedging recognises that the total variability or risk of

a currency exposure portfolio should be less than the sum of the individual variability’s of

each currency exposure considered in isolation. The assumption underlying exposure

netting is that the net gain or loss on the entire currency exposure portfolio is what

matters, rather than the gain or loss of any individual monetary unit.

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In practice exposure netting involves one of the three facilities:

A firm can offset a long position in a currency with the same position in that same

currency.

If the exchange rate movements of the two currencies are positively correlated,

then the firm can offset a long position in one currency with a short position in the

other.

If the currency movements are negatively correlated, then the short or long

positions can be used to offset each other.

6. Currency Risk Sharing:

Currency risk sharing can be implemented by developing a customized hedge contract

imbedded in the underlying trade transaction. This hedge contract typically takes the form

of a price adjustment clause, whereby a base price is adjusted to reflect certain exchange

rate changes. For eg. The price can be set at any amount, but both the parties should

share the currency risk below a neutral zone. The neutral zone represents the currency

range in which the risk is not shared.

7. Foreign Currency Options:

In many circumstances a firm is uncertain whether the hedged foreign currency inflow or

outflow will materialize. This uncertainty has important consequences for the appropriate

hedging strategy.

Taking the above example, GE would like to guarantee that the exchange rate does not

move against it between the time it bids and the time it gets paid, should it win the

contract. The danger of not hedging is that its bid will be selected and the Deutschemark

will decline in value, possibly wiping out GE’s anticipated profit margin. For Eg. If the

forward rate on April 1st for delivery December 31st falls to DM 1 = $0.36, the value from

the contract will drop from $9.57 million to $9 million, for a loss of $ 570,000.

The apparent solution for GE is to sell the anticipated DM 25 million receivable forward

on January 1st. However, if GE does that and loses the bid on the contract, it can cancel

the forward contract.

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Until recently, GE or any company that bid on a foreign contract in a foreign currency was

not assured of success would be unable to resolve its foreign exchange risk dilemma.

The advent of Currency Options has changed all that. Specifically, the solution to

managing its currency risk in this case is for GE, at the time of its bid, to purchase an

option to sell DM 25 million on December 31st. Suppose, that on January 1st, GE can buy

for $100,000 the right to sell Citibank DM 25 million on December 31st at a price of Rs

0.3828 per Deutschemark. If it enters into this option contract with Citibank, GE will

guarantee itself a minimum price ($9.57 million) should its bid be selected, while

simultaneously ensuring that if it lost the bid, its loss would be limited to the price paid for

the option contract (the premium of $100,000). Should the spot price of the DM on

December 31st exceed $0.3828, GE would let its option contract expire unexercised and

convert the DM 25 million at the prevailing spot rate.

There are two types of options available to manage exchange risk. A put option, such as

the one which is appropriate to GE situation, gives the buyer the right, but not the

obligation, to sell a specified number of foreign currency units to the option seller at the

fixed rupee price, up to the option’s expiration date. Alternatively, a call option is the right,

but not the obligation, to buy the foreign currency at a specified rupee price up to the

expiration date.

A call option is valuable, for example, when a firm has offered to buy a foreign

asset, such as another firm, a t a fixed foreign currency price, but is uncertain

whether its bid will be accepted. By buying a call option on the foreign currency,

the firm can lock in a maximum rupee price for its tender offer, while limiting its

downside risk to the call premium in case the bid is rejected.

Currency options are valuable risk management tools in other situations as well.

Conventional transaction exposure management says you wait until your sales are

booked or your orders placed before hedging. But, if a company does that, it faces

potential losses from exchange rate movements because the foreign currency price

doesn’t necessarily adjust right away to changes in the value of the rupee. As a matter of

policy, to avoid confusing customers and sales people, most companies don’t change

their price list every time the exchange rate changes. Unless and until the foreign

currency price changes, the unhedged company may suffer a decrease in its profit

margin. Because of the uncertainty of anticipated sales or purchases, however, forward

contracts are an imperfect tool to hedge the exposure.

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.

MANAGING TRANSLATION EXPOSURE

Firms have three available methods for managing their translation exposure:

Adjusting fund flows

Entering into forward contracts

Exposure netting

The basic hedging strategy for reducing translation exposure uses these methods.

Essentially, the strategy involves increasing hard cash (likely to appreciate) assets and

decreasing soft currency (likely to depreciate) assets, while decreasing hard currency

liabilities and increasing the soft currency liabilities. For example, if devaluation appears

likely, the basic hedging strategy would be executed as follows: borrowing, delay

accounts payable, and sell the weak currency forward.

