Your Assignment is to answer the following question:

"The recognition, measurement and management of Exposure and Risk is one of the primary roles of the Treasurer of an Multi -National Company.

Explain the Exposures and Risks that the Treasurer would need to recognise, the ways in which the Treasurer would seek to measure them and the contribution that effective management of these Risks and Exposures would make to Company Profit."

1. Executive Summary. This report defines the role of a treasurer in a Multinational corporation, it explains the exposure and risks that has to be identified and managed by the treasurer. It highlights the benefit and limitations of the Foreign Exchange (FX) exposure management functions. The report determines how the efficient management of risk and exposures relating to multinational financial trading results in proficient gain for the corporation.

1.1 Introduction The role of a treasurer is broad in the financial aspect of a Multinational corporation (MNC). The role mainly focuses on foreign exchange (FX) risk and working capital management. Fitch (2007.p.97) states that the treasurer is familiar with the local banking systems internal and external FX management techniques.

The global integration of the economy, the collapse of the Bretton Woods system due to lack of coordination and the end of the US do llar peg to gold in March 1973 necessitated management of FX risk. FX risk management is crucial for Multinational Corporation (MNC) as it forms the basis of decision made to reduce risk associated with foreign currency exposure. In simple words, a treasurer is an internal banker who is responsible for identifying, assessing, measuring, managing FX exposures and working capital.

2 Foreign exchange risks. The foreign exchange market is an example of the world being a market place as it trades almost around the clock. Baker (1998.p.69) noted that FX transactions involve trades of one currency in the spot and forward markets . However, the spot rates tend to be volatile therefore creating a major risk in the foreign exchange market. FX risk is basically the risk of undesirable changes in spot rate. An adverse FX rate move exposes assets and expected cash flow streams denominated (Buckley,2000.p.136) in foreign currencies to FX risk.

The FX rate linking key currencies such as US Dollar ($), Pounds Sterling (), Euro ( ), Japanese Yen (), presently experience volatile fluctuation (see figure 2). The constant occurrence of exchange rate instability since the end of the Bretton Wood system and pegged US dollar to gold in 1973, inflict persistent influence on cross border transaction which gives rise to FX exposure. Figure 2: Movement of foreign currencies to the dollar.

SOURCE: Madura,(2007).International Financial Management.

2.1 Relevance of Exchange Rate Risk : According to Buckley (2000.p. 59) the four-way equivalence model assemble theories that tend to determine FX rate (see figure.3.2). The model explains FX rate is determined by interest rate and inflation rate based on empirical evidence.

MNC s are conscious of the risk associated with fluctuations in spot rate and seek to closely monitor these exposures to FX risk. Some argue against the relevance of the FX risk which could draw from figure.3.2. The Power purchasing Parity (PPP) theory argue for the irrelevance of exchange rate risk as it assumes that exchange rate movement are just a response to differentials in price changes between countries (Madura,2008.p.280). In the sense that the effect of exchange rate is offset by a change in price. Clearly, PPP is a naive assumption in this case as it failed to recognise that the flow of international equity may cause the active exchange rate to fluctuate. The investor hedge argument for the irrelevance of exchange rate risk, assumes that investor have complete information on corporate exposure (Madura,2008.p.280) and can individually manage FX risk. In reality MNC s are able to manage FX rate risk at a lower cost than the individual investor. The treasurer has more information about these exposures which makes it easy for MNC s to effectively manage these exposures.

In contrast to this argument most MNC s believe that FX rate risk is relevant as they endeavour to stabilize income with FX management strategies which is identified on the annual report. For instance, Proctor and gamble exposure management is being accounted for on note 5 of the consolidated Financial statement under Statement of

accounting standards (SFAS 133) provision for Accounting for Derivative Instruments and Hedging Activities (P&G Annual Report,2010). .
Difference in Interest Rates
Interest Rate Parity Fisher Effect

Difference in Expected Inflation

Purchasing Power Parity

International Fisher Effect

Difference Between Spot & Forward

Expectations Theory

Expected Change in Spot Rates

International Financial Theories

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2.2. Identification of Currency Exposures: The different types of FX exposure identified by the treasurer include: Transaction exposure which basically arises from changes in spot rate. Eiteman et al ( 2007.p.280 ), states that transaction exposure affects(1)credit sales and purchases of goods and services whose prices are stated in foreign currencies ;(2)funds borrowed and loaned of which repayment is to be made in foreign currency ;(3)acquisition of assets and liabilities denominated in foreign currencies . Economic exposure relates to the assumption that a change in spot rate would affect the present value of future cash flows (Buckley,2000 .p.141) of a MNC. E.g. an MNC that incurs its major costs in Swiss francs (CHF) denomination and more than half of it revenue in USD. Due to FX volatility, the CHF may appreciate against the USD affecting the net cash flow in CHF denomination. As any price increase in its US operations would lead to an overprice

