Types Of Exchange Rate Systems

Published Date: 02 Nov 2017

Introduction

1.1-General Overview

This research studies the exchange rate of currencies, which are the medium of exchange between companies, and its effect on multinational companies. The value of goods, services, and property is measured by currencies. Currency exchange rate is the rate on which currencies are exchanged between each and another; it is the value of currencies relative to another.

Recently, ISO (International Organization for Standardization) is working on a three-letter system of codes to describe currency; these codes are currency signs and names. This system is important to specify and separate the different countries that use the same currency. For example USD refers to the United States currency.

Multinational corporations are international business organizations. The main common objective of multinational corporations is to maximize shareholder wealth. Managers in multinational corporations are expected to make decisions that will maximize the stock price and serve the shareholders, which is similar to the goal of managers employed by domestic companies. These decisions that are intended to maximize the value of the multinational corporations may attempt to export products to a foreign country or import supplies from a foreign manufacturer. However, many of them recognize additional foreign opportunities and eventually establish subsidiary in foreign countries (Madura, & Fox, 2002).

As business becomes more international, more companies are introducing themselves as multinational corporations. The aims of changing national companies into international corporations are to introduce new products and services, becoming market leaders and to generate more profits from foreign markets. This change from national to international companies have many challenges, one of them is their dealing in currency exchange rates. The fluctuation in currency exchange rates may affect multinational companies (Gleason, K. Kim, Y. & Mathur, I. 2005).

Exchange rate of currencies is one of the most important factors that affect the whole economy. All the companies in the world are affected by any change in the exchange rate of their currency. Multinational Corporation’s value is affected more than national companies by any movement in currencies exchange rate. This change may affect the company’s assets price, financial structure, profit margin, and cash flow (Feixiang, 2012).

This fluctuation of exchange rate will affect the corporation’s cash flow through the transaction, translation risks, and economic exposure risk (Ramasamy, 2004)

1.2-Purpose of the Study

All companies are urged to know about currencies and how they work in order to generate better profit and to avoid unanticipated losses. This study is conducted in order to understand and comprehend how exchange rates work and proof that their fluctuation has a huge effect on multinational companies.

1.3-Significance

The study of currency exchange rate will explain the reasons why multinational companies are losing and facing problems. This study will highlight on how companies can reduce and decrease the effect of currency exchange rate fluctuation on the company. Historically Lebanese companies faced this risk when the value of the Lebanese currency exchange rate dropped compared to other currencies such as the U.S. Dollar.

1.4-Research Question

This study is conducted to analyze and answer some questions that are always discussed in the exchange rate fluctuation and its effect on multinational companies. These questions are:

How exchange rate fluctuation impact multinational companies profits?

How do transaction risk, translation risk, and economic risk affect multinational companies financial reporting and performance?

What role does Hedging play in reducing multinational companies’ losses?

Chapter II

Literature Review

2.1-Exchange Rate

The exchange rate fluctuation is an important factor for most of the companies especially multinational corporations. There are many ways for dealing with such fluctuation which all of them have the same aim to reduce foreign exchange losses and reduce the instability of cash flow (Marshall, 2000).

Changes in exchange rate can be broken down into two types expected changes and unexpected changes. Usually companies have the ability to respond to an expected change in the exchange rate but things gets more complicated when it comes to unexpected change (Feixiang, 2012).

2.2-Types of Exchange Rate Systems

oreover, exchange rate system can be classified into four categories: Fixed, Freely loating, managed float, and Pegged.

2.2.1-Fixed Exchange Rate System

In this system either the exchange rate is constant or can fluctuate in very narrow limits. A fixed exchange rate would be beneficial for firms so they could engage in direct foreign investments without concern about exchange rate movements of that currency. Fixed exchange rate would help them to convert their foreign earnings into their home currency without worrying that their earnings might weaken over time. Thus, the management of multinational corporations would be much easier. In this exchange rate system corporations are encouraged to invest in foreign countries (Madura, & Fox, 2002).