Despite their prevalence among firms, however, these hedging activities are not

automatically valuable. If the market already recognizes the likelihood of currency

appreciation or depreciation, this recognition will be reflected in the costs of the various

hedging techniques. Only if the firm’s anticipations differ from the market’s and are also

superior to the markets then can hedging lead to reduced costs? Otherwise, the principle

value of hedging would be to protect a firm from unforeseen currency fluctuations.

Funds adjustment:

Most techniques for hedging impending local currency devaluation reduce local currency

assets or increase local currency liabilities, thereby generating local currency cash. If

accounting exposure is to be reduced, these funds must be converted into hard currency

assets. For example, a company will reduce its translation loss if before local currency

devaluation it converts some of its local currency cash holdings to the home currency.

This conversion can be accomplished, either directly or indirectly, by means of various

fund adjustment techniques.

Funds adjustment involves altering either the amounts or the currencies or both of the

planned cash flows of the parent and/or its subsidiaries to reduce the firm’s local currency

accounting exposure. If an local currency devaluation is anticipated, direct funds

adjustment methods include pricing exports in hard currencies and imports in the local

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currency, investing in hard currency securities, and replacing hard currency borrowings

with local currency loans. The indirect methods include, adjusting transfer prices on sale

of goods between affiliates; speeding up the payment of dividends, fees, and royalties;

and adjusting the leads and lags of intersubsidiary accounts. The latter method, which is

one of the most frequently used by multinationals, involves speeding up the payment of

intersubsidiary accounts payable and delaying the collections of intersubsidiary accounts

receivable. These hedging procedures for devaluations would be reversed for

revaluations.

Depreciation Appreciation

Sell the local currency forward Buy the local currency forward

Reduce levels of local currency cash and

marketable securities

Increase levels of local currency cash and

marketable securities.

Tighten credit(reduce local currency receivables) Relax local currency credit terms

Delay collection of hard currency receivables Speed up collection of soft currency receivables

Increase imports of hard currency goods Reduce imports of soft currency goods

Borrow locally Reduce local borrowing

Delay payment of accounts payable Speed up payment of accounts payable

Speed up dividend and fee remittances to parent

and other subsidiaries

Delay dividend and fee remittances to parent and

other subsidiaries.

Some of these techniques or tools may require considerable lead time and as is the case

with transfer price once they are introduced, they cannot be easily changed. In addition,

such as transfer price, fee and royalty, and dividend flow adjustments fall into the realm

of corporate policy and are not usually under the treasurer’s control. It is, therefore,

incumbent on the treasurer to educate other decision makers about the impact of these

tools on the costs and management of corporate exposure.

Although entering forward contracts is the most popular coverage technique, leading and

lagging of payables and receivables is almost as important. For those countries in which

a formal market in local currency forward contracts does not exist, leading and lagging

and local currency borrowing are the most important techniques. The bulk of international

business, however, is conducted in those few currencies for which forward markets do

exist.

Evaluating alternative hedging mechanisms:

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Ordinarily, the selection of funds adjustment strategy cannot proceed by evaluating each

possible technique separately without risking sub optimization; for example, whether or

not a firm chooses to borrow locally is not independent of its decision to use or not to use

those funds to import hard currency inventory. However, where the level of forward

contracts that the financial manager can enter into is unrestricted, the following two stage

methodology allows the optimal level of forward transactions to be determined apart from

the selection of what funds adjustment techniques to use. Moreover, this methodology is

valid regardless of the manager’s attitude toward risk.

Compute the profit associated with each funds adjustment technique on a covered

after tax basis. Transactions that are profitable on a covered basis ought to be

undertaken regardless of whether they increase or decrease the firm’s accounting

exposure. However, such activities should not be termed as hedging; rather they

involve the use of arbitrage to exploit market distortions.

Any unwanted exposure resulting from the above stage can be corrected in the

forward market. This is the stage of selection of an optimal level of forward

transactions based on a firm’s initial exposure, adjusted for the impact on exposure of

the decisions made in the above stage. Where the forward market is non existent, or

where the access to it is limited, the firm must determine both what techniques to use

and what their appropriate levels are. In the latter case, a comparison of the net costs

of funds adjustment technique with the anticipated currency depreciation will indicate

whether or not the hedging transaction is profitable on an expected value basis.

Designing a hedging strategy:

Management’s objectives will largely determine its decision about the specific hedging

techniques and strategy to pursue. These objectives, in turn should reflect management’s

view of the world, particularly its beliefs about how the markets work. The quality or value

to the shareholders, of a particular hedging strategy is, therefore related to the

congruence between those perceptions and realities of the business environment.

