Benson Kamau Munana

 Hedging Against Currency Risk Student’s Name Institutional Affiliation Thesis Statement: Hedging of Currency risk is an important success tool for Multinational Corporation that participates in International Trade Finance Introduction As Deng Elyasiani & Mao (2017) observes, Hedging refers to any technique used to eliminate or reduce any risk of adverse movement in financial terms. Currency hedging is the attempt to insure corporations against exchange rate moving in a direction that is opposite to the positions in the world market. As such, firms aims taking an offsetting stand in the related currency. This implies that corporations take another investment or instrument that is negatively correlated with an aim of minimizing risk of any event of movement to unfavorable directions of the monetary market. More specifically, hedging helps the investors to protect their money. For example, in a local and household setting, an insurer is a simple form of hedging that protects against fire, theft, disaster or unforeseen future risks. Therefore, hedging is an important tool for financial planning. When it comes to choice of when to hedge, an organization has to settle on the most appropriate. The purpose for this paper is to conduct a research on the hedging of currency risks by Multinational corporations. The research questions used in the research process are? What are the benefits of hedging currency risks by Multinational corporations? What other trade risks can corporations hedge against the What hedging options do corporations have to avoid hurting of the trade? According to Kennedy Welch & Monshipouri (2017), Multinational corporations refer to companies that have assets and facilities or operations in more than one country. Such organizations have their offices in different parts of the world but have one centralized office. The idea of hedging has gained momentum in the recent world. Consequently, the multinational corporations experiences or faces serious problem of vulnerability and instability with respect to volatility of the commodities prices at commodities exchanges and disproportion of foreign exchange rates. Good to say, the fluctuation of foreign exchange is a disturbing issue to most enterprises. Such firms usually have loans to clear on foreign currency from domestic ones, losses to profit from the fluctuations of exchange rates .The challenge affects all the industries including ship building, oil industry, tourism industry, as well as the confectionary producers. For this reason, to avoid any unpredictable events, the MNCs have to employ the concept of hedging. This helps the businesses to deal with the problem of price fluctuations in the markets which includes the prices for steel, Oil prices, fright space and foreign currencies securities. Literature Review Theoretical Review Liquidity models Two-period models:The two-period models state that the most compelling argument for hedging is based on ensuring the company’s ability to meet two sets of cash flow commitments which are; the exercise prices of their operating options reflected in their growth opportunities, and their dividends. Liquidity models identify the need to have an alignment between the demand of funds with the internal supply of funds as the major objective of hedging. Doing so helps in mitigating the needs to raise costly external finance (Jobst& International Monetary Fund, 2012). Internal shareholders manage the company. They are passive and thus don’t buy issued shares. Therefore, they major on the intrinsic value of existing shares. Therefore, such companies can choose a hedging strategy to reduce the riskiness of cash flows. Their investments produce a positive NPV and can therefore be funded out of the internal cash flow r funds can be externally raised. Jensen and Meckling Model The Jensen and Meckling model makes assumptions that the expected utility of the internal shareholder depends on the market value of the company, money wages and on the job perquisites that are inseparable from the company. The owner would fully bear the cost of additional perquisite consumption if he completely financed firm. The loss would be in form of a reduction in the value of the company. After the owner managers raise the external equity capital, he can enjoy full benefit of any additional perquisite consumption. Rational outsiders make unbiased estimates of the associated costs with increased perk consumption. These costs are passed back to the owner managers in full. They take the form of a reduction in the price they are committing to pay for the securities he initially desires to sell. The model demonstrates that whenever X1 is insufficient to finance the optimal investment volume in t=1, I *, utility maximizing owner managers will make a choice of investment volume I.It is below the optimal investment volume. The disparity between NPV which can be attained optimal investment volume and the NPV achieved through investment volume realized by owner managers are agency costs of external equity capital, c1 ac:. Therefore, the maximum benefit of hedging can be achieved when hedging can avoid the risk of cash flow falling below (Schmaltz, 2009). Empirical Review In their work, Biglaiser and DeRouen (2006) states that the idea of currency risk hedging is a practice that has been practiced for many years but has gained more interest in recent years. It is brings a great success for any organization that takes part in the international trade. The concept of globalization and trade across borders happens in the midst of much exchange rate volatility, which results to currency risk and other forms of trade instability. The global trade is changing very fast. As Demir (2018) states, according to the UNCTAD report of year 2016, in the last 15 years, there has been a major change in the business environment. This is propelled by technological advancement, with corporations