Page 109 - DMGT549_INTERNATIONAL_FINANCIAL_MANAGEMENT

International Financial Management

Notes In the above illustration, the net inflows and outflows in each currency were certain whereas the
exchange rates at the end of the period were assumed to be uncertain. In reality, both the net
inflow/outflow as well as the exchange rates could be uncertain. If this is so the measurement of
exposure in each currency would be more complex as now even the second column would be a
range. Techniques like sensitivity analysis or simulation could be used to generate a set of
possible estimates for exposures in each currency.

Self Assessment

State whether the following statements are true or false:

1. Transaction risk is critical to an MNC due to the high variability in exchange rates.
2. Transaction exposure measures only gains that arise from the settlement of existing
financial obligation.

7.2 Transaction Exposure based on Currency Variability

The expected range of possible exchange rates for each currency was assumed to be given in the
earlier example. In actual practice, MNCs have their own method for developing exchange rate
projections. Various methods can be used by MNCs to predict future currency values.
For example, MNC’s can use the historical data for the past few years to assess the expected
movement for each currency. The standard deviation method is also used very frequently to
measure the degree of movement for each particular currency. The idea here is to assess and
broadly identify some currencies which fluctuate more widely than others.

For example, during the period 1974–1989, it was found that the German mark had a standard
deviation of about 6 per cent, Canadian dollar of approximately 2 per cent, British pound and
French franc of approximately 5 per cent. Based on the above information, a US based MNC may
feel that an open asset or liability position in Canadian dollars is not as problematic as an open
position in other currencies.
Self Assessment

Fill in the blank:
3. Various methods can be used by MNCs to predict …………………… values.

7.3 Managing Transaction Exposure

The various methods available to a firm to hedge its transaction exposure are discussed below:

7.3.1 Forward Market Hedge

In a Forward Market Hedge, a company that is long in a foreign currency will sell the foreign
currency forward, whereas a company that is short in a foreign currency will buy the currency
forward. In this way, the company can fix the dollar value of future foreign currency cash flow.
If funds to fulfil the forward contract are available on hand or are due to be received by the
business, the hedge is considered “covered,” “perfect or “square” because no residual foreign
exchange risk exists. Funds on hand or to be received are matched by funds to be paid.

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