Here we assume that the basic purpose of hedging is to reduce exchange risk, where

exchange risk is that element of cash flow variability that is due to currency fluctuations.

Underlying the selection of a definition of exchange risk based on market value is the

assumption that management’s primary objective is to maximise the value of the firm.

Hence, the focus id on cash flow effects of the currency changes.

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In operational terms, hedging to reduce the variance of cash flows translates into the

following exchange management goal:

To arrange the firm’s financial affairs in such a way that however the exchange rate may

move in the future, the effects on home currency returns are minimized.

This objective is not universally subscribed to, however, instead many firms follow a

selective hedging policy designed to protect against anticipated currency movements.

But, if financial markets are efficient, firms cannot hedge against expected exchange rate

changes. Interest rates, forward rates, and sales contract prices should already reflect

currency changes that are anticipated, thereby offsetting the loss reducing benefits of

hedging with higher costs. In the case of Mexico, for instance, the one year forward

discount in the futures market was close to 100% just before the peso was floated in

1982. The unavoidable conclusion is that a firm can protect itself only against unexpected

currency changes.

Even shifting funds from one country to another is not a costless means of hedging. The

net effect of speeding up remittances while delaying receipt of inter company receivables

is to force a subsidiary in a devaluation prone country to increase its local currency

borrowings to finance additional working capital requirements. The net cost of shifting the

funds, therefore, is the cost of local currency loan minus the profit generated from the use

of the funds.

Reducing the level of cash holdings to lower exposure can adversely affect a subsidiary’s

operations, while selling local currency denominated marketable securities can entail an

opportunity cost. A firm with excess cash or marketable securities should reduce its

holdings regardless of whether devaluation is anticipated. Once cash balances are at

minimal level, however any further reductions will involve real costs that must be weighed

against the expected benefits.

Risk shifting by invoicing exports in the foreign currency and imports in the local currency

may cause the loss of valuable sales or may reduce a firm’s ability to extract concessions

on import prices. Similarly, tightening credit may reduce profits more than costs.

Cost of the basic hedging techniques:

Depreciation Costs

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Sell the currency forward Transaction costs: difference between forward

and future spot rates

Reduce levels of local currency cash and

marketable securities

Operational Problems: opportunity costs(loss of

higher interest rates on local currency securities)

Tighten credit (reduce local receivables) Loss of sales and profit

Delay collection of hard currency receivables Cost of financing additional receivables

Increase imports of hard currency goods Financing and holding costs

Borrow locally Higher interest rates

Delay payments of accounts payable Harm to credit reputation

Speed up dividend and fee remittances to parent

and other subsidiaries

Borrowing costs if funds are not available or loss

of higher interest rates if local currency securities

must be sold

Speed up payment of intersubsidiary accounts

payable

Opportunity cost of money

Delay collection of intersubsidiary accounts

receivable

Opportunity cost of money

A company can benefit from the abovementioned techniques only to the extent that it can

estimate the probability and timing of the devaluation more accurately than the general

market can. Attempting to profit from foreign exchange forecasting, however, is

speculating rather than hedging. The hedger is well advised to assume that the market

knows as much as he or she does. Those who feel that they feel have superior

information may choose to speculate, but this activity should not be confused with

hedging.

Under some circumstances, it is possible for a company to benefit at the expense of the

local government without speculating. Such circumstance would involve the judicious use

of market imperfections and/or existing tax asymmetries.

Centralization V/s Decentralization:

In area of foreign exchange risk management, there are good arguments both for and

against centralization. Favouring centralization is the reasonable assumption that local

treasurers want to optimize their own financial and exposure positions, regardless of the

overall corporate situation. For example, a multi billion dollar US consumer goods firm

that gives a free hand to its affiliates in deciding their hedging policies. The firm’s local

treasurer’s ignored the possibilities available to the corporation to trade off negative &

positive currency exposure positions by consolidating exposure worldwide.

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A further benefit of centralized exposure management is the ability to take advantage,

through exposure netting, of the portfolio effect discussed previously. Thus, centralization

of exchange rate risk management should reduce the amount of hedging required to

achieve a given level of safety.

Once the company has decided on the maximum currency exposure it is willing to

tolerate, it can then select the cheapest option worldwide to hedge its remaining

exposure. Tax effects can be crucial at this stage both in computing the amounts to

hedge and the costs involved, but only headquarters will have the required global

perspective. Centralized management is also needed to take advantage of the before tax

hedging cost variations that are likely to exist among subsidiaries because of market

imperfections.