from other emerging economies like India, Asia and Africa taking the positions that they never used to, of the market leadership, and consequently overturning the former leaders. As at now, the number of firms from Asia that have established themselves as leaders are by far more than that from USA market. This means that any organization that does not move fast enough to hedge against any risk will be easily edged out of the market, regardless of the size. The natural extraction firms, bunkering companies, ship owners, power plants, banks, bunkering companies and oil refineries all apply hedging for their survival and earning of competitive edge. As Khan & Arora, (2017) argues, the Organizations engaging in the international trade are exposed to different types of trade risks. These are way too many risks that destabilize the global economy, further destabilizing the multinational corporations. There are three types of risks that a firm stands to avert by the move to hedge currency risks in the international trade. These are Translation Exposure currency risk, Transaction Exposure and Economic Exposure, interest rates risks, products prices risks, As Ram all (2017) puts it, when a company embarks on the hedging practice and averts the above mentioned risks, it saves itself from the currency risk and gains from other benefits that come with that. Firstly, it is able to avoid unpredictable losses. Secondly, hedging helps an organization to be competitive in its market. Thirdly, such an enterprise is able to reduce the existence of cash position risk exposure and fix a stable and consistent cash flow. Fourthly, with the right hedging, an organization opens up opportunities for upper appeal for investors, easy access to credit and gains high competitiveness. When these things are attained, the corporation is assured of a minimized volatility of returns and high stability. Notably, there are various hedging methods that corporations use to hedge against the risks. Such includes forward contracts invoicing in domestic currency, futures, Benefits of MNCs Hedging against Currency Risk Protects against Translation Exposure currency risk Translation exposure refers to any change in the multinational corporation’s balance sheet and accounting income due to the changes in the exchange rates. This risk is measured in net terms as net foreign assets less net foreign liabilities. There are two instances that lead to the translation exposure. One is when a corporation has significant sales transactions in a foreign nations and the other one when one corporation has one or more subsidiaries operating in another nation (Biever et al, 2017). Protects the business against Transaction Exposure According to Macaulay (2018) transaction risk is an exposure that relates to settling of a particular transaction. These are mostly payables or payables from export or import contracts as well as repatriation of dividends. In this case, the time frame for the transactions committed is relatively short. However, in some special cases it can take several years. For example, this can be seen when a payment of receipt is due in a foreign currency but the payment is received in a This risk involved in such a case is that the at last as the investor receive the payment, the offshore income will be reduced when converted into Australian dollars, if there is a rise Australian dollar exchange. Protects against Economic Exposure Economic exposure refers to changes in planned and expected future cash flows. This is the most important risks of all. It entails the impact of exchange rate variation on a corporation’s future expenses and revenues through the variations in volume and price. For example, neither the quantities nor the prices in the domestic currencies are certain (Karmakar & Mukherjee, 2017). It is worth mentioning that the economic exposure affects the value of a company because any adverse fluctuation will hamper the present as well as the future cash flows. For instance, if a company of South Africa operates a in another country, and the foreign company country devalues its currency, then, when the profits are repatriated back to South Africa, every currency unit of earned profit would be at a loss. Further, if a firm is manufacturing all its goods in one country and that particular economy‘s currency strengthens against the other currencies, then, the exports will be more expensive than that of the customer countries. Consequently, the sales will lower or stagnant, and the cash flow reduction. Risk of Currency and investment Decline Currency risk is an important consideration by MNC’s. By hedging the risk, a corporation mitigates the any effects of currency exposure which in turn reduce losses and risks. As observes, the price of currency in the international trade happens to be very volatile. For instance, if a certain investment happens to return 5% and at the same time the dollar strengthens by 6% against the investment’s local currency, then the venture loses 1% of its value (Churchill & Merry, 2017). Protection Foreign exchange Fluctuation risk Foreign exchange risk is a consequence of the unexpected change in to the value of loan or investment, as measured on the basis of local currency. Normally, the basis currency is the local currency while for the companies that operates aboard, foreign currency is involved. There is a wide range of spectrum of opinions pertaining to foreign exchange hedging. Some corporations feel that hedging tools are speculative and do not fall in their area of expertise and thus, not falling in the area of hedging practice. On the other hand, some corporations are no aware that they are exposed to the foreign exchange risk. Other enterprises do not believe that the share holder value can be increased by the hedging of foreign exchange risk, based on the believe that the shareholders can be able to shield themselves using some concepts like forwards (Ibrahim