2.2.2-Freely Floating Exchange Rate System

In free exchange rate system, exchange rate values are determined by market forces without the interference of governments. In fixed exchange system there is no flexibility for exchange rate movements, unlike free exchange rate system there is complete flexibility. A free exchange rate changes in a continuous way in response to demand and supply conditions of the currency. Within this system of exchange rate it is hard for the multinational companies to control its earnings in the future (Madura, & Fox, 2002).

2.2.2.1-Managed Float Exchange Rate System

In some countries the exchange rate system is between fixed and free exchange rate system. This system is similar to the free exchange rate system in that exchange rates are allowed to vary from one day to another. It is similar to the fixed rate system in that government is able to interfere to prevent its currency from moving too far in a certain direction. This type of system is known as a managed float. In this system of exchange rate corporations are encouraged to invest in foreign countries (Madura, & Fox, 2002).

2.2.3-Pegged Exchange Rate System

In this system the currency of a certain country would be pegged into other stable foreign currency such as dollar. So this currency moves in line with that currency against other currencies. In pegged exchange system the companies are more likely to invest in foreign countries especially in the country that their currency is pegged to (Madura, & Fox, 2002).

2.3-Types of risks

The fluctuation of exchange rate will affect the corporation’s cash flow through the transaction risk, translation risks, and economic exposure risk. These three different types of currency fluctuation risks are being discussed in the study (Ramasamy, 2004).

2.3.1-Translation risk

Translation risk is the risk that results from the changes done to the financial statements of the multinational corporations. The financial statement is normally measured in its local currency, to be consolidated each financial statement should be translated into the currency of the multinational companies’ parent. Since exchange rate fluctuation by time, this translation into different currency is affected by the exchange rate changes. This translation risks with the fluctuation of currency exchange rate my lead to the loss or gain in translation of multinational company’s annual accounts. For this reason many companies seek to have a balanced balance sheet. The main source of risk for most of the corporations is the translation risk; translation profit or loss has a huge impact on the profitability of the company which has more harmful effects than those caused by operational activities like sales and profit margins (Dhanani, 2003).

Foreign currency translation from an accounting respective: assets and liabilities are translated at exchange rate at the balance sheet date, whereas the profit or loss is translated at an average rate for the whole financial year or at the closing year rate of exchange; nevertheless the share capital is translated at the historical rate of exchange which is the rate when it was first issued. These results are mentioned in the income statement to show the changes in assets and liabilities (Dhanani, 2003).

Some multinational corporations are subject to a greater degree of translation exposure than others. A multinational corporation’s degree of translation exposure is dependent on the following: The proportion of its business conducted by foreign subsidiaries, the locations of its foreign subsidiaries, and the accounting methods that it uses (Madura, & Fox, 2002).

2.3.2-Transaction risk

The second risk is the transaction risk, which is the cash flow risk that is generated from region currencies. Transaction exposure exists when the anticipated future cash transactions of a firm are affected by exchange rate fluctuations. Transaction risk is easier than translation risk to measure and reduce it since multinational companies always hedge policies against transaction risk but they rarely do for balance sheet account and translation risk. There are two reasons for the multinational corporations not to hedge against translation; the first is that the deflation and reduction in one country will affect its branches in other countries. Second reason is that in long term the net worth of the company will not be affected by exchange rate fluctuation because exchange rate is affected by the productivity of the corporation’s (Moguillansky, 2002).

In other words, transaction risk is the most clear and simply specialized form of exchange rate risk. It is a cash flow risk that corporations try for converting their foreign currencies into home currencies to avoid and decrease this risk (Dhanani, 2003).

When the transaction risk exists, then the company faces three major tasks. First one, the company must identify the level of transaction risk. The second task, it should decide whether to hedge this exposure. The third, if the company decides to hedge all or part of the exposure, it should choose one of the various hedging techniques available (Madura, & Fox, 2002).

2.3.3-Economic exposure

The third type of exchange risks is the Economic exposure risk which is the definite change in the financial performance of the company as a result of fluctuation in the rate of exchange (Dhanani, 2003).