All these arguments for centralization of currency risk management are powerful. Against

the benefits must be weighed the loss of local knowledge and the lack of incentive for

local managers to take advantage of the particular situations that only they may be

familiar with. Companies that decentralize the hedging decision may allow local units to

manage their own exposures by engaging in forward contracts with a central unit at

negotiated rates. The central unit may or may not lay off these contracts in the market

place.

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FOREIGN EXCHANGE RISK AND

ECONOMIC EXPOSURE

The most important aspect of foreign exchange risk management is to incorporate currency

change expectations into all basic corporate decisions. In performing this task, the firm must

know what is risk? However, there is a major discrepancy between accounting practice and

economic reality in terms of measuring Exposure, which is the degree to which a company is

affected by exchange rate changes.

The economic theory focuses the impact of the exchange rate on future cash flows.; that

is, Economic Exposure is based to the extent to which the value of the firm as

measured by the present value of the expected cash flows will change when exchange

rate changes.

Specifically, if PV is the present value of the firm, then the firm is exposed to a currency

risk if:

Change in PV/ Change in Exchange Risk is not equal to Zero

Where, Exchange risk is defined as the variability in the firm’s value that is caused by

uncertain exchange rate changes. Thus, exchange risk is viewed as the possibility that

currency fluctuations can alter the expected amounts or variability of the firm’s future

cash flow.

Economic exposure can be separated into two components:

Transaction Exposure

Operating Exposure

Transaction exposure stems from the exchange gains or losses on foreign currency

denominated contractual obligations. Although transaction exposure is often included

under accounting exposure it is more properly a cash flow exposure and hence, part of

economic exposure. However, even if the company prices all its contracts in the home

currency or otherwise hedges its transaction exposure, the residual exposure, longer

term operating exposure still remains.

Operating Exposure arises because currency fluctuations can alter a company’s future

revenue and costs, that is, its operating cash flows. Consequently, measuring a firm’s

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operating exposure requires a longer term perspective, viewing the firm as an ongoing

concern with operations whose cost and price competitiveness could be affected by

exchange rate changes.

Thus the firm faces operating exposure the moment it invests in servicing a market

subject to foreign competition or in sourcing goods or inputs abroad. This investment

includes new product development, a distribution network, foreign supply contracts, or

production facilities. Transaction exposure arises later on, and only if the company’s

commitment leads it to engage in foreign currency denominates sales or purchases.

The measurement of economic exposure is made specifically difficult because it is

impossible to assess the effects of an exchange rate change without simultaneously

considering the impact on cash flows of the underlying relative rates of inflation

associated with each currency. The Real Exchange Rate is defined as the Nominal

Exchange Rate adjusted for changes in the relative purchasing power of each currency

since some base period.

E = n X {(1+ fi)/ (1+fd)}

Where,

E = the real exchange rate (home currency per one unit of foreign currency) at time t;

n = the nominal exchange rate (home currency per one unit of foreign currency) at time t;

fi = the amount of foreign inflation between times 0 and t;

fd = the amount of domestic inflation between time 0 and t

Importance of Real Exchange Rate

The distinction between the nominal exchange rate and real exchange rate is important

because of their vastly different implications of exchange risk. A dramatic change in the

nominal exchange rate accompanied by an equal change in the price level should have

no effects on the relative competition positions of domestic firms and their foreign

competitors and, therefore, will not alter real cash flows. Alternatively, if the real

exchange rate changes it will cause relative price changes; changes in the ratio of

domestic goods’ prices to the prices of the foreign goods. In terms of currency changes

affecting the relative competitiveness, therefore, the focus must not be on nominal

exchange rate changes, but instead on changes in the purchasing power of one currency

relative to another.

Inflation and Exchange Risk

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Let us assume that the relative prices remain constant and we look only at the effect of

general inflation. This condition means if the inflation rate is 10%, the price of every good

in the economy rises by 10%. Let us also assume that all goods are traded in a

competitive world market without any transaction costs, tariff’s, or taxes of any kind.

Given these conditions the economic theory tells us that the law on one price must

prevail. That is, the price of any good, measured in a common currency, must be equal in

all countries.

If the law of one price holds and if there is no variation in the relative prices of goods or

services, then the rate of change in the exchange rate must be equal to the difference

between the inflation rates in the two countries. The implications of a constant real

exchange rate, that is, the purchasing power parity (PPP) holds. Purchasing power parity

does not imply that exchange rate changes will necessarily be small or easy to forecast.

If a country has high and unpredictable inflation, then the country’s exchange rate will

also fluctuate randomly.

