Multinational Companies are the companies that manage the production establishment or delivery services in at least two or more countries. They have a budget that exceeds more than those of other countries and have a powerful influence on international relations and the local economies. They have branches in many countries and thus bring benefits to the developing countries that conduct business with them.
The problems with these companies are that they offer very low-quality jobs and they poorly pay their employees in which they conduct their business. The profits that are generated by these companies are taken back to the places of origin. The domestic companies are the company that operates only within the mother country and the company does not participate in the international business or trades.
The financial market refers to the organization or companies that facilitate financial products in the stock exchange such as stocks bonds and warrants. It also involves the coming together of the buyers and sellers to trade the financial product such as shares and stocks using the stock exchange or by directly trading between the buyers and sellers. The money market is a market that consists of the financial institutions and dealers in money or credit that either borrows or lends money.
The participant borrows and lends money for short periods for example thirteen months. The money market is a segment of the financial market in which the financial instruments that are highly liquid and those that have short-term securities are traded. The money market securities consist of negotiable certificates of deposits (CD), bankers acceptance, United States treasury bills, commercial paper, municipal notes, federal funds, and the repurchase agreement
The currency market is a market where different currencies are traded between different countries in the world. It involves trading between large banks, central banks, currency speculators, multinational corporations, governments, and other financial markets in the world. The market is unique in the terms of its trading volumes, extreme liquidity of the market, a large number of and a variety of traders in the market, geographical dispersion, long trading hours of twenty-four hours, variety of factors that affect the exchange rate, low margins of profit as compared with other markets of fixed income and the way it uses its leverage.
The reasons why multinational companies face greater risk in the financial markets
The cost of capital across the countries differs significantly between multinational corporations than domestic companies thus it affects the performance of the multinational corporations and their subsidiaries. According to Feldstein (1994), it stated that the United States foreign affiliates accessed the financial market in their host countries so that they could utilize the tax-deductibility of the interest expenses and was used as a hedge against the fluctuation in the future local-currency earnings.
Multinational companies face some complicated factors when it’s trying to measure up their cost of debt these are when they are borrowing finances they use the Eurocurrency market, international bond markets, or the national capital markets thus they have to measure the before-tax cost of debt, estimate interest rates and the proportion of debt that can be raised in each of the markets. Multinational companies should measure the after-tax cost of debt, estimate the tax rates in each market in which they intend to borrow, and also they should determine the deductibility of interest in each of the national tax authorities.
The management of the multinational companies must use the nominal cost of principal and the interest in the foreign currency so that it can be adjusted to the foreign exchange gains and losses where the companies issues debts that are dominated by a foreign currency.
The Currency risk
According to Madura (1992), he stated that overseas investors are faced with exchange rate variations as compared to domestic investors although they derive higher returns as a result of venturing into those investments.
The fluctuating exchange rates mitigate the gains from the diversification of risks and this leads to the currency exposures of the investment returns. The rate of return incurred by the investors from the multinational companies can be increased or decreased by the appreciation or the depreciation of the foreign country’s exchange rate as compared with the investors of the domestic currency. The increased risk that is faced by the investors in the foreign country returns so long the correlation between the local foreign market returns and the exchange rate is low or negative. Multinational automotive companies face a difficult time because of the increased competition from international and domestic companies the unpredictable market demand and the lack of consumer brand loyalty.
The agency problems refer to the conflicts that exist between the managers and the stockholders, to ensure that the manager performs their duties and responsibilities as per the interest of the stockholders who elect them to hold these position they must be rewarded with appropriate incentives and to be fully monitored so that they can fulfill their obligation. The agency costs are the incentives and the monitoring costs. The agency costs can be larger for multinational corporations because they are larger and more diversified. The reason why the agency costs are large for multinational companies as compared to the domestic companies is that multinational companies have higher auditing costs, they face larger language differences, sovereign uncertainties, and varying legal and accounting systems.
Multinational corporation investors are confronted with bigger informational gaps and higher costs that are related to the investigation of how the transactions are carried out and recorded in the financial statements. They also face higher monitoring costs than the domestic companies since they have their business in different parts of the world thus it is not possible for them to monitor all the transactions effectively (Christian, W. 2000).
