"Exchange rates are the amount of one country's currency needed to purchase one unit of another currency (Brealey 1999, p. 625)". People wanting to exchange some money for their vacation trip will not be too much bothered with shifts if the exchange rates. However, for multinational companies, dealing with very large amounts of money in their transactions, the rise or fall of a currency can mean getting a surplus or a deficit on their balance sheets. What types of exchange rate risks do multinational companies face?
One type of exchange risk faced by multinational companies is transaction risk. If a company sells products to an overseas customer it might be subject to transaction risk. If a UK company is expecting a payment from a US customer in June and the invoice was made in January, the exchange rate is bound to have changed during the period. If the deal was worth £1,000,000 and the american dollar compared to pound sterling weakened from US$1.40 in January to US$1.50 in June, the UK company would loose £47,619 (Appendix A).
Economic risk is another type of exchange risks companies have to consider when dealing globally. Changes in exchange rates are bound to affect the relative prices on imports and exports, and that will again affect the competitiveness of a company. An UK exporter dealing with companies in the US would not want the US$ to depreciate, because it would make the exports more expensive for the US market, thus the company will loose business.
Other types of exchange rate risks are translation risk and so-called hidden risk. The translation risk relates to cases where large multinational companies have subsidiaries in other countries. On the financial statement of the whole group, the company may have to translate the assets and liabilities from foreign accounts into the group statement. The translation will involve foreign exchange exposure. The term hidden risk evolves around the fact that all companies are subject to exchange rate risks, even if they don't do business with companies using other currencies. A company that is buying supplies from a local manufacturer might be affected of fluctuating foreign exchange rates if the local manufacturer is doing business with overseas companies. If a manufacturer goes out of business, or experience heavy losses, it will affect all the companies it does business with. The company might not be able to pay its debts, or fulfill its contracts, and all the companies it does business with will consequently suffer.
Interest Rate Risk.
Interest can be explained as the "charge paid by a borrower for to lender for the use of a lender's money (Ritter 2000 p. 598)." The interest rate is simply the percentage of the sum a borrower has to pay the lender on top of the sum which is being lent for an agreed period of time. For example, if a company borrows £100,000 from a bank at 8% interest rate with payment due in 12 months. By the end of the 12 months the company then has to pay the bank £108,000 (Appendix B, i). What types of interest rate risks do multinational companies face?
One type of interest rate risks is the transaction risk. Since the interest rates constantly rise and fall companies often fix their interest rates on loans for long periods of time. As a result of this the company looses money if the interest rate falls below their fixed rate during the period the loan is for. For example, in 1998 a company borrows £2,000,000 for a 5 year period with fixed interest rate of 8% payable annually. Each year the company then has to pay interest of £160,000. If the interest rate in 2000 falls to 6%, the company is still paying 8% interest, and will consequently "loose" £40,000 annually.
Other types of interest rate risks are translation risk and economic risk. Translation risk relates to fact that changes in the interest rates will change the value of financial assets. If people expect the interest rate to increase, the values...