However, without relative price changes, a multinational company faces no real operating

exchange risk. As long as the firm avoids contracts fixed in foreign currency terms, its

foreign cash flows will vary with the foreign rate of inflation. Because the exchange rate

also depends on the difference between the foreign and the domestic rates of inflation,

the movement of exchange rate exactly cancels the change in the foreign price level,

leaving real cash flows unaffected.

The above conclusion does not hold if the firm enters into contracts fixed in terms of the

foreign currency. For example, debt with fixed exchange rates, long term leases, labour

contracts, and rent. However, if the real exchange rate remains constant, the risk

introduced by entering into fixed contracts is not exchange risk; it is inflation risk.

Real Exchange Rate Changes and Exchange Risk:

A decline in the real value of a nation’s currency makes its exports and import competing

goods more competitive. Conversely, an appreciating currency hurts the nation’s

exporters and those producers competing with imports.

The economic impact of a currency change on a firm depends on whether the exchange

rate change id fully offset by the difference in inflation rates or whether the real exchange

rate and, hence relative prices change. It is this relative price changes that ultimately

determine a firm’s long run exposure.

Page 23: Risk Mgmt - MNC

A less obvious point is that a firm may face more exchange risk if nominal exchange

rates do not change.

Page 24: Risk Mgmt - MNC

THE ECONOMIC CONSEQUENCES OF

EXCHANGE RATE CHANGES

Transaction Exposure:

Transaction exposure arises out of the various types of transactions that require

settlement in foreign currency. For example, cross border trade, borrowing and lending in

foreign currencies, and the local purchasing and sales activities of foreign subsidiaries.

The items already on firm’s balance sheet, such as loans and receivables, capture some

of these transactions. However, a detailed transaction exposure report must also contain

a number of off balance sheet items as well, including future sales and purchases, lease

payments, forward contracts, loan repayments, and other contractual or anticipated

foreign currency receipts and disbursements.

In terms of measuring economic exposure, though, a transaction exposure report, no

matter how detailed, has a fundamental flaw; the assumption that local currency cost and

revenue streams remain constant following an exchange rate change.

The assumption does not permit an evaluation of the typical adjustments that consumers

and firms can be expected to undertake under conditions of currency change. Hence,

attempting to measure the likely exchange gain or loss by simply multiplying the

projected predevaluation local currency cash flows by the forecast devaluation

percentage will lead to misleading results. Given the close relationship between nominal

exchange rate changes and inflation as expressed in purchasing power parity, measuring

exposure to a currency change without reference to the accompanying inflation is also a

misguided task

Operating exposure:

A real exchange rate change affects a number of aspects of the firm’s operations. Let us

assume dollar to be the home currency here. With respect to dollar appreciation then, the

key issue for a domestic firm is its degree of pricing flexibility; that is, can the firm

maintain its dollar margins both at home and abroad? Can the company maintain its

dollar price on domestic sales in the face of lower priced foreign imports? In the case of

foreign sales, can the firm raise its foreign currency selling price sufficiently to preserve

its dollar profit margin?

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The answers to these questions depend largely on the price elasticity of demand. The

less price elastic the demand, the more price flexibility a company will have to respond to

exchange rate changes. Price elasticity, in turn, depends on the degree of competition

and the location of key competitors. The more differentiated a company’s products are

the less competition it will face and the greater its ability to maintain its domestic currency

prices both at home and abroad. Similarly if most competitors are based in the home

country, then all will face the same change in their cost structure from home currency

appreciation, and all can raise their foreign currency prices without putting any of them at

a disadvantage relative to their domestic competitors.

Conversely, the less differentiated a company’s products are and the more internationally

diversified its competitors are, the greater the price elasticity of demand for its products

will be and the less pricing flexibility it will have. These companies face the greatest

amount of exchange risk.

Another important determinant of a company’s susceptibility to exchange risk is its ability

to shift production and sourcing of inputs among countries. The greater the company’s

flexibility to substitute between home country and foreign country inputs or production,

the less exchange risk will it face. Other things being equal, firms with worldwide

production systems can cope with currency changes by increasing production in a nation

whose currency has undergone a real devaluation and decreasing production in a nation

whose currency has revalued in real terms.