The presence of capital-labor market imperfections can lead to higher agency costs among multinational corporations thus they face greater risks than domestic companies. There are also capital and labor market barriers across the countries that limit the agency costs that are faced by multinational companies. Multinational companies are faced with greater exchange rate risk and political risk even though their diversification of investments reduces the volatility of the company’s earnings.
Multinational companies are exposed to greater economic exposure as compared to domestic companies, although the domestic companies face a great deal of exchange rate risk they face stiff competition from their local market. When the United States dollar appreciates against the foreign currencies, the foreign investors can reduce the dollar price of their products and still be in a position to maintain their profitability in their home currencies.
When the United States dollar depreciates against the foreign currencies, then the domestic companies pay higher prices for the inputs they buy from the foreign countries, but the multinational companies although they incur these risks they are in a better position to manage the risk. Multinational bank loans focus on a select range of activities as they provide the services those other banks with either less familiar with or those that do not offer such as the foreign currency loans, acceptances, and guarantees that are related to the international trade or the syndicated loans.
The domestic firm’s marginal cost of capital can increase as the suppliers of capital become saturated with the firm’s securities as compared to multinational corporations. The optimum capital budget of multinational companies is usually higher than that of domestic companies because of the following reasons. Multinational companies are in a better position to tap the foreign capital markets. When the domestic capital market s is saturated and this company faces lower risks as compared to the domestic companies.
Since multinational companies can access international capital and face lower risks as compared to domestic companies thus they can maintain their capital budget with a constant marginal cost of capital. Multinational companies have an optimum capital budget because they have more investment opportunities than domestic companies thus they can be in a position to generate much more revenue to cover up the costs that are associated with the implementation of investment opportunities.
The strategies to overcome the risks that are faced by multinational companies are
The risks that the multinational corporations are faced with can be overcome by transferring the risk from the firm that is exposed to the risk, but that would not mean that it’s exposed to the risks, but it means that it assumes some more exposed to risk for some fee. The foreign exchange risk is the additional variability of the company earning due to the unexpected currency fluctuation and the hedging distribution of the firm’s earning and their value can be used to overcome the risks. The hedging reduces the firm’s risk and the cost of capital and it enhances the ability to pursue plans and to invest decisions that are based on the more predictable future earnings (Donald, J. M., And Roldos, J. 2001).
There are two types of hedging these are internal and external hedging. The internal hedging minimizes the amount of currency that is bought or sold in the foreign exchange transaction this is achieved through appropriately pricing the domestic currency by leading and lagging the receipts and payment so that they can match with the currency inflows and outflows and by netting the remaining the currency receipts as liabilities.
The internal analysis allows multinational corporations to reduce the foreign exchange exposures using their resources.
The external hedging uses the foreign exchange hedging instruments such as the forward and futures contracts options and swaps. The forward contracts are used to hedge the currency exposures that occur in the future to protect the profit margins and prices of multinational corporations.
The currency option is used to guarantee the sale or the purchase of foreign rates at certain rates, although the multinational companies are not allowed to do if the rate returns are unfavorable thus the options are only attractive if the company wants to retain the possibility of the gain from the exchange rate change. The swap contracts can be used to adjust the forward contract timing and to arbitrage the favorable rates when converting the currencies. The portfolio risk and return enhancement can be used to manage the currency risks (Donald, J. M., And Roldos, J. 2001).
The multinational corporations that conduct businesses in the domestic markets hedge their foreign exchange risk by purchasing the $United State’s or the United State’s dominated government paper in the country or the offshore up to the level of their capital as this reduces the positive net foreign exchange of Foreign Direct Investments (FDI), although they may also entail other risks.
Multinational companies manage the risks for example for the economic risks they are managed by implementing strategic management that involves choosing the product markets, reviewing their pricing policies, promotion investment, and financing alternatives. The multinational corporation can shift the production cost to a lower cost to choosing areas where the companies incur lower costs when producing the goods and services.
Multinational corporations can utilize transfer pricing and international debt sourcing to overcome the economic exposures that the companies incur. Multinational corporations that are certain of having cash flows that are denominated by the foreign currencies for several years may use long-term hedging techniques such as long-term forward contracts currency swaps and parallel loans to overcome risks. The long-term forward contracts usually have maturities that are more than ten years or more and they can be used up for creditworthy customers.
