An MNC is, of course, a much more complicated system than is a simple exporter. Intuitively one might guess that an MNC manager would have a much more difficult job to do than would an export manager of a small company. The MNC manager does have a much more complex job to do, but at the same time there are a lot more options available to an MNC than to a small company. For the small company, the two basic hedging techniques explained in the last section are the only means available for managing foreign exposure.
For the MNC, hedging is merely a small portion of the entire process of risk exposure management. Hedging is usually used only for residual risk coverage-to cover transactions that cannot be handled through internal procedures. Most of the MNC's internal tools will be dealt with in the next section on cash management. Here we will consider the use of hedging by an MNC to manage translation exposure.
Whereas transaction exposure arises out of day-to-day cash flow movements, translation exposure results from uncertainty about foreign assets' value in domestic currency on a consolidation date on which the balance sheets are made public. Although translation exposure does not affect the company's liquidity and profitability, a company's legal responsibility to its stockholders requires that it be minimized. Before beginning to evaluate different options available for hedging, the international financial manager at headquarters must determine the balance sheet entries that are "exposed."
Which assets and liabilities are exposed depends on the legal system of the home country. In the United States the Financial Accounting Standards Board (FASB) sets out the guidelines managers must use to determine the types of assets and their exposure. The following brief example will demonstrate the use of both forward, or exchange market, hedging and credit, or money market, hedging.
Suppose a U.S. company is faced with the following situation:
- Its exposed assets are 500 FC (foreign currency).
- The exchange spot rate is $ I /FC.
- The end-of-year forward rate is $ 1 .05/FC.
The problem: because the exposure is positive (that is, because accounts receivable are vulnerable), the company must hedge by using either the foreign exchange market or the credit market. Figure 12.5 illustrates what can happen in this situation. The far left column shows some possible exchange rates on the day of delivery, 12/31. In the next column are the corresponding translation gains (losses). The third column gives the gain realized by entering into a forward contract that must be fulfilled on 12/31. Finally, the right-most column shows how the gain realized under the forward contract compares to the translation gain under the different scenarios.
As the first row shows, if the exchange rate turns out to be $1.10 /FC (a $0.10, or 10%, increase over the spot rate when the exchange was agreed upon), the translation gain will be $50 (500 x $0.10)' Because of the forward contract, however, the gain realized will be only $25. Thus the company will suffer a cash loss of $25-the difference between the forward rate ($1.05/FC) and the actual rate ($1.10/FC). The bottom row depicts the situation in which the exchange rate on 12/31 is $0.05 lower than the original spot rate and $0.10 lower than the forward rate. In this case, there will be a cash gain of $50. The gain actually realized, however, will still be $25, as in all the other cases. It is important to note that the balance sheet value of the foreign asset is locked in at the forward rate of $1.05/FC.
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