MULTINATIONAL CORPORATION
A multinational corporation (MNC); is a corporation that manages production or delivers services in more than one country. A multinational corporation (MNC) is also known as an international corporation. The International Labor Organization (ILO) has defined, "an MNC as a corporation which has it's headquarter in one country, known as the home country, and operates in several other countries, known as host countries.
Foreign Exchange Risk / Currency Fluctuation are a risk that results from the change in the price of one currency with respect to another. All the corporations that have assets or business operations across the national borders of their home countries, they face currency risk because the prices of currencies are very volatile. Corporations are exposed to this at every level if they operate outside the borders of their home country and therefore, in order to reduce the percentage of their exposure to currency fluctuation, these corporations use the tool of hedging. Hedging helps these corporations to reduce their exposure to the loss to be faced from high currency fluctuations.
MULTINATIONAL CORPORATIONS AND CURRENCY FLUCTUATION
The multinational corporations are the corporations that are vastly exposed to foreign exchange risk / currency fluctuation because these corporations manage production or deliver services in more than one country. These corporations have to face this risk at different levels of their business operations, especially in the process of decision making. Decision making is element on which the whole future of a corporation depends, whether it is short-term decision making or long-term decision making.
Multinational Corporations will have to face the foreign exchange risk when making short-term and long-term decisions for generating funds to attain resources of production and to carry out their operations in markets outside the border of their home countries. Short-term decisions of a multinational corporation exposed to foreign exchange risk are to obtain funds for the operational activities of the corporation whereas, long-term decisions that make a multinational corporation vulnerable to currency fluctuation include the generation of funds for the purpose of purchasing and maintaining all the fixed assets possessed by the corporation.
Foreign exchange risk / currency fluctuation is an important source of uncertainty for multinational corporations rather than being an advantage. It has been observed that foreign exchange risk affects both the cash flows of a multinational corporation's operations as well as the interest rate used in the valuation of these cash flows. The process of determining foreign exchange exposure has now become a central issue of international financial management and this issue has started to generate an extensive amount of research. The existing data on foreign exchange risk seems confusing because empirical studies have so far recorded a very weak link between foreign exchange risk and U.S multinational corporations. It has been found unconvincingly that the weak results imply that exchange rate changes have no effect on the multinational corporations (Gendreau, 1994).
Unexpectedly different from U.S multinationals, a sample of 171 Japanese multinationals has proved that there is a positive exposure between foreign exchange risk and the multinational corporations. The multinational corporations that are exposed to currency fluctuation mainly belong to three sectors of the economy including, electric machinery, precision equipment and transport equipment. Accordingly it has been observed that the extent to which a multinational corporation is exposed to foreign currency risk depends on its level of export ratio and by the variables that are proxies for the firm's hedging portfolio. The multinational corporations try to hedge their risk against foreign exchange risk with the help of financial derivatives including, options, forwards and futures. Another important conclusion observed is that the multinational corporations that form a particular group become more powerful and have a huge impact on the financial institutions operating in a particular geographic location which ultimately reduces the currency fluctuation risk of the multinationals (He, 1998).
It is widely believed that exchange rate changes affect the value of multinationals but various studies report that exchange rate changes do not have substantial impact for the majority of U.S multinationals because these multinational corporations have hedged themselves against the foreign exchange risk (Lee and Suh, 2010). Muller and Verschoor (2006) also find that exchange risk exposure is not significant for the majority of European multinationals.
It is a puzzling situation that the multinational corporations lack responsiveness to exchange rate changes, even though it is known that exchange rate changes affect the value of the home currency of multinational corporations' foreign income and their competitive position against their foreign rivals. In order to explain this puzzling situation, various authors point out that multinational corporations use financial hedging and geographical diversification to protect themselves from the adverse effects of exchange rate changes. Such as according to Allayannis and Ofek (2001) the U.S multinational corporations' use of foreign currency derivatives balances the size of their exchange rate exposure. Pantzali et al. (2001) show that the responsiveness of multinational corporations to exchange rate changes is relatively low for multinationals with more geographically diversified operations.
