Multinational companies are faced with numerous business risks compared to firms operating on a domestic scale (Mockler 2002, p. 65). One of the risks that these firms face relates to foreign exchange risks. Foreign exchange risk arises from the fact that different currencies are used in the firm’s process of operation. As a result, management teams of Multinational Corporations (MNCs) are increasingly being concerned with foreign exchange risks in undertaking their overall financial management processes (Vyuptakesh 2009, p. 186).
Marshall asserts that the core objective of managing foreign exchange risks is to maximize foreign exchange gains by minimizing associated foreign exchange losses. Collier (2009, p.150) asserts that there are a number of foreign exchange risks faced by MNCs. These include translation, economic and transaction risks. In order for these firms to effectively manage foreign exchange risks, it is vital that they understand the relationship that exists between the various foreign exchange risks. The paper analyzes the relationship that exists between economic, transaction, and translation risk with reference to MNCs.
Transaction and translation risk
According to Collier (2009, p. 150), transaction risk arises from changes in the nominal rate of exchange. This affects the MNC’s foreign cash flows which are denominated in foreign currency. In their operation, MNCs enter into contracts with other foreign companies whose settlement is in the future (Ajami, Cool, & Goddard 2006, p.110). Considering the fact that foreign exchange rates are subject to fluctuations due to changes in the external environment, there is a high probability that the cash flow in relation to imports and exports is either positively or negatively affected. According to Whittington and Delaney (2007, p.141), transaction risks entail the probability of a firm incurring gains or losses as a result of income transactions undertaken by the firm in the course of its operation. Considering the fact that accounting standards require recognition of gains and losses upon making the payments, multinational companies are faced with translation risk due to fluctuation in the exchange rate. Fluctuations in the rate of exchange affect the contract which indicates that there is a relationship that exists between transaction and translation risk (Rugman 2009, p. 29).
International financial management requires firms to consolidate all their financial statements resulting from international operations (Apte 2006, p. 45). In order to do this, all their financial statements resulting from foreign operations have to be converted into the firm’s operational currency. Whittington and Delaney (2007, p.141) define translation risk as the exposure faced by a multinational corporation since its financial statements have to be converted into functional currency. This means that there is a difference that is reflected in the firms’ financial statements upon converting the figures into the firm’s functional currency. In addition to the relationship that exists between transaction and translation risk in relation to international trade, multinational corporations are also faced with translation risk when listing foreign assets in their balance sheets (Carrada-Bravo 2003, p.25). This means that the translation risk of these companies is determined by the number of foreign assets, equities, or liabilities that are listed in their balance sheets. Carrada- Bravo (2003, p. 25) further asserts that MNCs face translation risk since the foreign exchange rates in the international markets change in between quarterly financial statements. In addition, the reporting currency may be different from the functional currency which is in most cases the local currency (Carrada-Bravo 2003, p.42).
Collier (p.151) defines economic risk as the extent to which a firm’s future cash flows are subject to fluctuation due to changes in the exchange rate. Collier further asserts that economic risks affect multinational corporation operations before the commencement of business transactions. As a result, transaction risks are not measurable. According to Marshall (1999, p. 186), economic risk presents a challenge to MNC’s management teams due to fluctuation in their net cash flow which goes
beyond the normal accounting period in which the foreign exchange fluctuation occurs. Economic risk also affects multinational corporation balance sheets. This is due to the fact that these risks relate to sales that are expected to be made in the future.
Multinational corporations mostly face transaction risk when they sell their products at debt (Ghosh 1995, p.373). For example, the company may sell when the currency exchange rate is high and receive the payments when the exchange rate is low. The resultant effect is that the company suffers a loss which may result in the closure of the firm due to poor performance.
Multinational corporations also face economic risk due to stipulations of accounting principles. For example, it is required that transactions be recorded when incurred and not when money is received. When the company transacts on credit the cash flow may not balance due to the changes in the exchange rates. Upon making transactions, multinational corporations change the currency to their local currency (Ghosh 1995, p.373). In some cases, the value of the domestic currency may be lower or higher than the foreign currency. Therefore, the value of the company’s net worth may vary according to the currency exchange rates. This affects the financial statements of MNCs.
In their operation, multinational companies are faced with a number of foreign exchange risks. Some of these risks include translation, transaction, and economic risks. From the above analysis, it is evident that there is a relationship that exists amongst these risks. For example, MNCs are faced with risk in relation to foreign contracts. In most cases, settlement of these contracts is undertaken in the future. Due to fluctuations in the exchange rate, the amount to be paid may be higher than the expected amount. On the other hand, the firm may receive less than the expected amount. This arises due to the existence of differences in the currency used in settling the contract.
Multinational companies are required to consolidate their financial statements. As a result, the figures in the consolidated financial statement may differ from the original figures due to the existence of a difference between reporting and functional currency. On the other hand, economic risks affect Multinational corporations’ future cash flow prior to commencement of the transactions. This indicates that foreign exchange risks can result in a high degree of volatility in reporting a firm’s earnings. It is therefore important for multinational management teams to consider integrating strategies aimed at hedging against foreign exchange risks.
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