The currency swaps take the form of having two parties with the aid of the brokers agreeing to exchange the specified amounts of currencies on the specified dates in the future. The parallel loan or back-to-back loan involves an exchange of currencies between two parties that promise to exchange the currencies at a specified exchange rate at a future date.
The transaction exposure occurs when the future cash transaction of a firm is affected by exchange rate fluctuations. The multinational corporation can be able to overcome the transaction pricing of some of its exports in the same currency as that needed for paying its imports (World Bank. 2002).
Multinational corporations can also the future hedge that involves the use of the currency futures. For the companies to hedge the future payables the companies purchase the currency futures contracts that it requires it also hedges the future receivable by selling the currency. The multinational corporation can use the currency option hedge that involves the use of the currency call put options of the hedge transaction exposure. In this situation, the firms are insulated from the adverse exchange rate movements and yet be in a position to benefit from the favorable movements, although the firms must take into consideration whether the premiums paid are worthwhile (Christian, W. 2000).
The tender is an offer to do work or to supply goods and services at a fixed price for a customer. The tender process is designed to ensure that the work that is granted is done fairly. There are many policies such as price which an investor has to take into account before he accepts the tenders, once the parties concerned with tender agree on how to carry out their duties and responsibilities then the person who wins the tender must provide the goods and services in the manner agreed to and at the price that has been offered and the investor must pay the agreed on price at the agreed time. The other factors that are taken into account when offering tenders are the quantity, quality, and delivery time of the procured goods and services.
When the United States companies convert their funds from the Yen into dollars they face the possibility that the Yen Japanese currency will appreciate thus leading to the elimination of the apparent cost savings.
The minimum amount of Yen amount that should be bid for the contract while using the several hedging strategies, money market hedge, forward contract, and the options contract.
The money market hedge
It is the process of borrowing and lending in multiple currencies to eliminate the currency risks through locking the value of the foreign currency transaction in one own country’s currency. The process involves evaluating the stock of a company by examining the company’s operations and financial condition in terms of several valuation methods, factoring of the price or earnings ratio, dividend yields, book value, price or sales ratio, and the return on equity using the fundamental analysis.
For example, the United Kingdom Company has a one-year receivable of $500,000. Assuming the spot fix rate is 2,000 and the United States rate is 4% and the United Kingdoms’ interest rate of 5%. The company would have $500,000 discounted at 4%
$500,000/1.04 = $480,769.231
The conversion of $480,769.231 into sterling at 2000 would be
480,769.231/2 =£230,384.615
The sterling would be placed on a deposit of 5%
£230,384.615 x 1.05 =£252,403.846
In one year’s time, the company would receive the expected $500,000 and it would repay its loan in full, thus the company would hedge the foreign exposure and it would also enjoy the sterling equivalent for the full period.
The calculation of the effective foreign exchange forward outright is
$500,000/252,403.846 = 1.981
The forward outright formula is
(spot-(cc1=ih)/ (1=if)-1)x spot)or(2-(cc1.05)/(1.04))-12)
Spot = current fix rate if=interest in foreign country
ih = Interest in home currency
The forward contract
It refers to the agreement between the parties who want to buy and sell an asset at a specified period in the future. The price of the underlying instrument changes in value. It occurs when the buying or selling of orders does not take place when the securities themselves are exchanged. The forward price of a contract is different from the spot price because the spot price refers to the price at which the assets are exchanged at the spot date.
The other difference between the forward and spot price is that the forward price has forward premiums or forward discounts that are associated with them that take the form of profit or loss by the purchasing party. The forward contracts are used by the investors in their financial operations to hedge risk as a means of speculation or to allow the parties to take advantage of the quality of the underlying instrument that is sensitive to time (Donald, J. M. And Roldos, J. 2001).
For example when the company invites the tenders and gets a supplier to supply goods and services that are worth $500,000, then the company and tender enter into a forward contract. If the contract states that the company would receive £510,000 from the contract after undertaking it then afterward the tenders current market valuation increases to £520,000 this transaction implies that the supplier would sell to the company goods worth £510,000 and the company would receive a profit of £10,000, this is because the company can buy from the tender for £510,000 and then immediately sell the market for £ 520,000.
