Introduction
The development of international business and the fickleness of the global market have increased the need to for organisations to initiate proper foreign exchange risk management strategies.
When companies trade their products and services in the international markets and/or receive payments in the form of foreign currencies, an adjustment in the exchange rates leads to the risk of reducing companies’ income.
For instance, in1997, the East Asian bloc revealed how a volatile currency exchange rate can influence trading. Most companies and investors found it difficult to cope with the radical exchange rate adjustments.
Being the most vulnerable state with respect to global trade, Malaysia suffered a huge loss. Any Malaysian businessperson who exported products to India faced huge losses because of the tremendously depreciated Rupees.
These risks are frequent in the global trade and finance. Most international investors have opted to stay away from the international business because of their inability to tackle the foreign exchange risk.
Thus, companies that seek to utilise the global market must be aware of risks that they are exposed to and/or learn to manage them. This paper critically analyses the risk implications for international businesses with reference to money management and foreign exchange risk.
Description and Types of Foreign Exchange Rate Risks
Foreign exchange rate risk refers to the impact of unanticipated exchange rate adjustments on a company. It translates into an express debit due to the evident vulnerability or oblique deficit through a company’s currency movement and property.
To overcome the exchange rate risk among multinational companies’ activities, the businesses should determine the risk they are susceptible to and the means to prevaricate it (Tóth 2014). Foreign exchange rate risk affects firms that have transactions in more than a single currency.
Their customers in foreign countries do their payments using the respective countries’ local currency. Other firms are also indirectly affected because they heavily depend on imported items and services. Foreign exchange rate risk should be controlled particularly if influences the rate of a firm’s profitability.
In instances where other key activities of the firms are more than the monetary services, the company should then strive to ensure that its key activities are not susceptible to foreign exchange rate risk (van der Laan 2013).
Exchange rate risks often occur in three forms, namely transaction risk, translation risk, as well as economic exposure. Transaction risk comprises the effects that the exchange rate has on the committed cash flow.
According to Sribunnak and Wong (2006), the risk entails the degree to which foreign exchange values influence individual transactions. These risks include the duty to pay for products and services at the initially agreed costs, as well as the monetary lending in the form of foreign currencies (Tóth 2014).
On the other hand, translation risk refers to the impact of exchange rate on the firm’s consolidated balance sheet. It involves the current interpretation of the previous events (Attila 2014). Translation risk has an insidious impact on the company with reference to foreign exchange transactions.
In the case of economic exposure, it refers to how the adjustments in the exchange rates will influence the future global revenue capability (Al-Momani & Gharaibeh, 2009). It focuses on the prolonged impact of fluctuations in the exchange rates.
According to Tóth (2014), the main contrast between economic risk and transactions exposure is that the former focuses on the long-term impact of foreign exchange oscillation while the other focuses on the interim impact of exchange rate.
Exchange rate exposure occurs in four forms, namely forecast exposure, revaluation exposure for financial items, foreign denominated cash exposure, and income translation exposure. Both the forecast and revaluation exposures have traits of transactional risks.
Forecast exposure refers to prospective transactions where income and expenses are denominated in different currencies. The occurrence of this risk means that companies will have different receipts contrary to what they had planned for.
In the case of forecast risk, businesses that have international markets have varying incomes that are in line with the exchange rates in different periods. For example, this risk may occur when suppliers in Canada provide products to the Indian market where they are paid in Rupees at a future date.
Prior to the payment, income margin is likely to vary depending on the adjusting rates of the US Dollars and Rupees (Wang & Bidarkota 2012).
Companies should develop effective strategies to evade the effects of forecast risk and thus control their profit margins. Many firms have the belief that estimating a future transaction with a foreign client who pays in the US dollars makes them evade foreign exchange.
However, the assumption is misleading because the risk is transferred to the buyer (Rejeb 2012). For example, where a foreign vendor agrees to transact business through the US dollars, the vendor will be compelled to exchange the US dollars for domestic currencies.
The vendor may be forced to adjust the prices to fit the changes in the foreign exchange rate (Utsunomiya 2013). Thus, the solution will be to transact business with the vendor through domestic currency while striving to control the foreign exchange threat.
The strategy can help the importer to remain in control of the risk instead of relying on the vendor’s choice to deliver as agreed upon. Certain firms often choose to control their transaction volatility because it influences their existing revenues.
Present earnings often show the impact of foreign exchange on the value of transaction vulnerabilities. Thus, in his view, Walley (2015) sees no need to prepare a cash flow to reveal the impact of foreign exchange on the business.
Literature and studies have shown the impact of exchange rate and money management in international business. Its impact is not only restricted to companies that export products but also firms that import items, whether for retail or production purposes.