2.2. An illustration of transaction and economic exposure. TRANSACTION / ECONOMIC RISK A UK based MNC has an agreement with a Swiss customer to sell goods for CHF100, 000 to a Swiss customer. At the time of the transaction the exchange rate was 1 = CHF1.40. However when the transaction was settled, the pound had strengthened to 1 = CHF1.56 (yahoo finance, 28/11/10). The loss on this transaction occurred as a result of transaction exposure equivalent at the commencement of the transaction: CHF100,000 = 71,429 CHF 1.40: 1 received on payment of the transaction: CHF100,000 = 64,102 CHF1.56: 1 An economic exposure would occur as a result of a prolonged strengthening of pound against the Swiss Franc. This would create a constant loss on future sales to the Swiss customer

Translation exposure: Arises as a result of an unexpected change in spot rate that may occur during the period of consolidation of financial statement involving foreign currency denominated assets and liabilities (Buckley,2000.p.137.) .It is clearly an exposure of statement of financial position. According to ( Madura,2008.p.296) the location of foreign subsidiaries can influence the degree of transaction exposure . For example, an MNC headquartered in Switzerland with assets and liabilities denominated in USD is required prepare group consolidated statement of financial position(SFP)quarterly. The USD denominated asset and liabilities must be translated to CHF equivalent. As there are different account ruling, the translation exposure may lead to a gain or a loss.

Political Risk

Political risk is the risk that an MNC faces when government intervene in the national economies (Buckley, 2000.p.485) where they intend to locate their foreign subsidiaries. It involves factors such as laws that require local nationals to possess key management positions, laws that prohibit the repatriation on profits back to home country, etc. These factors go beyond the control of MNC s. However the treasurer has to assess these risks and provide advice when devising an overseas strategy.

The political risks arise from numerous factors such as governments imposing rise in taxes, limitations in exports and imports. Host governments also exercise control over of international corporations and impose rulings on subsidising . Baker (1998.p.144) states that political risk can be shifted by changing their financial structure by diversifying international investments and contract design . The treasurer can overcome these risks by assessing the rules and regulations of the host nation. In regards to subsidizing an MNC could enter the foreign market through franchising.

3. Measurement and Management of currency exposure and risk. A corporate treasurer measures and manages FX exposure using Internal and external techniques. Internal techniques of managing exposure endeavour to reduce exposed positions. (Buckley, 2000 p.211) states that external techniques insure against exposed position that the internal positions failed to eliminate.

The treasurer necessitates consolidation of a fixed contract linking the entire subsidiaries cash inflows and out flow characterized by currency, when measuring the transaction exposure. The treasurer persuades management decision on the centralization of group

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involves associated companies trading with each (Buckley, 2000.p. 211) the treasurer can persuade a netting agreement. In order to allow for the settlement of net debt between group companies by netting off intra group transactions. As illustrated in figure 3.1 (Ex :). If UK subsidiary has an obligation to pay the French subsidiary $ m, and the French subsidiary has an obligation to pay the UK $2m. The treasurer will net off both intra group transactions resulting to a netted amount of $ m. Other internal techni ues include matching, parallel currency leading and lagging.etc.

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Matching applies to both intra- group and third party balancing (Buckley, 2000.p.214) a matching procedure is a reciprocal cash flow in the same foreign currency. For example, if a subsidiary has optimistic net inflows denominated in the local currency of the

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subsidiary. The treasurer can persuade parent company to increase expenses denominated in the subsidiary s local currency thereby reducing the net exposure.

3.1.2. Parallel currency: The concept is to match receivables and payables in different currencies that move closely together Hanke et al (1993.p.88) states the a parallel currency is one that circulates extensively alongside another currency . The treasurer can monitor the movement of the movement of Euro and Danish Krone and pick (see figure3.1.2). Currencies Closely Linked in their Market Performance: Euro and Danish krone

