Most large MNCs manage their foreign-exchange risk by using a pre-established exposure management strategy. For example, Merck uses the following five steps for currency exposure management: (1) projecting exchange rate volatility, (2) assessing the impact of the 5-year strategic plan, (3) deciding on hedging the exposure, (4) selecting the appropriate financial instruments, and (5) constructing a hedging program (for details, see Case Problem 6: Merck's Use of Currency Options). To protect assets adequately against risks from exchange rate fluctuations, MNCs must (1) forecast the degree of exposure, (2) develop a reporting system to monitor exposure and exchange rate movements, (3) assign responsibility for hedging exposure, and (4) select appropriate hedging tools.
Forecasting the degree of exposure To develop a viable hedging program, an MNC must forecast the degree of exposure in each major currency in which it operates. Approaches range from gut feelings to sophisticated economic models, each of which has had varying degrees of success. Whatever the approach, the MNC should estimate and use ranges within which it expects a currency to vary over the forecasting period. Some companies develop in-house capabilities to monitor exchange rates, using economists who also try to obtain a consensus of exchange rate movements from the banks with which they deal. Their concern is to forecast the direction, magnitude, and timing of an exchange rate change. Other companies contract out their forecasting needs.
Developing a reporting system to monitor exposure and exchange rate movements Once the MNC has decided how to forecast the degree of exposure, it should develop a reporting system that will assist in protecting it against risk. To achieve this goal, substantial participation from foreign operations must be combined with effective central control. Because exchange rates change frequently, MNCs should obtain input from those who are attuned to the foreign country's economy. Central control of exposure protects resources more efficiently than letting each subsidiary monitor its own exposure. The management of the MNC should devise a uniform reporting system for all of its subsidiaries. The report should identify the exposed accounts that it wants to monitor, the amount of exposure by currency of each account, and the different times under consideration.
Assigning responsibility for hedging exposure It is important for management to decide at what level hedging strategies will be determined and implemented. Most MNCs today continue to centralize exchange exposure management, because it is impossible for regional or country managers to know how their foreign-exchange exposure relates to other affiliates. A three-country study of exchange risk management by Belk (2002) found that 66 percent of the sample companies highly centralized their exposure management, 19 percent lowly centralized their exposure management, and only 15 percent decentralized their exposure management. However, a centralized policy may miss opportunities to detect the possibility of currency fluctuations in certain regions or countries. Thus, some MNCs decentralize some exposure management decisions so that they can react quickly to a more rapidly changing international environment.
Selecting appropriate hedging tools Once an MNC has identified its level of exposure and determined which exposure is critical, it can hedge its position by adopting operational techniques and financial instruments (see Global Finance in Action 9.1). Operational techniques are operational approaches to hedging exchange exposure that include diversification of a company's operations, the balance-sheet hedge, and exposure netting. Financial instruments are financial contracts to hedging exchange exposure that include currency forward and futures contracts, currency options, and swap agreements. This chapter and chapter 10 will discuss these and other hedging devices in detail.
Global Finance in Action 9.1
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