Economic exposure represents any impact of exchange rate fluctuations on a corporation’s future cash flows. Corporate cash flows can be affected by exchange rate movements in ways not directly associated with foreign transactions. Multinational corporations should verify its economic exposure before the company can manage it. the company has the ability to determine its exposure to each currency in terms of its cash inflows and outflows. Thus, corporations cannot focus just on hedging their foreign currency payables or receivables but must also attempt to determine how all their cash flows will be affected by possible exchange rate movements (Madura, & Fox, 2002).

Multinational corporations usually face the problem of managing economic risks which is the impact of exchange rate on net cash flow and managing economic risk poses a serious challenge for multinational corporations, particularly as the impact of exchange rate fluctuations on net cash flows enlarged well beyond the accounting period in which these fluctuations occur (Marshall, 2000).

2.4-Hedging

2.4.1-The use of financial and operational hedging strategies

These risks, that companies are facing, result from the fluctuation of exchange rate. To reduce the effect of these risks that may affect the company’s cash flow, assets, profit, and financial structure; the company should use hedging activities to reduce exchange rate fluctuation risk (Ramasamy, 2004).

There are 3 variables of financial and operational hedging: (i) the number of countries the company operates in, (ii) the number of large area which the company is located, (iii) the geographic distribution of its subordinate. To know whether the corporation exchange risk is affected by hedging or not the corporation should consider two factors which are the company’s stock rate of return and the exchange rate index (Allayannis, Ihrig, & Weston, 2001).

When the company uses geographic distribution as a technique to reduce exchange rate risks (hedging), then a negative relationship will take place; companies that have huge operation regions have high exposure. As corporations increase their foreign revenues, the higher is the exposure; foreign revenues are part of the total revenues generated by the company which are used in financial hedging to proxy the company’s exchange rate exposure. Financial hedging is related to the sales ratio which indicates that the more the sales are the most likely that the corporation will use financial hedging. Financial hedging will not be represented by hedging the foreign exchange rate but it is by hedging the usage of currency derivatives (Allayannis, Ihrig, & Weston, 2001).

Operational hedging in geographic diversification is useful for multinational companies for reducing the fluctuation of cash flows. Multinational corporations have many actions located in countries whose currencies fluctuate in different percentage and may be in opposite direction. Hence multinational companies can benefit through operational hedging from the unexpected variation in exchange rate of foreign countries. Operational hedging helps the company only if the corporation faces a combination of exchange rate and demand uncertainty. It can be used as a complement to financial hedging; large multinational companies use financial derivatives to hedge the risk of exchange rate fluctuation. For short-term exposure (transaction exposure) most of the companies use financial hedging; on the other hand they use operational hedging for long-term exposure (economic exposure) (Gleason, K. Kim, Y. & Mathur, I. 2005).

There are some corporations that used operational hedging but the result was not reduction in exchange risks; companies are more likely to use financial strategies for reducing exchange rate risk. Operational hedging is not a substitute for the financial hedging; operational and financial hedging are being complementary to reduce the exchange rate risks (Allayannis, Ihrig, & Weston, 2001).

2.4.2-Hedging Exposure to Fixed Assets

In this point the focus is on the result of economic exposure on cash flows. The effects of economic exposure may exceed cash flows. When multinational has fixed assets in a foreign country, the cash flows received from sales of these assets is subject to exchange rate risk. Some multinational companies do not worry about their fixed assets because they expect normally to save the fixed assets for several years, given the regular reorganization of global operations. However multinational corporations must think about hedging against the possible sales of these assets in the future. The sales of these assets can be hedged by forming a liability that matches the expected value of the assets in the future if sold. The sale of the fixed assets provides a foreign currency cash inflow that can be used to pay the liabilities that is denominated in the same currency (Madura, & Fox, 2002).