Characteristic Economic Effect of Exchange Rate Changes on MNC’s

Cash Flow

Categories

Relevant Economic

Factors

Devaluation

impact

Revaluation

impact

Revenue Parent company

revenue impact

Parent company

revenue impact

Export Sales Price Sensitive Demand Increase Decrease

Price insensitive demand Slight increase Slight decrease

Local Sales Weak prior import

competition

Sharp decline Increase

Strong prior import

competition

Decrease Slight decrease

Costs Parent company

cost impact

Parent company

cost impact

Domestic Inputs Low Import Content Decrease Increase

High Import content/ Inputs

used in export or import

competing sectors

Slight decrease Slight Increase

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Imported Inputs Small local market Remain the same Remain the same

Large local market Slight decrease Slight increase

Depreciation Cash flow impact Cash flow impact

Fixed assets No asset valuation

adjustment

Decrease by

devaluation %

Increase by

revaluation %

Financial Management of Exchange Risk

The one attribute that all the strategic marketing and production adjustments have in

common is that they take time to accomplish in a cost effective manner. The role of

financial management in this process is to structure the firm’s liabilities in such a way that

during the time the strategic operational adjustments are underway, the reduction in

asset earnings is matched by the corresponding decrease in the cost servicing of these

liabilities.

One possibility is to finance the portion of the firm’s assets used to create export profits

so that any shortfall in operating cash flows due to an exchange rate change is offset by

a reduction in the debt servicing expenses. For example, a firm that has developed a

sizeable export market should hold a portion of its liabilities in that country’s currency.

The portion to be held in foreign currency depends on the size of loss in profitability

associated with a given currency change. No more definite recommendations are

possible because the currency effects will vary from one company to another.

The implementation of hedging policies is likely to be quite difficult in practice, if

only because the specific cash flow effects of a given currency change are hard

to predict. Trained personnel are required to implement and monitor an active

hedging program. Consequently hedging should be undertaken only when the

effects of the anticipated exchange rate changes are expected to be significant.

Page 27: Risk Mgmt - MNC

CASE STUDY ON

EXCHANGE RATE RISK MANAGEMENT

IN MNC NAMED

LTCM

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Barings, the Russian meltdown, Metallgesellschaft, Procter & Gamble, LTCM. These

are all events in the financial markets, which have become marker buoys to show

where it went wrong. The common weakness, in LTCM’s case, was the misguided

assumption that 'its counter party and the market it was operating in, were

performing within manageable limits.' But once those limits were crossed for

whatever reason, disaster was difficult to head off.

The LTCM fiasco is full of lessons about :

Model risk

Unexpected correlation or the breakdown of historical correlations

The need for stress-testing

The value of disclosure and transparency

The danger of over-generous extension of trading credit

The woes of investing in star quality

And investing too little in game theory.

The latter because LTCM's partners were playing a game up to hilt.

LTCM was unregulated, free to operate in any market, without capital charges and

only light reporting requirements to the US Securities & Exchange Commission

(SEC). It traded on its good name with many respectable counter parties as if it was

a member of the same club. That meant an ability to put on interest rate swaps at the

market rate for no initial margin - an essential part of its strategy. It meant being able

to borrow 100% of the value of any top-grade collateral, and with that cash to buy

more securities and post them as collateral for further borrowing: in theory it could

leverage itself to infinity.

To make 40% return on capital, however, leverage had to be applied. In theory,

stepping up volume doesn’t increase market risk, provided you stick to liquid

instruments and don't get so big that you yourself become the market.

Some of the big macro hedge funds had encountered this problem and reduced their

size by giving money back to their investors. When, in the last quarter of 1997 LTCM

returned $2.7 billion to investors, it was assumed to be for the same reason: a

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prudent reduction in its positions relative to the market.

But it seems the positions weren't reduced relative to the capital reduction, so the

leverage increased. Moreover, other risks had been added to the equation. LTCM

played the credit spread between mortgage-backed securities . Then it ventured into

equity trades. It sold equity index options, taking big premium in 1997. It took

speculative positions in takeover stocks, according to press reports. One such was

Tellabs whose share price fell over 40% when it failed to take over Ciena, says one

account. A filing with the SEC for June 30 1998 showed that LTCM had equity

stakes in 77 companies, worth $541 million. It also got into emerging markets,

including Russia. One report said Russia was "8% of its book" which would come to

$10 billion!

Some of LTCM's biggest competitors, the investment banks, had been clamoring to

buy into the fund. Meriwether applied a formula which brought in new investment, as

well as providing him and his partners with a virtual put option on the performance of

the fund. During 1997, LTCM entered 1998 with its capital reduced to $4.8 billion.

A New York Sunday Times article says the big trouble for LTCM started on July 17

when Salomon Smith Barney announced it was liquidating its dollar interest arbitrage

positions: "For the rest of the that month, the fund dropped about 10% because

Salomon Brothers was selling all the things that Long-Term owned."

On August 17,1998 Russia declared a moratorium on its rouble debt and domestic

dollar debt. Hot money, already jittery because of the Asian crisis, fled into high

quality instruments. Top preference was for the most liquid US and G-10 government

bonds. Spreads widened even between on- and off-the-run US treasuries.

