48130359 Case Study
1. Should multinational firms hedge foreign exchange rate risk? If not, what are the consequences? If so, how should they decide which exposures to hedge?
Generally, multinational firms should hedge foreign exchange rate risk.
Because foreign exchange risk
1) Affects existing income statement items and balance sheet assets, liabilities, and equity through translation exposure.
2) Influences the value of outstanding foreign-currency-denominated contracts and obligations, thus firm’s earning and cash flow through transaction exposure.
3) Impacts firm’s future revenues and costs, thus firm’s earning, cash flow, enterprise value, and equity value through operating exposure.
In order to reduce cash flow uncertainty and earning volatility, to minimize negative impacts from foreign currency gain & loss on firm’s value and equity, in most cases foreign exchange risk should be hedged and exposures should be managed.
If translation exposure is not hedged, under FASB 52 the value of financial statement items that translated at current exchange rate may negatively affect consolidated earnings and equity value in case of adverse exchange rate movements. If firms fail to hedge transaction exposure, firms will face uncertainty in future cash flows and earnings since foreign exchange swings tend to fluctuate cash flows and distort earnings. If operating exposure is not managed, unfavorable exchange rate changes may jeopardize or threaten firm’s competitiveness and prospects thus affect profit margin, sale volume, and enterprise value.
Firms base on following factors to decide which exposures to hedge:
1. Significance of impacts. Firms may first determine how large will exposures affect earnings, cash flows, and firm value by analyzing exposure value, currency volatility, value at risk, scenario analysis, sensitivity analysis, and etc. Only those exposures have potentials to exert significant negative impacts should be hedged.
2. Cost of hedge. Explicit costs such as
Generally, multinational firms should hedge foreign exchange rate risk.
Because foreign exchange risk
1) Affects existing income statement items and balance sheet assets, liabilities, and equity through translation exposure.
2) Influences the value of outstanding foreign-currency-denominated contracts and obligations, thus firm’s earning and cash flow through transaction exposure.
3) Impacts firm’s future revenues and costs, thus firm’s earning, cash flow, enterprise value, and equity value through operating exposure.
In order to reduce cash flow uncertainty and earning volatility, to minimize negative impacts from foreign currency gain & loss on firm’s value and equity, in most cases foreign exchange risk should be hedged and exposures should be managed.
If translation exposure is not hedged, under FASB 52 the value of financial statement items that translated at current exchange rate may negatively affect consolidated earnings and equity value in case of adverse exchange rate movements. If firms fail to hedge transaction exposure, firms will face uncertainty in future cash flows and earnings since foreign exchange swings tend to fluctuate cash flows and distort earnings. If operating exposure is not managed, unfavorable exchange rate changes may jeopardize or threaten firm’s competitiveness and prospects thus affect profit margin, sale volume, and enterprise value.
Firms base on following factors to decide which exposures to hedge:
1. Significance of impacts. Firms may first determine how large will exposures affect earnings, cash flows, and firm value by analyzing exposure value, currency volatility, value at risk, scenario analysis, sensitivity analysis, and etc. Only those exposures have potentials to exert significant negative impacts should be hedged.
2. Cost of hedge. Explicit costs such as