Companies that fail to understand and monitor the changes in the exchange rate suffer huge losses because they are caught unaware of the fluctuation in the foreign currencies.
A study by Utsunomiya (2013) where 817 international corporations were taken to determine their vulnerability to exchange rates showed that that most firms were susceptible to exchange rates and that they were unable to control the danger they were exposed to.
The study used an empirical technique to approximate the effect of the exchange rate differences on the companies’ stock profits. It showed that the fluctuating Great Britain Pound, the US dollar, and the Japanese Yen hugely affected the companies.
This vulnerability largely depended on the nature of the business since exporting companies were more vulnerable to the exchange rate more than those that dealt with imports (Walley 2015).
Foreign Exchange Rates and Prices
One the main reasons that the exchange rate affects multinational businesses is that it has the potential to control global prices, which in turn also affect the domestic and international economic atmosphere. Exchange rates influence the import products, which eventually trickle down to local consumers.
The impact of adjustments in the currency rates also trickles down to the cash flow and the rate of consumer expenditure and saving among other economic issues in the country.
The cash flow in a country means that the markets of international businesses will be affected to the extent of reducing their sales volume (Wang & Bidarkota 2012).
The high competition in the global market may influence exporters to change the prices of their products to outwit their rivals.
Stiff competition, for instance, in developing states compels multinational firms to modify their marketing strategies to fit the domestic currency rates in an attempt to reduce the negative volume impact.
Notably, in a competitive economic atmosphere such as the current globalisation-based environment, the exchange rate may tamper with the expected profit margin.
Studies by Sribunnak and Wong (2006) have shown a correlation between the exports levels and the exchange rates. For instance, an analysis of exchange rate in Europe between 1994 and 2004 reveals a homogeneous rate of exports in comparison with the currency rate changes (Sribunnak & Wong 2006).
The aforementioned observation implies that exchange rates eventually affect companies’ profitability. When the cash flow and consumer spending reduce, the volume the multinational companies’ anticipated selling goes down.
The local economy is also affected because of a reduction in revenues that the country gets due to the reduced consumer spending, export, and import of products (Rashty & O’Shaughnessy 2012). As a country’s economy stagnates, the situation worsens until it gradually becomes a crisis.
Poor money management by international leaders and organisations may lead to a global financial crisis and eventually the crippling of global firms’ income, which highly depends on the international market.
Previous global monetary crises, as well as continental financial turmoil in Europe, have confirmed how poor money management can affect the profitability of international companies (Utsunomiya 2013).
According to Wang (2010), globalisation has drastically expanded the market that producers, manufacturers, and retailers can supply their services and merchandise. Free trade has also allowed firms to transact business with clients from other different countries without stringent laws and policies.
It has opened doors for multinational companies to invest in countries across the world, including the developing countries. Nonetheless, whenever companies invest in these countries, they are compelled to adhere to their domestic economic market terms, including the currency rates.
Rejeb (2012) confirms that most of the developing countries often have weak and unstable currencies. Hence, when the countries become weaker, international firms are likely to suffer loss instead of profits as they had pre-planned.
This risk and vulnerability force most companies that intend to diversify their market to remain reluctant to establish their branches in developing countries.
Nonetheless, for the companies that are willing to face the risk of investing in developing countries, they have to create hedging strategies that will help to avert the risk that are caused by foreign exchange exposure (Wang & Bidarkota 2012).
A focus on the microeconomic impact of exchange rate reveals why most companies have chosen to remain in the domestic market, rather than expanding their supplies to the ready international market (Mancini, Ranaldo & Wrampelmeyer 2013).
The fear of the unpredictable profits discourages firms from seeking global markets. For instance, a rise in the exchange rate often reduces the global costs of products, thus reducing the expected profitability of an international company (Bartram 2015).
The depreciation in the volume of sales, as well as the amount profit by a firm due to foreign exchange fluctuation, can be controlled by minimising the prices of goods. According to Wang (2010), reducing the cost of products can effectively increase the volume of sales.
However, the move will significantly reduce the profit that the company gets from exporting its products. Similarly, an appreciation in the currency rate will benefit companies that import products by minimising the price of imported products.
A reduction in the cost of imports reduces the input budget while at the same time increasing productivity (Utsunomiya 2013).
According to Rejeb (2012), the fluctuations in the exchange rate will not only have a direct influence on international companies but also on domestic firms because of the stiffness of local the competition.
When export firms are forced to reduce their prices because of an appreciation in the currency exchange rate, other firms in the local market will also be under pressure.
They have to reduce the cost of their products so that they do not lose their market to the international companies that sell their products at a cheaper cost (Sribunnak & Wong 2006).
