International Finance Organizations of Foreign Exchange Management - Research Paper Example

Introduction International organizations have truly embarked on a journey which foretells the globalization of the world. The increasing complexitiesof doing business in such an environment however require organizations to operate more prudently and employ its resources in a way which can ensure maximum returns at the acceptable level of risk. All firms involved in trading at the international level need to take into account different strategies to take on their foreign exchange exposures in order to ensure that the exposure is correctly managed and in the most efficient manner. As such the management of foreign exchange exposure is one of the most critical aspects of operating into an international environment. The management of foreign exchange is also more critical because of the increasing turmoil and volatility in the financial markets as intensity of global competition is forcing many international organizations to hedge their foreign exchange exposures in more prudent manner. Further, the rising volatility of US dollar against major currencies specially Euro has forced many international organizations to guard their exposures in order to optimize the impact of volatility on their revenues as foreign exchange translation may significantly reduce their revenues. The need to pay close attention to the foreign exchange exposure is also important because of the globalization of the financial markets as speed at which the transactions can be concluded require that the financial managers of the organizations must employ techniques and tools which help them to react to the other opportunities as well as threats in the international market. This research paper will outline the hedging and other strategies required to be undertaken by financial managers of international organizations. Globalization of financial markets Globalization has been considered as a revolutionary idea which is sweeping away the traditional boundaries of trade and inflicting serious socio-economic changes in many societies. This trend has carried forward to the financial markets and instruments also as the advancement in technology and the open access to capital and its relatively easier flow allowed many firms to engage into activities at much larger scale and with this broader integration of trade activities, financial transactions such as foreign exchange become global in nature too as the management of inflow and outflow of foreign exchange has resulted into more complications as organizations have to face different regulatory environments in each country, they operate or trade. It has also been argued that the globalization of financial markets have made the volatility a regular feature of the financial markets and as such financial managers have to manage complex risks including counterparty risks, liquidity risks, delivery risk as well as rollover risks. (Levich, 1998). Further, the increasing quantum of foreign exchange involved in international transactions making it more volatile due to the unique risks faced by each currency and as such organizations have to engage into taking hedging as a tool to avoid taking excessive losses. The following section will discuss some of the issues which a firm may consider in choosing the strategies to design and implement appropriate hedging strategies for their foreign exchange exposure. Foreign Exchange Exposure Risk Foreign Exchange Exposure is defined as “a contracted projected or contingent cash flow whose magnitude is not certain at the moment and depends on the value of the foreign exchange rates” (Sivakumar & Sarkar, 2008). The above definition indicates that the transcations concluded in foreign currencies are subject to volatilities and as such require effective risk management policies in place to safeguard the interests of the organization. As discussed above that the due to globalization and de-regulation of economic policies, firms have become international in their orientation as they manage their operations at multiple locations across the world. Due to this factor, they have to deal in multiple currencies also as transactions are settled in different currencies. However, any firm dealing with multiple currencies also has to face the risk of unexpected price changes due to sudden or often unanticipated fluctuations into foreign currencies. (Sivakumar & Sarkar, 2008). Organizations need to manager their foreign exchange exposure potentially based on the assumption that values of the foreign currencies are largely unpredictable. Therefore, in presence of weak form of efficient markets, it is possible that the speculative activity in the market can derive the value in either way thus international organizations get exposed to the external risks which can cause the value of their money go down i.e. as one currency depreciates against other, the value received by the international organizations for international transactions start to erode. Hedging is one investment tool available to firms to secure themselves against the fluctuations in the value of their investments and as such gain considerable degree of comfort because through hedging, organizations basically can insure against the down side risk of currency fluctuations. Choice of Markets & Various Risks One of the basic requirements to manage the foreign exchange exposure is the choice of the markets where the transactions are to be done i.e. the respective country of the transaction. For example, if a company has to repatriate its profits from India, it needs to consider the political as well as legal environment of the country as various countries legally restrict the repatriation of foreign exchange from their country. Therefore, international organizations significantly run the political risk and as such has to include the premium for taking such a risk. As such, it has also been witnessed that the organizations are increasingly getting the insurance for the political risks they run in order to compensate themselves against the volatility in foreign exchange due to political factors. (Miller, 2005). Assessment of risk in foreign exchange exposures is controversial also as according to the classical theories of Modigliani and Miller, risk management, in any sphere, may be irrelevant because shareholders of the firm take into account such risks into their required rates of return. (Allayannis & Weston, 2001). However, when it comes to the risk management of foreign exchange exposures, it becomes more complicated because organizations need to monitor the risk at micro-level. Further subsequent studies also suggested that the hedging strategies are value enhancing strategies and as such organizations find it more beneficial to employ such hedging strategies. Assessment of Political risk is also important because of the fact that it can result into substantial losses to the international organizations due to unfavorable political environment. Further, de-regulated political system can significantly increase the currency speculations therefore, increasing the overall volatility of the foreign currency exposure. The supposedly freehand