MGMT S-2710 By: Cesar M. Fernandez H. Summary of: Hedging Currency Exposures by Multinationals: Things to consider by Ira G Kawaller.

Multinational corporation manage the inherent risk of developing business enterprises across different countries. It entails being exposed to different social, political and economic risks, which in some cases are unpredictable and, therefore, difficult to prevent. Currency risk is one of the most volatile, both in the short term and long term, faced by a multinational corporation doing business across countries that use different currencies. In today's modern financial markets, there are a number of financial instruments designed to reduce this risk. Future contracts, options and forward contracts have all helped to minimize the risk for corporations whose subsidiaries do business with different "functional currencies"(Kawaller 92) This refers to the currency used by the business units, or, in other words, in which all transactions are denominated. Therefore, a multinational corporation, with business units across the world, would have different functional currencies and a different currency used by the consolidated firm. So, how should this risk be managed? Should each independent subsidiary manage its risk only considering the currency risk they are exposed to? The easy answer would be yes, hedging should occur whenever the consolidated firm presents in its balance sheet the assets or earnings of the subsidiary in other than their local functional currency. However, a study done by Ira Kawaller has shown that it may be against the consolidated firm's interest to expose currency risk from its subsidiary. Managers should analyze wether currency risk really exists, as some operations may offset it by only looking at the risk through the subsidiaries lens. For example, sales and purchases in the same denominated currency are natural offsets of each other and, therefore, this should be something to take into account if the subsidiary is buying products in the same currency as the consolidated firm. Hedging to prevent currency risk can be done through different financial instruments. By using a forward contract, a multinational corporation can have a guaranteed exchange rate for a transactions that will happen sometime in the future. Options can also be used to offsets the volatility of currencies by offsetting a loss through the purchase of a financial instrument whose value is derived from the currency in question. Therefore, there are various instrument at hand for managers to limit the exposure to currency volatility. However, as mentioned in the article, it depends on the analysis of managers to decide if their exposure requires hedging. The article exposes that only "excesses", which could represent an unbalance between purchases and sales in a denominated currency, should be considered currency risk (Kawaller 93). Those are the exposures that should be considered for hedging. But manages should be very diligent in their task of calculating the magnitude of those exposures so that risk is adequately managed. If not, the hedge could become costlier than the eventual risk.

Furthermore, they should take into account the inherent risk to the business unit as well as to the consolidated firm. Once the potential currency exposure has been adequately identified, a different problem, according to the article arises: risk should be managed by taking into consideration the risk at the unit level - the business unit - and at the consolidated level. Unit managers and corporate managers should be able to find the adequate equilibrium asses the risk by analyzing it through the eyes of both the business unit and the consolidated. Currency exposure at the business unit level may not translate into the same exposure if looked through the lens of the consolidated firm. For example, as exposed in the article, hedging activities may introduce new risks at the consolidated level (Kawaller 94). The costs of hedging, can have greater changes on net income than unhedged activities. Therefore, there should be an exhaustive analysis of the real exposure to currency risk at the business level and if that risk prevails, decreases or increases at the consolidated level. Individual cases have distinct variables and, as always, managers have the discretion to value them according to their own standards. On how well they are able to appraise the risk depends how appropriate the solution they design is. that an appropriate solution is developed.

Works Cited Kawaller, Ira G. Hedging Currency exposure by Multinationals: Things to consider. Journal of Applied Finance: 18 92-98. Tampa, Spring 2008