Nonetheless, the general effect of exchange rate largely depends on the amount of international transactions that the company conducts, irrespective of whether they comprise inputs or outputs.
Hence, companies should strive to reduce the importing input at a time the exchange rate does not favour them while those that export products should develop mechanisms to avoid the susceptibility (Wang & Bidarkota 2012).
Globalisation has made it impossible for companies to ignore the huge international market, despite the risks. Moreover, several multinational companies such as Wall-Mart and Starbucks have successfully dodged the risks that foreign exchange rate fluctuations pose (Adam & Axel 2000).
The persistence of trade integration means that most of the benefits are derived from the products that are sold in the international market. Thus, the persistence increases the products’ vulnerability to the negative effects of the vacillation of the exchange rate.
Moreover, multinational companies’ move to create a strong foundation in the domestic market by increases competition within their hosting state. Since they enjoy economies of scale, international businesses are well placed to benefit from the local market (Walley 2015).
Moreover, the impact of foreign exchange rate trickles down to customers, hence restraining the positive impact on profit margins. Similarly, a rise in fiscal globalisation limits the cost of controlling foreign exchange rate oscillations, thus raising a firm’s vulnerability to the exchange rate against which it strives to protect itself.
Thus, globalisation has made it difficult for firms to predict and control the changes in the trade rate (Ko & Moon 2012). However, empirical studies indicated that most multinationals firms have acclimatised to the unpredictable exchange rate, which barely affects their income (Beckmann & Stix 2014).
For example, firms in the US have shown a steady growth and development, despite the transforms in foreign exchange.
Companies have developed strategies to help them to overcome the pressures that come with unstable currencies and poor global money management. In fact, many multinational firms are willing to invest in countries across the world, despite the risk implications of an unstable exchange rate (Sribunnak & Wong 2006).
Minimising the Vulnerability to Foreign Exchange Risk Implications
One of the key ways through which companies can avoid the risk implications of foreign exchange is through shifting transaction vulnerability to other rivals in the industry (Ng, Eburne & Kaye 2014).
For instance, a US vendor who sells his or her products in the Canadian market can shift transaction vulnerability by stating the price of the product using the US dollars of the Canadian currency (Broll, Wahl & Wessel 2011).
Thus, the buyer in Canada will be the one who will be exposed to the unpredictable currency change while importing the product.
Shifting the vulnerability can also be done by quoting the price of the product using the Canadian dollar and then requesting payment to be made immediately before the value of the currency changes (Wong 2013).
Secondly, a multinational firm can escape the unstable foreign exchange rate by netting out transaction vulnerability. Netting out works for large multinational companies whose foreign exchange trade are bulky (Rashty & O’Shaughnessy 2012; Brennan & Yihong 2006).
The company should strive to ensure that it settles its debts promptly to avoid creating an opportunity for the changes t o affect their transaction. Moreover, the exposure to the risk of foreign exchange is also minimised when the company has receipts in the form of various currencies (Byström 2013).
In fact, while a change in the value of the currency in another country may have an insidious impact on the firm, a change in the value of another country may also benefit it. Netting out does not completely protect a company from the dangers of the fluctuating exchange rate.
Thus, a company can opt for hedging techniques, although the company may have to incur an extra cost for such techniques to be successful (Mandel & Tomšík 2013)..
Firms can apply to major methods, for instance, natural hedging and monetary hedging, to control the exposure to foreign exchange risks.
Natural hedging involves minimising the variation between the delivery and payment (Hartsink 2013). It works effectively, although it normally requires a prolonged time for it to be implemented effectively.
On the other hand, monetary hedging entails purchasing instruments that are often prepared by financial institutions and brokers who understand the stock market and/or predict foreign exchange rates (Menkhoff 2012).
One of the universal hedging mechanisms is the presumptuous contract. According to Wang and Bidarkota (2012), forward contracts enable companies to determine the exchange rate at which they are willing to transact particular goods at a given future date.
Conclusion
Poor money management and overseas trade rates cause several threats to international businesses. They reduce a company’s profitability and its volume of sales. Globalisation has led to the integration of the international market.
It has encouraged companies to invest in several countries other than their home areas. Moreover, free trade system that has been endorsed by international leaders has encouraged the import and export of products.
Nonetheless, the unpredictable foreign exchange rate creates a lot of danger to companies that are involved in the global business since they can get losses even in areas where they had planned to get profits.
Thus, companies should prepare techniques of avoiding the risks of the unstable foreign exchange rates. Some of the methods of dodging the fluctuating foreign exchange rate include shifting transactions, netting out, and hedging. Firms should choose a technique that they consider the most effective.
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