Exchange Rate Risk." 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 lb 1, 000, 000 and the american dollar compared to pound sterling weakened from US$1. 40 in January to US$1. 50 in June, the UK company would loose lb 47, 619 (Appendix A). Economic risk is another type of exchange risks companies have to consider when dealing globally. Changes in exchange rates are bound to affect the relative prices on imports and exports, and that will again affect the competitiveness of a company.
An UK exporter dealing with companies in the US would not want the US$ 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 lb 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 lb 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 lb 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 lb 160, 000. If the interest rate in 2000 falls to 6%, the company is still paying 8% interest, and will consequently "loose" lb 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 of financial assets, such as bonds and stocks, are likely to decrease. So, stock values are very much inter-related to the rate of interest. This idea goes hand in hand with the economic risk. Changes in a country's interest rates affect the whole business environment in that country.
Increased interest rates are likely to make people spend less money, so the income of companies goes down. Methods of mitigating exchange rate and interest risk. A company has lots of options trying to safeguard against interest and exchange rate risks. The company could do nothing and hope the market evens itself out. Rise of some country's economy might mean that another country's economy is falling. To avoid being exposed to exchange rate risk a company might decide to transfer the risk over to its overseas customer by making the customer pay the exchange rate difference from the date a deal was being made.
The effect of this could be that the company looses its business partners. However, most companies practice internal hedging to safeguard against exchange and interest rate risks. A company can buy forwards, which enables a company to freeze the price at which it buys its currency at the end of the agreed period. For a company buying from a foreign company, this method will eliminate all exchange risk totally. If a company has a payment due in two months, it could buy the foreign currency at spot rate straight away and invest the money until payment due. The company will then be sure to have enough currency to go through with the payment, plus surplus from the investment.
A third method of hedging is called timing, which means that a company could speed up or delay payments if they have a hunch on which way the rates are going. This method applies to both exchange rates and interest rates. Timing is the most risky method of hedging, because there's no way to predict a future rate with a hundred percent accuracy. The Structure of Interest Rates.
There are various models used to explain the term structure of interest rates. "The relationships between interest rates on short-term securities and those on long term ones can be represented on a diagram known as a yield curve (Howells 2000 p. 242)." A term premium, also known as risk premium, is an amount offered to borrowers on top of the interest rate to persuade investors to lend money long-term. The risk is higher borrowing capital for longer periods of time compared to short-term, because it's harder to predict interest rates over a long period of time. Since all lenders want investors to borrow long term, they offer a term premium.
Another theory of interest rate structure is the preferred habitat model. People have attachments to certain segments of the market and investors are unlikely to move their assets when there are only small changes in the interest rates, like for example 0. 5%. However, if the change is over 1% people might be more inclined to move their assets, and the overall yield curve will be humped. Market segmentation is another theory involving the structure of interest rates.
The fact that people invest in different segments of the market regardless of the change in interest rates is the core of the market segmentation theory. Since short-term bonds are no substitute for long-term bonds, and vice versa, the interest rates aren't likely to influence the investor's inclination towards either of them. The yield curve tells us if the professionals think the interest rate is going to rise or fall. Looking at the current UK yield curve on can conclude that the pro's think the interest rate is going to fall. If a yield curve is inverting the short-term investments are loosing value, sp it might be better to buy long-term bonds instead. Earlier in the curve one sees the curve going steeply up.
That means the best value for money was in short-term bonds. There can be a number of reasons for the shape of the UK yield curve. The UK might have had some political instability, which caused investors to be reluctant about investing in the UK economy. The relationship to the European Union, and the stance to stay out of the monetary system of the European Union, is likely to have been factors that helped shape the curve. Appendix A. Transaction Risk: A UK exporter invoicing US$1, 000, 000 in January for payment in June.
Spot rates: January: US$1. 40 lb 714, 286 February: US$1. 50 lb 666, 667 Loss on transaction: lb 47, 619 (lb 714, 286 - lb 666, 667) Appendix B. Interest Rates: i. A company borrows lb 100, 000 from a bank at 8% interest rate.
lb 100, 000 X 1. 08 = lb 108, 000 ii. A company borrows lb 2, 000, 000 in 1998, with a fixed interest rate of 8%, payable annually for a 5 year period. Fixed annual interest, 8%: lb 2, 000, 000 X 0.
08 = lb 160, 000 New annual interest, 6%: lb 2, 000, 000 X 0. 06 = lb 120, 000 Annual loss, 6% vs. 8%: lb 160, 000 - lb 120, 000 = lb 40, 000 References: web 22/11/2000, web Brealey, Richard A. , Marcus, Alan J.
, Myers, Stewart C. 1999, Fundamentals of Corporate Finance, 2 nd en, Craig S. Bey tien, USA. Howells, Peter.
, Bain, Keith 2000, Financial Markets and Institutions, 3 rd en, Henry King Ltd. , Great Britain. Ritter, Lawrence R. , Silber, William L. , Udell, Gregory F. 2000, Money, banking, and Financial Markets, 10 th en, USA..