Foreign exchange risk affects MNCs’ day-to-day operations whenever they deal in foreign currencies. These risks stem from changes in exchange rates that affect the cost and profitability of cross-border payments. Liquidity risk, if uncontrolled, may lead to certain losses or failure to make a profit. Organizations must manage FX risk because fluctuations in the foreign exchange market considerably affect the stability of financial performance and the sustainability of competitive advantage in global markets.
Below is a view of the actions of foreign exchange market risk management.
Table of Contents
Hedging with Forward Contracts
Forward contracts are the most frequently used technique in managing FX exposure. A forward contract permits a firm to agree on an exchange rate for an upcoming transaction to discount risk on adverse currency changes. For instance, an MNC must pay a supplier in a foreign currency in three months; hence, using a forward contract enables the company to fix today’s rate to avoid the volatility that may exist forward.
Currency Options
Currency options help in averting FX risk by allowing the company to lock an exchange rate for a particular date but not an obligation to do so. Unlike forward contracts, options have an upfront cost, but they provide a limited measure of cover; the holder can capitalize on movements in exchange rates, and the futures contract does not. It’s most effective in situations where the exchange rate direction is unsustainable.
Natural Hedging
Natural hedging groups operations such that costs and revenues will occur on the base currency. For instance, a company that uses the euro as revenue similarly applies it as the cost of its products or services, mostly eliminating the currency translation process, hence reducing the exposure to the currency exchange rate fluctuation. Natural hedges can be realized through revenue and expense matching by the same foreign currency and financing in such a currency as operational cost.
Multicurrency Accounts
The setting up of multicurrency accounts helps to limit the conversion transactions between different currencies because using currency foraying attracts transaction costs and owning to changes in exchange rates. When money is received in foreign currency, the receipt and management of such currency in such companies mean that conversion of the currency to local currency is done after analyzing the appropriate market rates that are most favorable. This also affords operational flexibility in managing and processing a country’s international business payments.
Netting Systems
Since MNCs have subsidiaries in various countries, they have to reduce exposures through netting systems, enabling them to offset the payments. Thus, through this operation, MNC can plan to bring the number of currency flows in the organization to a given optimum or convenient level as a mechanism for curtailing the number of transactions and hence derivatively reducing the exposure level to the forex volatilities. It also reduces transaction costs and increases the operational effectiveness of internal payments across borders.
Management of Currency Risk: A Diversification Approach
Another management strategy for FX risk is diversification across several currencies. As the results indicate, MNCs can effectively manage currency risks by holding currency exposures across the basket of currencies to minimize the impact of an unfavorable change in a particular currency. For instance, an MNC that invests in the eurozone and Japan has assets and revenues in euros against the yen, though it may hedge between these two.
Final Thoughts
Hedging foreign exchange risk is essential for MNEs because FX transactions can be unstable and cause a decline or an increase in corporate profits and risks. Some strategies and techniques, including hedging, natural hedging, multicurrency accounts, and diversification, strengthen every MNC’s capacity to reduce risks in the forex market. If organizations want to address FX risks comprehensively, they should implement the following best practices for managing currency fluctuations, critical during global economic volatility affecting international business payments.
