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How The Multinational Corporations Take Advantage Of Currency Fluctuations Finance Essay
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MULTINATIONAL CORPORATION
A multinational corporation (MNC); is a corporation that manages production or delivers services in more than one country. A multinational corporation (MNC) is also known as an international corporation. T he International Labor Organization (ILO) has def ined, an MNC as a corporation which has its headquarter in one country, known as the home country, and operates in several other countries, known as host countries. Foreign Exchange Risk / Currency Fluctuation are a risk that results f rom the change in the price of one currency with respect to another. All the corporations that have assets or business operations across the national borders of their home countries, they f ace currency risk because the prices of currencies are very volatile. Corporations are exposed to this at every level if they operate outside the borders of their home country and theref ore, in order to reduce the percentage of their exposure to currency f luctuation, these corporations use the tool of hedging. Hedging helps these corporations to reduce their exposure to the loss to be f aced f rom high currency f luctuations.

MULTINATIONAL CORPORATIONS AND CURRENCY FLUCTUATION

T he multinational corporations are the corporations that are vastly exposed to f oreign exchange risk / currency f luctuation because these corporations manage production or deliver services in more than one country. T hese corporations have to f ace this risk at dif f erent levels of their business operations, especially in the process of decision making. Decision making is element on which the whole f uture of a corporation depends, whether it is short-term decision making or long-term decision making. Multinational Corporations will have to f ace the f oreign exchange risk when making short-term and longterm decisions f or generating f unds to attain resources of production and to carry out their operations in markets outside the border of their home countries. Short-term decisions of a multinational corporation exposed to f oreign exchange risk are to obtain f unds f or the operational activities of the corporation whereas, long-term decisions that make a multinational corporation vulnerable to currency f luctuation include the generation of f unds f or the purpose of purchasing and maintaining all the f ixed assets possessed by the corporation. Foreign exchange risk / currency f luctuation is an important source of uncertainty f or multinational corporations rather than being an advantage. It has been observed that f oreign exchange risk af f ects both the cash f lows of a multinational corporations operations as well as the interest rate used in the valuation of these cash f lows. T he process of determining f oreign exchange exposure has now become a central issue of international f inancial management and this issue has started to generate an extensive amount of research. T he existing data on f oreign exchange risk seems conf using because empirical studies have so f ar recorded a very weak link between f oreign exchange risk and U.S multinational corporations. It has been f ound unconvincingly that the weak results imply that exchange rate changes have no ef f ect on the multinational corporations (Gendreau, 1994).

Unexpectedly dif f erent f rom U.S multinationals, a sample of 171 Japanese multinationals has proved that there is a positive exposure between f oreign exchange risk and the multinational corporations. T he multinational corporations that are exposed to currency f luctuation mainly belong to three sectors of the economy including, electric machinery, precision equipment and transport equipment. Accordingly it has been observed that the extent to which a multinational corporation is exposed to f oreign currency risk depends on its level of export ratio and by the variables that are proxies f or the f irms hedging portf olio. T he multinational corporations try to hedge their risk against f oreign exchange risk with the help of f inancial derivatives including, options, f orwards and f utures. Another important conclusion observed is that the multinational corporations that f orm a particular group become more powerf ul and have a huge impact on the f inancial institutions operating in a particular geographic location which ultimately reduces the currency f luctuation risk of the multinationals (He, 1998). It is widely believed that exchange rate changes af f ect the value of multinationals but various studies report that exchange rate changes do not have substantial impact f or the majority of U.S multinationals because these multinational corporations have hedged themselves against the f oreign exchange risk (Lee and Suh, 2010). Muller and Verschoor (2006) also f ind that exchange risk exposure is not signif icant f or the majority of European multinationals. It is a puzzling situation that the multinational corporations lack responsiveness to exchange rate changes, even though it is known that exchange rate changes af f ect the value of the home currency of multinational corporations f oreign income and their competitive position against their f oreign rivals. In order to explain this puzzling situation, various authors point out that multinational corporations use f inancial hedging and geographical diversif ication to protect themselves f rom the adverse ef f ects of exchange rate changes. Such as according to Allayannis and Of ek (2001) the U.S multinational corporations use of f oreign currency derivatives balances the size of their exchange rate exposure. Pantzali et al. (2001) show that the responsiveness of multinational corporations to exchange rate changes is relatively low f or multinationals with more geographically diversif ied operations. Multinational Corporations have to deal with f oreign exchange risk to take proper advantage of their operations and prevent their prof itability f rom decreasing as prof itability is the major f actor of increasing stock returns, and theref ore, the responsiveness of stock returns to exchange rate changes is determined by the ability of exchange rate changes to af f ect prof itability. According to recent studies exchange rate changes do not have a huge impact on the prof itability of multinationals f oreign operations because of the weak relationship between the stock returns and f oreign exchange rate. (Lee and Suh, 2010) It has been observed that the responsiveness of exchange rate changes to the prof itability of multinational corporations may not be substantial but exchange rate changes pose a great hurdle to multinational corporations along with many other variables. T he other variables apart f rom exchange rate risk can move in a direction that negates the ef f ects of currency f luctuations. Another important aspect that has been f ound is that the multinational corporations respond to unf avorable exchange rate changes by slashing their operating costs and expanding their range of diversif ication. T his strategy if successf ul will protect the prof itability of the multinational corporations. (Lee and Suh, 2010) Bodnar and Weintrop (1997) state that the value of U.S multinationals is directly related to the prof itability of their f oreign operations. But these authors do not investigate the impact of exchange rate changes on the prof itability of their f oreign operations and their results imply that this relationship may be weak. In order to state why, assume that exchange rate changes would impact multinational corporations value mainly with their ef f ects on f oreign operations prof itability of the corporations. Yet, according to various studies conducted in the past the impact of currency f luctuation on multinational corporations value is rather weak. In this case it is assumed that the ef f ect of f oreign operations prof itability on multinational corporations value is strong as Bodnar and Weintrop (1997) f ind one can conclude that the impact of currency f luctuation on f oreign operations prof itability may be weak, if the impact of exchange rate