et al, 2017 It is important to note that there is a vast pool of research that clearly proves the efficacy of management of the foreign exchange risks. A significant volume of evidence proves the reduction of exposure of the by the use of tools to manage the risks. As There is a recent study by Albouy & Dupuy (2017 that used a multivariate analysis of 500 non financial companies and calculated companies’ by the use of ratio of foreign sales to that to total sales as a proy, and by isolating the effects of the foreign currency instrument on an enterprise’s foreign exchange. Most interestingly, the found a statistically significant relationship between the absolute value and the % use of the foreign currency. The research proved that the employment of the derivatives reduces the exposure (Sushko, 2017) Methods of Reducing exposure to currency risk in International Trade Finance The price Risk management In the physical market, the risk of price movements can be offset by locking of the same goods and services in the future market. As such, in the future market, the payment and delivery happens in the future specified date. This date is determined at the time when the agreement of transaction is commenced. As per this price risk management, the involved brokerage house sells the investor’s goods and services when the bottom or top price is already agreed upon between the broker and the investor .In that view, the hedging allows the corporation to lock a highly acceptable forward price. When this tool is used in such a manner, the windfall price is sacrificed but this help in the protecting the windfall losses. This type of hedging helps the multinational corporations to manage price vola (Borio, et al, 2017) Employment of Euro Invoicing Euro invoicing in this case implies invoicing in a home currency, very important in protecting against transaction risk. This is a mode of transferring the transaction risk to the foreign customer. As such, the manufacturer of the export invoices the customer in domestic currency. One would expect to see the exporter having a lot of interest in using the technique. However, considering many market structures like competition and, economic risks, it becomes less certain. According to Glassman’s law, trade in manufactured products is in most cases invoiced by the exporter. The rationale behind this strand is that both the exporter and importer wishes to minimize exchange rate risks by the way of using their domestic currency. Further, in the developed nation’s trade, the exporter is usually able to impose his own country currency because of the advantage of the first mover in bargaining over the invoicing currency. Additionally, he usually has some market power before any atomistic demand. (Ventura & Witte, 2017 Use of forward contracts Study by Liu & Lu, D (2018) discussed the pros and cons of the use of forwards. They further provided the evidence on why forward should be preferred. The forward contract is a hedging tool with no upfront payment requirement .International markets presents market with positive growth opportunity but at the same time expose firms to foreign exchange currency risks. When two trade agents enter to the forward agreement, they agree to trade on a particular amount of on currency for another at a later date. Additionally, they set the exchange rate to their future trade. This is important in minimizing currency risk. Forward contracts are effective means by corporations to ensure future stability. Notably, the cost of operating a future is lower when compared with other instruments with the settlement date being one year. The price of the future exchange rate, set in FX period is computed as: Leading & lagging Leading and lagging is important in solving the problem of transaction exposure. Leading is the practice of making payment before it falls due. On the other hand, lagging, means to defer the payment and making it when it is due. If the payer’s currency is weakening against that of the seller, then it is advisable that one pays earlier-leading. On the other hand, if the payer’s currency is appreciating against that of the one paid, it is then advisable to pay later. Moreover, futures can be closed out before the set delivery date (Gopinath & Stein, 2018).  Futures As opposed to the forwards, the futures happens to be standardized in terms of quantities that are to be traded on the settlement date .Moreover, futures are mainly used for profit speculations purposes, currency hedging and obliged on the actual delivery date .Some views the instrument as a special form of a forward tool traded in a future market. Currency options Currency option as a hedging instrument guarantees the worst case exchange rate for future buying of another currency. This tool is also a contract, only that it’s cost of is much higher than that of the forward. In this instrument, the corporation has right and not an obligation to either buy or sell the said currency at the agreed exchange rate. For that, the buyer buys it at a premium, making it more expensive than forward. One major advantage of the instrument is the protection against the downside risk and at the same time allows an appreciation something that results to a more stable company. The idea of how far the profit goes is dependent on how high or low the foreign currency goes when compared with the local/ domestic currency. If it goes up a little, then it is worthless and insignificant. It is also worth mentioning that the gains or appreciation will be offset also by the cost of losses that comes with the purchase of the foreign currency. Currency Swamps. Among the available studies by Boz, Gopinath & Plagborg (2017), currency swaps are the most cost effective. This tool is mostly used for long term period, where high volume with an ensured high liquidity. When entering into this one simultaneously buys and sells the specified currency, re-exchange the currency at