1. In international finance, every multinational enterprise (MNE) experiences translational risk, or the risk associated with currency exchange fluctuation. Rodriguez (1979) states that firms can take concrete steps in order to reduce their exposure to risks of this kind. There are two primary strategies that MNEs can adopt in order to prevent undue losses due to currency fluctuations and translational risk. The first is “adjustment in operations” and the second is adopting “financial hedging policies” (Rodrigues, 1979, p. 51). A risk management program that effectively integrates policies that prevent losses from currency fluctuations, such as “pricing polic[ies] that peg domestic prices to the exchange rate”, is one example of a strategy that MNEs can employ in order to mitigate exposure to translational risk.
However, Rodriguez (1979) goes on to argue that MNEs are inherently limited in the operational capacity of these policies and that a firm will undoubtedly experience overflow of exchange risk in its business abroad. While adjustment in operations can mitigate translational risk considerably, the overflow or residual risk must be addressed through financial hedging, which are designed “to eliminate exposure [by] either borrowing the local currency and investing the proceeds in dollars, of selling the local currency against dollars in the foreign exchange market” (p. 52). However, it is important to note that this strategy is not sustainable, and can only be used to plug temporary leaks in the protection that adjustments in operations provide during the implementation period.
2. There are certain political factors that impact exchange rates, namely the impact of lobbying groups working closely with select government officials, as well as the powerful influence that globalization has on the exchange rate and subsequent impact on the competitiveness of international firms and MNEs. Knight (2010) argues that “globalization is responsible for much of this variation in political contestation on exchange rates” and that “globalization is redrawing the political cleavages on exchange rates” (p. 1-2). In short, the impact of exchange rates has become increasingly apparent over the years, especially in economic sectors that either deal with international trade or attempt to compete domestically against foreign goods.
Moreover, as the importance of politics in exchange rates continues to increase, political pressure from domestic lobbying groups adversely affected by globalization begin to push the politics of exchange rates towards different results than the market would ordinarily find itself in. Indeed, “the globalization of production and finance is redrawing the landscape of exchange rate politics” in the sense that, as hedging and other financial protection systems expand and develop, the pressure placed on political lobbying to affect the exchange rate also increases in sectors of the economy where traditional hedging operations fail to secure business security (Knight, 2010, p. 8). Thus, it is clear that, in cases where domestic economic sectors compete against foreign industry, political factors such as lobbying groups and globalization have impacted exchange rates significantly.
3. The asset approach to determining foreign exchange rates is, simply put, driven by the decisions of investors as they weigh the prospective rate of return between foreign and domestic investments. Bruhn (1995) states that the asset approach to the exchange rate is, in effect, the analysis conducted by investors when they decide to put their money in either domestic or foreign markets. If the rate of return abroad is higher than in domestic markets, an investor will, barring other factors, engage in economic activity in the regions and states where the rate of return is higher. However, translation risk and exposure to currency fluctuations come into play here—if an investor moves funds and capital into foreign enterprises in order to capitalize on higher investment percentages, they may experience a loss of some or all of these profits when converting the foreign currency back into their own national currency. In other words, once the rate of return is calculated per each of the investment opportunities (foreign and abroad)
Assche (2005) goes on to outline the importance of currency deprecations and fluctuation in this model. Assche argues that when “investors assume a risk when they have foreign investments” the value of their investment “may fall because of a chance in the exchange rate” between domestic and foreign currencies (p. 1). Given an investment of a particular value, the interest rate abroad may be insufficient to counteract a depreciation in the home currency. Thus (in Assche’s hypothetical example of an investment of U.S. dollars in Euros), assuming that the “interest rate on U.S. deposits is higher than that of European deposits, the rate of return of holding your money in Euro deposit for a year if higher than that of holding it in dollar deposits” given that “the depreciation of the dollar has increased the rate of return of holding money in euros” (p. 2). It is clear that currency fluctuation plays a major role in the asset approach to exchange rates.
4. Operational exposure is, in effect, the level, degree, and extent of risk that an MNE or other firm is exposed to when investments abroad are subject to changes in the level of the respective currency values in which the investments are held. Edens (2010) argues that “foreign exchange risk”, at least when “long-term growth trends in global currency volatility [are] combined with recent dramatic market events” can, in effect, “point to the increased economic vulnerability for companies” that do not sufficiently attempt to account for varying levels of currency values or do not control their operational exposure via financial hedging or adjustments in operations (p. 341). In other words, operational exposure is the extent to which the exchange rate can change and affect a company’s operational cash flows in the future.
In order to mitigate operational risk, MNEs can use several tools to hedge their potential losses. Specifically, Edens (2010) states that “the process of mitigating risk” usually involves “acquiring an offsetting exposure, which may be either a derivate instrument such as an option, future, or swap” or even obtaining “an offsetting asset or liability in order to limit the uncertain impact to value or cash flow” (p. 346). Operational risk can be successfully hedged in order to provide additional predictability in future cash flows and to reduce the risk of losses from fluctuations in exchange rates.
5. Translational exposure is different from transactional exposure. Whereas translational exposure is measured in the difference between vulnerable (exposed) assets and exposed liabilities, transactional exposure is instead risk that originates from business transactions that necessitate the use of funds in a foreign currency. In other words, transactional exposure is risk assumed when there is a difference between the agreed-upon cash flows stated in a business deal and the current, or live, exchange rate itself. Veblen and Desai (2005) argue that there are very different strategies employed by corporations in order to mitigate the two different types of risk and different methods for determining the actual impact of the two risk types. Translational risk can be calculated using the value of assets at either the current rate or by using exchange rates that correspond to the value they were at when the item itself was formed (Veblen and Desai, 2005, p. 1).
Thus, translational exposure differs greatly from its transactional counterpart. Translational exposure is, in other words, “the change in the nominal exchange rate from the previous reporting period” and does not affect cash flow, whereas transactional exposure results from changes in future cash from the “future transactions the firms is expected to enter into [and] whose value will be influenced by a current exchange rate” variation (Bodnar, 2009). Translational exposure does not affect future cash flow, though transactional does.
Assche, A. V. (2005). Asset-Market Approach to the Exchange Rate. Asset-Market Approach to the Exchange Rate. Retrieved July 28, 2013, from www.econ.ucdavis.edu/faculty/asschea/ECON162/notes/Chapter13b.pdf
Bodnar, G. (2009). Corporate Exposure to Exchange Rates. Corporate Exposure to Exchange Rates. Retrieved July 28, 2013, from finance.wharton.upenn.edu/~bodnarg/courses/readings/xrexposure.pdf
Bruhn, J. (1995). The Real Interest Differential Hypothesis, How Did It Fare In The 1980s?. American Economist, 39(2), 78-86.
Edens, C. (2010). A holistic view of corporate foreign exchange exposure management. Journal Of Corporate Treasury Management, 3(4), 341-347.
Knight, S. (2010). Divested Interests: Globalization and the New Politics of Exchange Rates. Business & Politics, 12(2), 1-28.
Rodriguez, R. M. (1979). Measuring and Controlling Multinationals' Exchange Risk. Financial Analysts Journal, 35(6), 49-55.
Veblen, M. F., & Desai, M. A. (2005). Foreign Exchange Hedging Strategies at General Motors: Transactional and Translational Exposures. Harvard Business School Cases, 1.