Multinational Corporations have to deal with foreign exchange risk to take proper advantage of their operations and prevent their profitability from decreasing as profitability is the major factor of increasing stock returns, and therefore, the responsiveness of stock returns to exchange rate changes is determined by the ability of exchange rate changes to affect profitability. According to recent studies exchange rate changes do not have a huge impact on the profitability of multinationals' foreign operations because of the weak relationship between the stock returns and foreign exchange rate. (Lee and Suh, 2010)
It has been observed that the responsiveness of exchange rate changes to the profitability of multinational corporations may not be substantial but exchange rate changes pose a great hurdle to multinational corporations along with many other variables. The other variables apart from exchange rate risk can move in a direction that negates the effects of currency fluctuations. Another important aspect that has been found is that the multinational corporations respond to unfavorable exchange rate changes by slashing their operating costs and expanding their range of diversification. This strategy if successful will protect the profitability of the multinational corporations. (Lee and Suh, 2010)
Bodnar and Weintrop (1997) state that the value of U.S multinationals is directly related to the profitability of their foreign operations. But these authors do not investigate the impact of exchange rate changes on the profitability of their foreign operations and their results imply that this relationship may be weak. In order to state why, assume that exchange rate changes would impact multinational corporations' value mainly with their effects on foreign operations profitability of the corporations. Yet, according to various studies conducted in the past the impact of currency fluctuation on multinational corporations' value is rather weak. In this case it is assumed that the effect of foreign operations' profitability on multinational corporations' value is strong - as Bodnar and Weintrop (1997) find - one can conclude that the impact of currency fluctuation on foreign operations' profitability may be weak, if the impact of exchange rate changes on multinational's value is to be weak. (Lee and Suh, 2010)
Lee and Suh (2010) have found that in the majority of industries, foreign exchange risk does not have a significant impact on the profitability of U.S multinational corporations' foreign operations. Furthermore, in a few industries where the impact of foreign exchange risk on foreign operations' profitability is significant, the significance is negated once changes in profitability from currency conversion are accounted for. It has also been found that foreign operations' profitability has three determinants - foreign profit margin, foreign asset turnover and foreign equity multiplier - are not significantly affected by exchange rate changes in most industries. This study shows that the impact of currency fluctuation on the profitability of U.S multinational corporations' foreign operations is not significant either statistically or economically in the majority of industries. These results are different in different sub-periods, as well as to the use of individual exchange rate changes and to a different model specification that considers the negative exchange rate effect. Furthermore, it has been found that similar results hold for many non-U.S multinationals. It has also been examined that the impact of foreign exchange risk changes on foreign operations' profitability is significant in only a few industries.
According to various studies, the effect of foreign currency risk on foreign operations' profitability is weak both statistically and economically. Therefore, the value of stocks are not responsive to currency fluctuations probably because their profitability, the driver of the value of stocks, is not responsive to currency fluctuations. Related to these results it has been observed that foreign exchange risk of multinationals is not substantial (Pantzalis et al,. 2001) and that foreign exchange risk shocks explain a very small proportion of the relative stock return performance of industries (Griffin and Stulz, 2001).
Research findings suggest that financial hedging may not clearly explain for the weak exchange rate exposure of multinationals. Previous studies state that financial hedging, such as the use of currency derivatives, contributes in protecting firm values from negative exchange rate movements (Allayannis and Weston, 2001). Even though the importance of financial hedging may be indisputable, findings raise the possibility that the foreign exchange risk of multinationals could not be important even before we take into consideration the perspective of financial hedging. This interpretation is obtained because, according to certain research findings, currency fluctuations do not have a significant influence on the profitability measure - the operating profitability of foreign operations - that does not include gains and losses from financial hedging (Lee and Suh, 2010).
It has been observed that the impact of currency fluctuations on foreign operations' profitability of multinational corporations is not significant statistically in the majority of industries. According to various variance components analysis, currency fluctuations explain less than 2% of the variation of foreign operations' profitability of multinational corporations. It has also been concluded that the impact of foreign exchange risk on foreign operations' profitability of multinational corporations is weak for majority of the multinationals all around the world. Evidences imply that foreign exchange risk of multinational corporations - measured by the relation of stock returns to foreign exchange risk changes - may be weak because foreign exchange risk does not have a significant impact on the profitability of multinational corporations' foreign operations. Thus, the present studies provide an explanation for the empirical regularity in the literature that the foreign exchange risk exposure of multinationals is generally not substantial. (Pantzalis et al., 2001; Muller and Verschoor, 2006).
Country specific disclosures are critical, since currency fluctuations themselves are country specific and cannot be used without country-specific accounting information. Currency fluctuation sensitivity depends on country and/or industry and foreign exchange rate risk seems to be much more prevalent in European segments than in other parts of the world. This result may have to do something with the composition of the European sample, which is larger and includes a better cross section of industries (Johnson, 1996).
The operating effect of foreign exchange risk relates to the impact of currency fluctuations on future sales volume, selling prices and costs. Bodnar and Gentry (1993) suggest that the magnitude and direction of operating effects can be a function of: (1) the type of goods produced by the firm; (2) whether the firm exports its product; (3) whether the firm imports its inputs; (4) whether the firm competes with foreign firms that export to its location; and (5) whether the firm uses internationally-priced inputs. Levi (1990) also shows that the mentioned factors should combine with the elasticity of demand for the multinational corporations' products and/or inputs to measure the ultimate effect of currency fluctuation on profits.
CONCLUSIONS
Based on the literature reviewed the following conclusions have been interpreted:
The impact of currency fluctuation depends on the country and/or industry in which a multinational corporation operates.
The relationship between majority of the multinational corporations and currency fluctuation is very weak because of financial hedging and geographical diversification.
The weak relation between the multinational corporations and currency fluctuation is due to the lower impact of foreign exchange risk on the stock returns, value of firm's stocks and the operating profitability of the firm.
The multinational corporations can take advantage of currency fluctuation only when transferring the capital to their headquarters and converting the currencies into their home currencies.
The foreign exchange risk is hedged by the multinational corporations by using currency derivatives, such as, options, futures and forwards.