Most of LTCM's bets had been variations on the same theme, convergence between

liquid treasuries and more complex instruments that commanded a credit or liquidity

premium. Unfortunately convergence turned into dramatic divergence.

LTCM's counter parties, marking their LTCM exposure to market at least once a day,

began to call for more collateral to cover the divergence. On one single day, August

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21, the LTCM portfolio lost $550 million, writes Lewis. Meriwether and his team, still

convinced of the logic behind their trades, believed all they needed was more capital

to see them through a distorted market.

Perhaps they were right. But several factors were against LTCM.

Who could predict the time frame within which rates would converge again?

Counter parties had lost confidence in themselves and LTCM.

Many counter parties had put on the same convergence trades, some of them as

disciples of LTCM.Some counter parties saw an opportunity to trade against LTCM's

known or imagined positions.

In these circumstances, leverage is not welcome. LTCM was being forced to

liquidate to meet margin calls.

On September 2, 1998 Meriwether sent a letter to his investors saying that the fund

had lost $2.5 billion or 52% of its value that year, $2.1 billion in August alone. Its

capital base had shrunk to $2.3 billion. Meriwether was looking for fresh investment

of around $1.5 billion to carry the fund through. He approached those known to have

such investible capital.

But offers of new capital weren't forthcoming. Perhaps these big players were waiting

for the price of an equity stake in LTCM to fall further. Or they were making money

just trading against LTCM's positions. Under these circumstances, if true, it was

difficult and dangerous for LTCM to show potential buyers more details of its

portfolio. Two Merrill executives visited LTCM headquarters on September 9, 1998

for a "due diligence meeting", according to a later Financial Times report (on October

30, 1998). They were provided with "general information about the fund's portfolio, its

strategies, the losses to date and the intention to reduce risk". But LTCM didn't

disclose its trading positions, books or documents of any kind, Merrill is quoted as

saying.

The US Federal Reserve system, particularly the New York Fed which is closest to

Wall Street, began to hear concerns about LTCM from its constituent banks. In the

third week of September LTCM's clearing agent, said it wanted another $500 million

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in collateral to continue clearing LTCM's trades.

Peter Fisher, executive vice president at the NY Fed, decided to take a look at the

LTCM portfolio. On Sunday September 20, 1998, he and two Fed colleagues,

assistant treasury secretary and bankers from Goldman and JP Morgan, visited

LTCM's offices. They were all surprised by what they saw.

It was clear that, although LTCM's major counter parties had closely monitored their

bilateral positions, they had no inkling of LTCM's total off balance sheet leverage.

LTCM had done swap upon swap with 36 different counter parties. In many cases it

had put on a new swap to reverse a position rather than unwind the first swap, which

would have required a mark-to-market cash payment in one direction or the other.

LTCM's on balance sheet assets totalled around $125 billion, on a capital base of $4

billion, a leverage of about 30 times. But that leverage was increased tenfold by

LTCM's off balance sheet business whose notional principal ran to around $1 trillion.

The off balance sheet contracts were mostly nettable under bilateral ISDA

(International Swaps & Derivatives Association) master agreements. Most of them

were also collateralized. Unfortunately the value of the collateral had taken a dive

since August 17.

Surely LTCM, with two of the original masters of derivatives and option valuation

among its partners, would have put its portfolio through stress tests to match recent

market turmoil. But, like many other value-at-risk (Var) modelers on the street, their

worst-case scenarios had been outplayed by the horribly correlated behavior of the

market since August 17. Such a flight to quality hadn't been predicted, probably

because it was so clearly irrational.

According to LTCM managers their stress tests had involved looking at the 12

biggest deals with each of their top 20 counter parties. That produced a worst-

case loss of around $3 billion. But on that Sunday evening it seemed the mark-

to-market loss, just on those 240-or-so deals, might reach $5 billion. And that

was ignoring all the other trades, some of them in highly speculative and illiquid

instruments.

Page 32: Risk Mgmt - MNC

The next day, Monday September 21, 1998, bankers continued to review the

problem. It was still hoped that a single buyer for the portfolio could be found - the

cleanest solution.

According an article, LTCM's portfolio had its second biggest loss that day, of $500

million. Half of that was lost on a short position in five-year equity options. AIG had

intervened in thin markets to drive up the option price to profit from LTCM's

weakness. At that time, as was learned later, AIG was part of a consortium

negotiating to buy LTCM's portfolio. By this time LTCM's capital base had dwindled

to a mere $600 million. That evening, UBS, with its particular exposure on a $800

million credit, with $266 million invested as a hedge, sent a team to Greenwich to

study the portfolio.