a future date until the point of converting the stream of cash flows of one currency into another, at a fixed rate. Some of the advantages of this tool are It minimizes the cost of foreign exchange, hence the protection against the foreign exchange risk. Clients can either prolong or shorten the period. It costs nothing to use the instrument or to join A survey done by further points out that currency swaps are the best in hedging against translation risk, with forward being the best at transaction risks. The instruments can be compared in the following table: Research Paradigm Following the research topic in question, the paper will employ positivism philosophy in the research philosophy. The paradigm is based on the ground that the reality is stable and can be observed, analyzed and described from an objective perspective without altering or affecting the phenomena under study. Also, the phenomena under study should be isolated and the observations repeated to manipulate reality and arrive at variations (Hughes & Sharrock, 2016). The initial observations and realities related to the phenomena under study can be used to make predictions. Therefore, this paper will utilize positivism as a philosophy and will analyze hedging of currency risk for multinational companies and come up with various benefits for hedging against trade risks for MNCs and the hedging instruments applied. Qualitative data will be used as the research will be analyzing qualitative aspects of hedging of currency risks for multinationals and their benefits thereafter. Additionally, the research will make use of secondary data from sources such as books, journals and past researches among other sources. Thematic data analysis will be used in the research and will be used in identifying and recording information patterns from the data. Thereafter, the outcome of the analysis will be used in answering the research question. Data collection The data used in the research was secondary and was collected from books, periodicals, past researches, and journals. Information obtained from the data sources was collected in form of short notes and later used in the research process. Factors that were considered during data collection included usability, reliability and validity. Usability involves the relevance of the source and its importance in answering the research question. Usability was utilized by collecting data that was relevant to the question under study and which is related to the study. Therefore, the process of data collection ensured that only relevant materials were used to ensure that they were useful for the study (Vartanian, 2010). Additionally, the data used ensured validity. Validity refers to the process of data collection’s conformance to its roles while accomplishing its assigned duties. External and content validity are the two main forms of validity. External validity is the extent to which data can be generalized from the sample used to the general population. On the other hand, content validity refers to the appropriateness of the collection method during the research. In regards to the research, external validity will be drawn from the sources of data used in answering the research question. Content validity will be drawn from the effectiveness of the collected data in answering the research question. Reliability is the consistency obtained from the collected data in meeting its objectives. An instrument can only be regarded as objective if it meets its set purpose in a consistent manner regardless of the changes in the research question (Vartanian, 2010). Procedure The data collection procedure involved the collection of secondary data based on understanding factors that improve hedging of currency risk for multinational companies. Data was collected in a systematic manner using various subtopics to ensure that relevant, reliable and valid data was collected. After collection, the information obtained was used to answer the research questions on the basis of aspects such as hedging options for corporations to avoid hurting the trade and profits, trade risks that corporations can hedge against, and benefits of hedging currency risks by multinational corporations. Relevance was important during data collection. It refers to the relationship between the collected data to the research questions for effective results. To ensure relevance, specific key words and topics were used during the data collection process. Keywords used included, hedging options for corporations, benefits of hedging currency risk and hedging currency and international trade. Topics used to facilitate relevance included “benefits of hedging for multinational companies” and “Hedging options available for MNCs”. The keywords and the topics facilitated data collection as most of the secondary sources were obtained from the internet. By using them, irrelevant materials were filtered ensuring that only useful data was obtained and used. In addition, a ten year timeline for the data was set to ensure to ensure that the most recent findings were used. Data collected was also arranged in a systematic manner based on different aspects of the research to facilitate analysis. Data Analysis In the study, thematic analysis was used in analyzing the data. Themes and patterns identified in the collected data were used to derive the information that was used to answer the research question. The analyzed themes include various currency and trade risks. These were translation risks, transaction risks and the economic risks. The research process also conducted an analysis for the various instruments that can be used to mitigate the risks of currency decline .Such included forward, the futures, domestic currency invoicing and currency options. The collected data was later organized in a systematic manner to ease its use for research users Summary The data collection and analysis played an important role in solving the research