Exchange Rate Risks and Direct Foreign Investment: A Comprehensive Guide

Posted on May 17, 2024 in Economy

  1. Arguments for and against the Relevance of Exchange Rate Risks

– Exchange rates are highly volatile.

– The dollar value of an MNC’s future payables or receivables in a foreign currency can change significantly in response to exchange rate movements.

  • Investor Hedge Argument
  • Currency Diversification Argument
  • Stakeholder Diversification Argument

  1. Forms of Exchange Rate Exposure

  • Transaction exposure: sensitivity of the firm’s contractual transactions in foreign currencies to exchange rate movements.
  • Economic exposure: the sensitivity of the firm’s cash flows to exchange rate movements, sometimes referred to as operating exposure.
  • Translation exposure: the exposure of the MNC’s consolidated financial statement to exchange rate fluctuations.

  1. Hedging Transaction Exposure Techniques

(Hedging payable):An MNC may decide to hedge part or all of its known payables transactions using:

  • Futures hedge
  • Forward hedge
  • Money market hedge
  • Currency option hedge

(Hedging receivable)

  • Forward or futures hedge
  • Money market hedge
  • Put option hedge


  1. Specifications on Forward and Future Contracts

  • Currency that the firm will pay
  • Currency that the firm will receive
  • Amount of currency to be received by the firm
  • Rate at which the MNC will exchange currencies (called the forward rate)
  • Future date at which the exchange of currencies will occur

  1. Revenue and Cost Motives for Direct Foreign Investment (DFI)

(REVENUE)

  • Attract new sources of demand
  • Enter profitable markets
  • Exploit monopolistic advantages
  • React to trade restrictions
  • Diversity Internationally

(COST)

  • Fully benefit from economies of scale
  • Use foreign factors of production
  • Use foreign raw materials
  • Use foreign technology
  • React to exchange rate movements

  1. Incentives for and Barriers to DFI

  • Barriers to DFI
    1. Protective barriers – agencies may prevent an MNC from acquiring companies if they believe employees will be laid off.
    1. Industry barriers – local firms may have substantial influence on the government and may use their influence to prevent competition from MNCs
    2. Environmental barriers – building codes, disposal of production waste materials, and pollution controls.

  1. Strategies for Reducing Exposure to a Host Government Takeover

Strategies to reduce exposure to a host government takeover include:

  1. Use a short-term horizon
  2. Rely on unique supplies or technology
  3. Hire local labor
  4. Borrow local funds
  5. Purchase insurance
  6. Use project finance


  1. Factors for Multinational Capital Budgeting

  1. Initial investment – Funds initially invested include whatever is necessary to start the project and additional funds, such as working capital, to support the project over time.
  2. Price and consumer demand – Future demand is usually influenced by economic conditions, which are uncertain.
  3. Tax laws – International tax effects must be determined on any proposed foreign projects.
  4. Exchange rates – These movements are often very difficult to forecast.
  5. Salvage (liquidation) values – Depends on several factors, including the success of the project and the attitude of the host government toward the project
  6. Required rate of return – The MNC should first estimate its cost of capital, and then it can derive its required rate of return on a project based on the risk of that project.

  1. Characteristics of Political and Financial Risks of Country Risks

(a) Political risks

  1. Attitude of consumers in the host country – a tendency of residents to purchase only locally produced goods.
  2. Actions of the host government – A host government might impose pollution control standards and additional corporate taxes, as well as withholding taxes and fund transfer restrictions.
  3. Blockage of fund transfers – A host government may block fund transfers, which could force subsidiaries to undertake projects that are not optimal (just to make use of the funds).
  4. Currency inconvertibility – Some governments do not allow the home currency to be exchanged into other currencies
  5. Inefficient bureaucracy – Bureaucracy can delay an MNC’s efforts to establish a new subsidiary or expand business in a country.

(b) Financial risks

  1. Interest rates: higher interest rates tend to slow growth and reduce demand for MNC products
  2. Exchange rates: strong currency may reduce demand for the country’s exports, increase volume of imports, and reduce production and national income.
  3. Inflation: inflation can affect consumers’ purchasing power and their demand for MNC goods.