Source: Yahoo finance(2010) Fig.3.1.2

3.1.3. Leading and Lagging Leading means making payments in advance of due date while lagging means delaying payment of an obligation beyond its due date (Buckley,2000.p.215).A treasurer can reduce transaction exposure by speeding up or slowing down the payment period for diverse currency . It is also useful in reinstating the liquidity position of MNC. For instance if

subsidiary is experiencing short-term illiquid financial position, the treasurer can persuade the parent to lead payments to the subsidiary and lag expected payment from the subsidiary. The treasurer can manage a translation exposure by having a balance of uncovered foreign currency assets and liabilities on an MNC s consolidated SFP. Transaction and translation exposures materialise in the SFP. Measuring economic exposures can be complicated because it is not easy to monitor in the accounting statements. 3.1.4. Forward/Futures Contracts The treasurer can manage economic FX exposure using the external techniques, including forward/future contracts, currency options and currency swaps. Forward and future contracts allow an MNC to lock in a specific rate at which it can pursue a specific currency (Madura,2008.p.309). The two contracts are clearly distinguished, A forward contract is an agreement between an MNC and a bank to trade a fixed amount of currency at a fixed period at a fixed exchange rate. A future contract is for a standard period a can be traded on a market. Figure3.1.4. Illustrates forward/ futures contract. Fig 3.1.4. An illustration of forward/futures contract. XYZ a US based MNC anticipated that it will need 200,000 Euros in a year. XYZ could enter an could obtain a forward contract to purchase the forward contract in one year Assuming One year forward contract =$1.20. Therefore, Cost in $ = Payables x forward rates = 200,000 Euros x $1.20 = $240,000.

NB: the same applies to future contracts.

3.1.5. Currency Options and Currency Swap: Eiteman et al (2007.p.211) defines Currency options as a contract giving the buyer the right but not the obligation, to buy a given amount of FX at a fixed price until the maturity date . A call option is to buy while a put option is to sell. The buyer only has the right but not the obligation to exercise the option, only the seller assumes the risk. Illustrating the currency option. Currency swap is a temporary arrangement to reduce risk. The treasurer adopts a portfolio approach by simultaneously buying and selling a currency for different maturities (Buckley,2000 p.224). For example, suppose a U.S.-based company needs to acquire Swiss francs (CHF) and a Swiss-based company needs to acquire U.S. dollars. These two companies could arrange to swap currencies by establishing an interest rate, an agreed upon amount and a common maturity date for the exchange. Currency swap is a flexible method of FX as they are negotiable for a number of years

4. Benefits of in internal and external of FX exposure management functions The benefits are that the treasurer would be able to take decision at group level in order to use the internal techniques. Netting reduces transaction costs and bank

charges because a few payments would made. FX would be matched using netting and matching technique which would increase central control of intra group settlements. Forward contract eliminates all transaction exposure, and both forward and future contract provides a way for lock in a price for future transactions.

4.1. Limitations in internal and external functions of FX exposure management functions: The treasurer manages these FX exposures frequently under rigid time constraint; as there is a risk that an operational error may occur. The degree of the centralisation of an MNC can affect the treasurer s efforts to successfully use the internal techniques. Buckley (2000.p.211) states that some of the internal techniques listed above are illegal in some country and restricted in the others . Euro money (2005) noted that CLS bank agreed to investigate the feasibility of adding a netting and matching facility for non eligible currencies . Leading and lagging relies on the capability of an MNC to predict FX rate future movement. Forward contracts are not traded on a market. Government regulations can control spot and forward markets.

5. Conclusion and recommendation

MNCs are faced with the challenges involved in accurately managing risk exposure as it is autonomous to their core business. Management seek for the most efficient and cost effective means of managing foreign exchange exposure that would minimize or eliminate risk while maximizing benefit. The treasurer should be viewed as a profit centre and a source of financial benefit to the MNC. As they apply their expertise in

managing FX exposures with they are likely to use a combination of the FX risk management facilities stated in this report.

Having a treasurer access economic and cross cultural issue associated with political risk would facilitate foreign direct investment (FDI) strategy. Small and medium sized companies should bank on forward exchange contracts, which they can organize with their bank in order to lock in a required amount of profit.

Reference:

Baker .C.J.(1998).International finance: management, markets and Institutions. Prentice hall Inc, USA Buckley, A (2004). Multinational Finance . 5th edition, Harlow: Financial Times-Prentice Hall

Eiteman.D.K. Stonehill .A, Moffett,(2007).Multinational business finance, Eleventh edition, Pearson education, Inc, USA. Euromoney, (2005). Risk management: seek better matching and netting techniques for FX derivatives. ,Online available at: EUR/DKK(2010) Euro and Danish krone Online available at: http://uk.finance.yahoo.com/q/bc?s=EURDKK=X http://www.euromoney.com/Article/1000928/Article.html . Fitch. P.(2007). Career opportunities in banking, finance and insurance, second edition, InfoBase publishing,USA.

Hanke.S.H, Jonung .L. Schuler.K,(1993). Russian currency and finance: a currency board approach to reform. First edition, Routledge, USA .
Madura.J. (2008).International financial management, Ninth Edition, Thomson south western, USA.

Yahoo finance (2010) British Pound / Swiss Franc:Online available at: http://finance.yahoo.com/q?s=PSFU10.CM