The company has made a profit of £10,000 and the supplier has made a potential loss of £10,000 and an actual profit of £10,000.
The forward contracts are privately negotiated and are not standardized and the parties involved in the contract must bear each other’s credit risk. If the underlying value of a commodity changes the value of the forward contract either becomes positive or negative depending on the position that is held.
The pricing of the forward is done by adding the spot price to the cost of the carry of the interest foregone, convenience yield, storage costs, and interest or dividend received on the underlying contract
The option contract
The option contracts refer to the right or not the obligation to buy a call option or sell for the put option a specific amount of stock, commodity, currency, index, or debt at a specified price during a specified period. The option contract consists of two persons that are the buyer and the seller. The buyer is known as the holder while the seller is referred to as the writer. The seller or the writer is charged with the responsibility of fulfilling all the terms of the contract by delivering the shares, or stock to the appropriate party.
The holder or the buyer incurs potential loss that is limited to the price that is paid to acquire the option, if an option contract is not exercised it expires. The seller or the writer incurs a potential loss that is unlimited unless the contract is covered meaning that the writer owns some liability for the security that underlay the option.
This is either referred to as a leverage or protection contract. The leverage option contract allows the holder to control equity in a very limited capacity for a fraction of what the shares would cost and the difference can be invested elsewhere until the option is exercised. The protection option guards against price fluctuations soon since they provide the right to acquire the underlying stock at a fixed price for a limited time. The risks are limited to option premium not unless the writing options are for securities that are not already owned. The options are very complex and they require a great deal of observation and maintenance (Harvey, C. R., and Gray, S. 1997).
For example, the company purchases one contract for £500,000 of September 100 1BM call options and at the same time the price of 1BM share is £105 and the price of the call options on the Japanese Board options Exchange is £12.80 thus when entering into the contract the company pays (£500,000×12.80) = £6400, 000 for the right to purchase the £500,000 at any time before the contract matures. If at the maturity date tender’s value increases to £510,000 thus for one to exercise the option one would receive £510,000 but if the tender is £490,000 then the option would lapse and no funds would be used to carry out the transaction.
I would recommend the company to use the forward contract since after carrying out the contract the company can generate some profits in case the procured goods and services increase in value. In the case of the options contract, the disadvantage of the contract is that in case the contract loses value then the investor is bound to lose their money while this is not the case for the forward contract. Since the contract can take place regardless of the current market value of an economy in a country.
The exposures of money market hedge
The money market hedge involves taking one or more money market positions to cover up a transaction exposure. The two positions of this hedge are payable and receivables.
The techniques that can be used to eliminate the money market hedge are by using one’s own funds and borrowed funds to pay up the money that is owed by different companies. Companies need to note that if the companies have excess cash they need not borrow in the home currency when hedging the payables and firms in need of cash should not invest in the home currency money market when hedging for the receivables. Technical analysis of using the money market hedge involves the investors trying to predict the price changes by studying the market itself.
The technical analysis concepts that are chosen in this strategy are the moving averages, support and resistance, advance or the decline lines, relative strength, momentum, and value of the stock. The hedging strategies can thus be used to overcome the risks that the company faces since they are meant to deal with the exchange risks, currency risks that occur when the multinational companies are carrying out their transactions.
References
Christian, W. (2000) b. “Multinational Banks in Developing and Transition Economies.” Economic Policy Institute, Technical Paper No. 241. Washington, D.C.: EPI.
Christian, W. (1999). “The Connection between More Multinational Banks and Less Credit in Transition Economies.” Center for European Integration Studies, ZEI Working Paper B99-8. Bonn, Germany: University of Bonn.
Donald, J. M. And Roldos, J. (2001). “The Role of Foreign Banks in Emerging Markets.” Paper prepared for the IMF-World Bank-Brookings Institution Conference on Financial Markets and Development, Washington, D.C.
World Bank. (2002). Global Development Finance: Financing the Poorest Countries. Washington, D.C.: World Bank.
The Cost of Capital for Foreign Projects.
Forward contract.
Option contract.
WWW Finance TM Global Financial Management.
Option Contracts.
Harvey, C. R. and Gray, S. 1997.
Managing Transaction Exposure 11 Chapter South-Western/Thomson Learning © 2003.