changes on multinationals value is to be weak. (Lee and Suh, 2010) Lee and Suh (2010) have f ound that in the majority of industries, f oreign exchange risk does not have a signif icant impact on the prof itability of U.S multinational corporations f oreign operations. Furthermore, in a f ew industries where the impact of f oreign exchange risk on f oreign operations prof itability is signif icant, the signif icance is negated once changes in prof itability f rom currency conversion are accounted f or. It has also been f ound that f oreign operations prof itability has three determinants f oreign prof it margin, f oreign asset turnover and f oreign equity multiplier are not signif icantly af f ected by exchange rate changes in most industries. T his study shows that the impact of currency f luctuation on the prof itability of U.S multinational corporations f oreign operations is not signif icant either statistically or economically in the majority of industries. T hese results are dif f erent in dif f erent sub-periods, as well as to the use of individual exchange rate changes and to a dif f erent model specif ication that considers the negative exchange rate ef f ect. Furthermore, it has been f ound that similar results hold f or many non-U.S multinationals. It has also been examined that the impact of f oreign exchange risk changes on f oreign operations prof itability is signif icant in only a f ew industries. According to various studies, the ef f ect of f oreign currency risk on f oreign operations prof itability is weak both statistically and economically. T heref ore, the value of stocks are not responsive to currency f luctuations probably because their prof itability, the driver of the value of stocks, is not responsive to currency f luctuations. Related to these results it has been observed that f oreign exchange risk of multinationals is not substantial (Pantzalis et al,. 2001) and that f oreign exchange risk shocks explain a very small proportion of the relative stock return perf ormance of industries (Grif f in and Stulz, 2001). Research f indings suggest that f inancial hedging may not clearly explain f or the weak exchange rate exposure of multinationals. Previous studies state that f inancial hedging, such as the use of currency derivatives, contributes in protecting f irm values f rom negative exchange rate movements (Allayannis and Weston, 2001). Even though the importance of f inancial hedging may be indisputable, f indings raise the possibility that the f oreign exchange risk of multinationals could not be important even bef ore we take into consideration the perspective of f inancial hedging. T his interpretation is obtained because, according to certain research f indings, currency f luctuations do not have a signif icant inf luence on the prof itability measure the operating prof itability of f oreign operations that does not include gains and losses f rom f inancial hedging (Lee and Suh, 2010). It has been observed that the impact of currency f luctuations on f oreign operations prof itability of multinational corporations is not signif icant statistically in the majority of industries. According to various variance components analysis, currency f luctuations explain less than 2% of the variation of f oreign operations prof itability of multinational corporations. It has also been concluded that the impact of f oreign exchange risk on f oreign operations prof itability of multinational corporations is weak f or majority of the multinationals all around the world. Evidences imply that f oreign exchange risk of multinational corporations measured by the relation of stock returns to f oreign exchange risk changes may be weak because f oreign exchange risk does not have a signif icant impact on the prof itability of multinational corporations f oreign operations. T hus, the present studies provide an explanation f or the empirical regularity in the literature that the f oreign exchange risk exposure of multinationals is generally not substantial. (Pantzalis et al., 2001; Muller and Verschoor, 2006). Country specif ic disclosures are critical, since currency f luctuations themselves are country specif ic and cannot be used without country-specif ic accounting inf ormation. Currency f luctuation sensitivity depends on country and/or industry and f oreign exchange rate risk seems to be much more prevalent in European segments than in other parts of the world. T his result may have to do something with the composition of the European sample, which is larger and includes a better cross section of industries (Johnson, 1996).

T he operating ef f ect of f oreign exchange risk relates to the impact of currency f luctuations on f uture sales volume, selling prices and costs. Bodnar and Gentry (1993) suggest that the magnitude and direction of operating ef f ects can be a f unction of : (1) the type of goods produced by the f irm; (2) whether the f irm exports its product; (3) whether the f irm imports its inputs; (4) whether the f irm competes with f oreign f irms that export to its location; and (5) whether the f irm uses internationally-priced inputs. Levi (1990) also shows that the mentioned f actors should combine with the elasticity of demand f or the multinational corporations products and/or inputs to measure the ultimate ef f ect of currency f luctuation on prof its.

CONCLUSIONS
Based on the literature reviewed the f ollowing conclusions have been interpreted: T he impact of currency f luctuation depends on the country and/or industry in which a multinational corporation operates. T he relationship between majority of the multinational corporations and currency f luctuation is very weak because of f inancial hedging and geographical diversif ication. T he weak relation between the multinational corporations and currency f luctuation is due to the lower impact of f oreign exchange risk on the stock returns, value of f irms stocks and the operating prof itability of the f irm. T he multinational corporations can take advantage of currency f luctuation only when transf erring the capital to their headquarters and converting the currencies into their home currencies. T he f oreign exchange risk is hedged by the multinational corporations by using currency derivatives, such as, options, f utures and f orwards.

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