The limitations of selling the fixed assets are that the multinational corporations do not have the ability to know (1) the date that the company will sell the assets, (2) the price in local currency at which it will sell them. Moreover, the company is unable to create a liability that matches the amount of the sale of the fixed assets. Nevertheless, these limitations must not prevent a firm from hedging. Long-term future contracts are also a possible way for hedging far-away fixed assets in foreign countries, but they may not be available for many rising market currencies (Madura, & Fox, 2002).

2.5-Management of foreign exchange risk

Managing foreign exchange rate fluctuation is expected to protect multinational corporations from the bad effects of this change in exchange rate. To manage and hedge currency fluctuation risk there is two methods the company should use; these two methods are internal and external methods (Marshall, 2000).

Internal method

Internal method is the method that works on the management of the company’s financial statements without any relationship with any company outside the corporations that are concerned. There is two main ways for internal methods to manage exchange rate fluctuation, first one by leading, lagging, and netting, balance sheet hedging and pricing policies in short-term cash flows. Secondly by international diversification in manufacturing and financing decisions in the long-term cash flows (Marshall, 2000).

External methods

External methods works on making contractual relationships with other companies to reduce potential exchange rate losses. External methods are contracts and derivatives such as currency futures, currency options, and currency exchange (Marshall, 2000).

2.6-Currency derivatives

The possible shifts in the demand and supply for a currency will affect the firms and individuals who have assets in foreign currencies can be affected negatively or positively. So they have to change their currency exposure in order to benefit from this fluctuation. Some multinational corporations that expect to be affected negatively they may hedge their exposure.

The currency derivative is the contract whose price is partly formed from the value of the original currency that it represents. Usually multinational corporations hedge their exposure to exchange rate risk. Also their managers have to know how to deal with these derivatives to achieve the company’s goals (Madura, & Fox, 2002).

2.7-Forward Market

The forward market facilitates the trading of forward contracts on currencies. A forward contract is an agreement between a corporate and a commercial bank to exchange a specific amount of a specific currency into another currency at a specified exchange rate for a specified period of time. When multinational corporations look forward for a future receiving of a foreign currency the company can set up a contract at the rate of exchange of this currency into another currency. Most of the multinational corporations uses forward contract. Since these contracts help large companies usually the value of such contract is one million dollar or even more and most of the forward contracts are for 30, 60, 90, 180, and 360 days. Multinational companies usually use forward contracts to hedge their imports. So that they know the rate at which they know the currency needed to purchase imports (Harvey & Hogan, 2000).

2.8-Future market

Future currency contracts are very similar to forward contracts in term of their responsibility but they differ from forward contracts in the way they are traded. Multinational company uses both of them forward and future contracts to hedge its foreign currency positions and capitalize on its expectations of exchange rate movements (Madura, & Fox, 2002).

2.9-Currency Call Options

A currency call option gives its holder the right to buy the underlying assets; in this case currency, at a specified strike price and within a specified time period. The option should specify the strike price or the exercise price and time period where this right remains valid. Currency call option is used by investors believe that they will need the specific currency some time near in the future. Therefore to lower the risk from currency exchange fluctuation the will be willing to pay a small premium (cost of the call option) to lock on the maximum price of the currency. When the exercise price is below the currency spot price in the market, the call option holder exercises the option and buys the currency at the specified exercise price. When the exercise price is above the market price of the currency the option holder leaves the option unexercised and buy the currency at the market price (Madura, & Fox, 2002).

2.10-Currency Put Options

A currency put option gives its holder the right to sell the currency, at a specified strike price and within a specified time period. Similar to the call option the put option would specify the strike price or the exercise price and time period where this right remains valid. Currency put option is used by investors believe that they will be selling a currency some time near in the future. Therefore to lower the risk from currency exchange fluctuation the will be willing to pay a small premium (cost of the put option) to lock on the minimum price of the currency.

When the exercise price is above the market price of the currency the option holder exercises the option and sells the currency at the specified exercise price. When the exercise price is below the currency spot price in the market, the put option holder leaves the option unexercised and sells the currency at the market price (Madura, & Fox, 2002).