The bankers decided to form working groups to study possible market solutions to

the problem, given the absence of a single buyer. Proposals included buying LTCM's

fixed income positions, and "lifting" the equity positions (which were a mixture of

index spread trades and total return swaps, and the takeover bets). During the day a

third option emerged as the most promising: seeking recapitalization of the portfolio

by a consortium of creditors.

But any action had to be taken swiftly. The danger was a single default by LTCM

would trigger cross-default clauses in its Isda master agreements precipitating a

mass close-out in the over-the-counter derivatives markets. Banks terminating their

positions with LTCM would have to rebalance any hedge they might have on the

other side. The market would quickly get wind of their need to rebalance and move

against them. Mark-to-market values would descend in a vicious spiral.

LTCM's clearing agent was threatening to foreclose the next day if it didn't see $500

million more collateral. Until now, LTCM had resisted the temptation to draw on a

$900 million standby facility that had been syndicated by Chase Manhattan Bank,

because it knew that the action would panic its counter parties. But the situation was

now desperate. LTCM asked Chase for $500 million. It received only $470 million

Page 33: Risk Mgmt - MNC

since two syndicate members refused to chip in.

To take the consortium plan further, the biggest banks, either big creditors to LTCM,

or big players in the over-the-counter markets, were asked to a meeting, to get 16 of

them to chip in $250 million each to recapitalize LTCM at $4 billion.

Head of global credit risk at Chase warned that nothing would be gained a) by raking

over the mistakes that had got them in this room, and b) by arguing about who had

the biggest exposure: they were all in this equally and together.

The delicate question was how to preserve value in the LTCM portfolio, given that

banks around the room would be equity investors, and yet, at the same time, they

would be seeking to liquidate their own positions with LTCM to maximum advantage.

It was clear that John Meriwether and his partners would have to be involved in

keeping such a complex portfolio a going concern. But what incentive would they

have if they no longer had an interest in the profits? Chase insisted that any bailout

would first have to return the $470 million drawn down on the syndicated standby

facility. But nothing could be finalized that night since few of the representatives

present could pledge $250 million or more of their firm's money.

Goldman Sachs had a surprise: its client, Warren Buffett, was offering to buy the

LTCM portfolio for $250 million, and recapitalize it with $3 billion from his Berkshire

Hathaway group, $700 million from AIG and $300 million from Goldman. There

would be no management role for Meriwether and his team. None of LTCM's existing

liabilities would be picked up, yet all current financing had to stay in place.

Meriwether had until 12.30 to decide.

It was clear that Meriwether had rejected the offer, either because he didn't like it, or,

according to his lawyers, because he couldn't do so without consulting his investors,

which would have taken him over the deadline.

The bankers were somewhat flabbergasted by Goldman's dual role. Since there

were only 13 banks, not 16, they'd have to put in more than $250 million each. In the

end 11 banks put in $300 million each.Meriwether and his team would retain a stake

Page 34: Risk Mgmt - MNC

of 10% in the company. They would run the portfolio under the scrutiny of an

oversight committee representing the new shareholding consortium.

The message to the market was that there would be no fire-sale of assets. The

LTCM portfolio would be managed as a going concern.

In the first two weeks after the bail-out, LTCM continued to lose value, particularly on

its dollar/yen trades, according to press reports which put the loss at $200 million to

$300 million. There were more attempts to sell the portfolio to a single buyer. But

there was no sale. By mid-December, 1998 the fund was reporting a profit of $400

million, net of fees to LTCM partners and staff.

Within six months there were reports that Meriwether and some of his team wanted

to buy out the banks, with a little help from their friend, who was due to leave

Goldman Sachs after its flotation in May, 1999.

By June 30, 1999 the fund was up 14.1%, net of fees, from last September.

Merewether’s plan approved by the consortium, was apparently to redeem the fund,

now valued at around $4.7 billion, and to start another fund concentrating on buyouts

and mortgages. On July 6, 1999, LTCM repaid $300 million to its original investors

who had a residual stake in the fund of around 9%. It also paid out $1 billion to the

14 consortium members. It seemed Meriwether was bouncing back.

BIBLIOGRAPHY

Page 35: Risk Mgmt - MNC

MULTINATIONAL FINANCIAL MANAGEMENT – ALAN C SHAPIRO

ICFAI JOURNAL

JOURNAL ON RISK MANAGEMENT

BUSINESS INDIA

MULTINATIONAL FINANCE – KRIT C BUTLER

WEBSITES ON THE INTERNET