Types of Risk an International Multinational Company Face
To begin with, it needs to identify and briefly describe the main sources of risk an international multinational company might face. The main type of risk a multinational company might face is that of foreign exchange risk. This is the risk that trading in another country might be more or less profitable depending on the strength of the two countries currencies. For example, if a UK company was trading in Malaysia then on that day the exchange rate might be £1 to RM 5.5 Malaysia Ringgit. The exchange rate of next day might be £1 to RM 5.30 Malaysia Ringgit. This means that it is now less profitable to be trading in Malaysia. This could be due to no fault in the product being traded. Another type of risk that an international multinational company or any company might face is that of interest rate risk. This is the risk related with the movement of the interest rate. This can be linked to foreign exchange risk as the interest rate of a particular country is one factor that goes to determine the exchange rate. The more countries the multinational company trades in the more interest rate risk they will exposed to. Another type of risk is that of political risk. This is when the policies of a country directly affect the multinational company. Trading in more countries means being exposed to greater political risk. Another main type of risk is that of regulatory risk. This is very important to a multinational company as it will be trading in many countries. This will mean that it subject to many different regulations. These different regulations will mean that the company will have to spend time and money managing them to make sure they are not breaking any rules. Translating these regulations back to the parent company's regulations will also be risky as profits could be affected by the translation.
As well as the above risks which have outlined, there are many other types of risk. This will mean that multinational companies will try to make sure that the risk can be managed. One way of doing this is by using hedging. This is when the company enters into a particular type of financial transaction to try to reduce the company's risk exposure. These transactions try to lock in a price that the company can try to guarantee. The main financial transactions linked with hedging are forward contracts, futures, options and swaps.
Furthermore, the main advantage of these financial contracts is that it lets the hedger to enter into a financial transaction that will let him to stay in a price. This will mean that the company can draw up a strategy that is devised around this guaranteed price. The staying of the price is an advantage as big losses that are related with the activity are now not possible as if these losses do happen then the future contract or swap will cover these losses. However, the disadvantage of this is that if the activity performs well then the big gains of the activity are not realised as the price has been fixed or stayed. However, this is not true of all the financial transactions used for hedging. One such is that of options. With an option the hedger can say that he will sell or buy at a certain price. If the real price of the activity goes above this agreed option price then the hedger is not obliged to sell or buy. The high profits from the activity can be realised. However, some authors have observed that buying the option in the first place will even the possible gains out, meaning that no profit is made.
There is a big disadvantage of using future contracts. Although they are relatively simple an easy to use and on paper they can stay in a future exchange price, in reality they are much more complex. This complexity gives arise to what is known as basis risk. This arises due to the fact that the exact length of the contract is not known and due to the fact that the hedging asset is not exactly the same as the asset being hedged against.
Moreover, there are advantages and disadvantages of using these financial transactions. As these are used as hedging methods, it will be talking about the advantages and disadvantages of hedging. There are some advantages of hedging. The main reason why companies try to use hedging is that they are trying to provide an insurance against a particular investment. This is the same principle as when a company insures against fire and theft. A Company will take out a hedging position to insure that if a certain market condition occurs they do not lose out. Hedging against currency risk is especially important in today's growing global market. As more and more businesses are trading in many countries then different currencies are being used.
Another reason for hedging is that many businesses are in the manufacturing, retail or service industries. These companies will have little expertise in predicting future exchange rate changes or changes in prices of commodities. These companies will hedge so risk is reduced. This will mean that they can get on and concentrate on the main activity of their business. However, the hedging process is complex. The use of such methods as options and future contracts requires specialised expertise. This will cost the company money. Also, these personnel will need to be monitored. This is because they could be taking hedging positions that could bankrupt the company. One example of this was that of Nick Leeson at Barings Bank. Over a couple of years he managed to lose close to $1 billion. He was able to hide these losses due to a lack of monitoring. According to Smith and Stulz (1985) who believe that hedging can increase the value of a company. They claimed that hedging could increase the value of the firm by reducing the probability, and thus expected costs, of financial distress.
On the other hands, there are some disadvantages of hedging as well. Hedging could cause losses. This is because market conditions could be favourable and the activity of the business is profitable. Therefore, the hedging put in place to reduce risk will now cause losses for the company. The treasurer will now have to explain why these losses have occurred. An article that supports the view of hedging causing loss is that by Cornwell (2005). In this article the author looks at the earnings of Countrywide. The author found that the company lost out due to hedging. The value of the financial hedges fell in the business causing a pre tax loss of $278 million
In addition, there are many different methods that can be used to hedge. These methods could be very complex. However, any methods to use could prove a difficult decision to the company. This decision could affect the amount of profit or loss a company makes from a hedge. An example of this is that of currency risk. With currency risk there are two types of exposure, that of translation and translation. Deciding which to hedge against is a difficult decision.
Conclusion
To conclude, this essay has described some of the main types of risk. These were foreign exchange risk, interest rate risk and political risk. There are also many other different types of risk a multinational company could face, but in this essay only mentioned some of them. This essay also looked at advantages and disadvantages of the different types of hedging methods and hedging itself. There are many good advantages such as insuring a price and reducing risk. Besides that, there are many disadvantages as well such as the complexity of the methods and the potential for massive losses.