given by most of the Asian countries culminated into one of the worst foreign currency crises in the region indicating that the assessment of political as well as legal environment is one the basic steps for hedging oneself against the volatility of foreign exchange exposures. Issues to be considered for hedging As discussed above that the international organizations are subject to foreign exchange risk and hence require effective risk management policies and practices. Therefore, there are different issues which an organization must take into account for designing effective hedging strategy. Choice of Instruments There are various instruments available for the purpose of hedging as organizations can employ each one as per the exact requirements of the transaction. The basic requirement for setting up an effective hedging strategy is to choose the appropriate type of instruments to be used for hedging purposes. It is important to note that the choice of hedging instruments depends largely on the individual risk profile of each instrument and as such financial managers have a wide variety of instruments available for hedging purposes. The literature on determining the choices of instruments for carrying on the hedging operations of foreign exchange risk is really scarce as there are very few studies which indicate the choice of instruments for hedging operations. (Sivakumar & Sarkar, 2008). Most of the studies focused on cost benefit analysis of the employing hedging strategies and forward contracts are considered most cost effective hedging strategies. Following instruments may be used for hedging purposes: Forward Contracts “A forward contract is an agreement struck today that bind two counterparties to an exchange at a later date” (Levich, 1998). Foreign currency forward contracts involve the buying and selling of foreign currency at a given date in future. In order to hedge themselves against the fluctuations in foreign currency values, international firms often buy and sell foreign currency through forward contracts. For example, if a firm in US has to receive a payment against goods it sold to a German firm in Euro than it can hedge its proceeds to be received in Euro and realized in US dollar by entering into a contract with someone who may be requiring EUROs in forward contracts. Future Contracts Future contracts are similar to the forward contracts with a slight difference as they are traded on the organized exchanges. Due to this factor, international firms often do not engage into negotiating future contracts strictly for the purpose of trade. However, the treasury of the international firms, as a part of its strategy, may involve into buying and selling of future contracts. Though, futures market offers more liquidity and better risk management. However, they are marked to market. Therefore, it becomes impossible for the international firms to hedge cash flows as well as the value of the contract. (Mello & Parsons, 2000). Aligning production and trade with hedging positions One of most important consideration for the international organizations is the fact that how they manage to rationalize the production and trade shares with the overall hedging positions to be taken. The increasing amount of research suggests that the firms’ decision to decide upon their production and trade in different countries is not affected by their risk management perspectives and as such risk management of their foreign exchange exposures follows their decisions to produce and sell in different countries. (Broll, 1993). However, in assessing the overall revenue and cost impacts of such international trade, the hedging becomes more significant as organization have to anticipate the total quantum of their trade and corresponding degree of risk management measures to be taken to safeguard the value of such transactions. Cost Cost is probably the most important issue which an organization needs to take care of while formulating the hedging strategy. With the increase in information technology access and reach, the overall transactions might have reduced however; it is still a significant challenge to the international firms to reduce their transaction costs to manage the foreign exchange exposure under reasonable levels. As discussed above that the forward contracts may be the most preferred instruments for the international firms to hedge their foreign exchange portfolio. However, if cost is not within the acceptable limit, the choice of instruments to hedge may not be an ideal preference for the firms. Firm Size The size of the firm is another critical element at the time of designing the strategies for hedging as increasing evidence indicates that the firms which are larger in size and with significant R&D exposure tend to involve more in hedging their foreign exchange exposure than the firms which are relatively smaller. (Allayannis & Eli, 2001). Degree of Leverage Degree of leverage is another important element which needs to be considered as research suggests that the firms which have relatively higher leverage find it more beneficial to hedge their foreign exchange exposure than the firms with a relatively lesser degree of exposure. This is basically done in order to reduce the probability of having high financial distress cost. Conclusion Management of foreign currency exposure is one of the most complex jobs which international organizations have to perform. The issues of risk management necessitate that the organizations takes various factors into account before deciding on the various hedging strategies. Assessment of political risk, choice of hedging instruments, cost, leverage as well as firm size are some of the determinants of the deciding on any hedging strategies. Increasing globalization and associated volatility of foreign exchange exposure therefore requires that the organizations must hedge themselves properly against the potential losses to be incurred due to abnormal movements into the values of the foreign currencies. Bibliography 1. Allayannis, G., & Eli, O. (2001). Exchange rate exposure, hedging, and the. Journal of International Money and Finance , 20, 273-296. 2. Allayannis, G., & Weston, J. P. (2001). The Use of Foreign Currency Derivatives and Firm Market Value. The Review of Financial Studies, , 14 (1), 243-276. 3. Broll, U. (1993). Foreign Production and International Hedging in a Multinational. Open economies review , 4, 425-432. 4. Levich, R. M. (1998). International Financial Markets: Prices and Policies. New York : McGraw Hill. 5. Mello, A. S., & Parsons, J. E. (2000). Hedging and Liquidity. The Review of Financial Studies, , 13 (1), 127-153. 6. Miller, S. (2005). Risky business: political risks still abound for foreign companies in Latin America, and insurers are there to profit. Retrieved Feb 22, 2009, from http://findarticles.com: http://findarticles.com/p/articles/mi_m0BEK/is_8_13/ai_n15370694 7. Sivakumar, A., & Sarkar, R. (2008). Corporate Hedging for Foreign Exchange Risk in India. Retrieved Feb 22, 2009, from www.rbi.org: http://www.iitk.ac.in/infocell/announce/convention/papers/Marketing,%20Finance%20and%20International%20Strategy-07-Anuradha%20Sivakumar%20Runa%20Sarkar.pdf Read More