question. The effectiveness of data collection method enabled the researcher to collect appropriate data whose analysis resulted in significant findings that were effective in solving the research issue at hand. Findings The issues analyzed in the paper of research relates to the reasons why Multinational corporations have to hedge against the currency risk. From the data analyzed, there is a total number of 8 risks that a company overcomes when it applies the hedging concept .These are protection against economic exposure where, protection against product prices, protection against interest rate risks , protection against transaction risks, protection against the currency and investment decline, and protection against the translation exposure. On protection against translation exposure, an organization is shielded from the unhealthy change in the balance sheet or the accounting income as a result of change in the exchange rate. This is common to the companies that does significant exportation or those that have foreign subsidiaries. Further, there is a protection against the transaction exposure which is composed of mainly payables and receivables. Additionally, the protection against economic exposure helps in the protection against the changes in expected and planned cash flows, from unfavorable variation of the exchange rate. This is comes from the fact that neither the quantities nor the prices are certain in an economy. This particular exposure is k known to further affect the value of the company. The other risk protection is the protection against the currency and investment decline. Currency exposure results to other risks and loses. Investment happens in this manner, if a company investment return grows by a certain percentage and the dollar grow significantly against the local currency, then the value gained against the local currency by the dollar offsets the investment decline. Further, the risk of foreign exchange fluctuation was also discussed. This is one serious firm’s consideration. It affects loans and investments of a company subsidiary in a foreign land. Another important risk analyzed is that of the prices risks. When trade is happening across the border, the fluctuations in the foreign exchange affect the income of the importer or exporter. This way, there is a contention because the exporter would wish to invoice in the local currency. This is however surrounded by many factors like the market structures and competition. Nevertheless, the exporter always has an added advantage against the importer because they have the first mover advantage. Discussion From the research finding, it became clear that the concept of hedging against risk is very important for the success of any MNCs. The need to protect the corporations’ economic risks has gained great importance in the recent years. Hedging against the foreign exchange risk is key to the stability of any firm that participates in the international trade. Though some firms, especial small ones are unaware of this danger, the risk affects corporations’ loans and investments. Additionally, there is also the protection against the economic exposure which was also analyzed. This is important to any enterprise because it ensures that the income and balance sheet changes are not witnessed. This is known to cause losses from loan repayments and loss of the investments. The price risk management was also pointed as an important tool for stability. This can be solved using the forward and futures, domestic invoicing .Further, the application of leading and lagging is also critical for business. This two implies that the trader pays when the forex conditions seems favorable. Value of the Research The research will help corporations, both local and international in their policy making. There are firms that even at the most competitive time as this, that does not view currency risk management as a tool to give them a competitive edge. However, the study will reveal to them on these issues, through shedding light on how hedging against these risks creates shareholders’ wealth, increase a firm’s competitiveness and ensure trade stability of a firm. Companies can also get crucial information on the available hedging options, ranging from Euro invoicing, use of currency option, forwards, futures and others explained in this paper. Additionally, investors will gain information on the association between the company value and management of risk. Conclusion From all the factors that are listed in the research paper, for importance of a multinational corporation applying the concept of hedging against currency risk, the idea of hedging against currency risk is the most critical of all. As a matter of fact, the currency risks something to do with the balance sheet changes, reported income changes, net cash flow and market value changes. This is because all the trade risk factors discussed in the paper starts with currency fluctuations. This is the most common risk that international corporations faces and is greatly feared because it causes the profits to decline and the Currency risk management through hedging plays a critical part in the portfolio management of Multinational corporations. It is a tool that determines the success of any organization. It is it helps in the lowering of risks in portfolio. However, the currency can increase the profit of a corporation if the exchange rate moves in the right direction. Moreover, the paper offers different options of hedging instruments that a corporation can employ in averting or avoiding these risks. Such includes, invoicing in domestic currency, use of forward s and futures, currency swamps, leading and lagging and currency options. As well as price risk management. The next research on the subject should be conducted on the financial performance of the MNCs. References Biglaiser, G. and DeRouen, K.R., 2006. 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