How exchange rate exposure creates risk and opportunities for firms.

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Risk is the uncertainty that you may not earn your expected return on your investments. For example, you may expect to earn 20% on your stock mutual fund every year. But your actual rate of return may be much lower. Multinational firms must constantly assess the business environments of the countries they are already operating in as well as the ones they are considering investing in. One of the most important international risks, which an organization faces, is exchange rate risk.

Exchange Rate Risk

Organization which invest internationally in today's increasingly global investment arena face the prospect of uncertainty in the returns after they convert the foreign gains back to their own currency. Unlike the past when most U.S. investors ignored international investing alternatives, investors today must recognize and understand exchange rate risk, which can be defined as the variability in returns on securities caused by currency fluctuations. Exchange rate risk is sometimes called currency risk.

Moreover firms must constantly assess the business environments of the countries they are already operating in as well as the ones they are considering investing in.

It involves country risk analysis, the assessment of the potential risks and rewards associated with making investments and doing business in a country. This is the subject matter of political economy?the interaction of politics and economics. Such interactions occur on a continuous basis and affect not just monetary and fiscal (tax and spending) policies but also a host of other policies that affect the business environment, such as currency or trade controls, changes in labor laws, regulatory restrictions, and requirements for additional local production.

There can be various Country-Specific Risks.

It affects both domestic and foreign firms that reside in a host country. These risks, which arise from the actions of the host government, apply more to the multinational corporation whose cash flows are impacted. Examples include exchange controls, currency inconvertibility, and blockage of funds.

Exchange Controls

A common policy of host governments facing balance-of-payments difficulties is to impose exchange controls that block the transfer of funds to nonresidents.

Currency Inconvertibility

Some governments will not permit conversion of the local currency into another currency

Blockage of Funds

Subsidiaries of MNCs typically send funds back to their parents to repay intercompany loans, remit dividends, and pay for supplies and other administrative services. When host governments experience a foreign exchange shortage, they may block the transfer of funds back to the parent.

Credit Risks:

Credit risk arises due to lack of knowledge and credit knowledge about the other party in foreign country.

Action Plan to deal with risk

1. Country Diversification

They can diversify their suppliers to reduce their exposure to one specific country.

2. Exposure Risk

Transaction exposure

It is the extent to which given exchanges rate change will change the value of foreign currency denominated transactions already entered into.

Translation (Accounting) exposure

The change in the value of a firm's foreign currency denominated accounts due to a change in exchange rates.

Economic exposure

It measures how greatly a firm's present value of future cash flows is affected by unexpected exchange rate fluctuations.

Comparison

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 ...