Do Exchange Rates Really Matter?

There are several schools of thought with regard to the significance of exchange rates and its effect on MNCs. According to Madura (2008), “Some have argued that exchange rate risk is irrelevant” (p. 280). Proponents of this theory subscribe to one of a number of ideas that assert that either purchasing power parity exists, that risk can be hedged, and/or attest to diversification arguments. In theory, or rather in a perfect world, prices would be offset, perfect knowledge of markets would exist, and MNCs would be equally exposed in all currency markets. However in the real world, these arguments largely do not hold. Organizations must remain aware of their potential exposure in order to remain successful.

There are three major forms wherein exchange rate exposure surfaces: transaction, economic, and translation exposure. Transaction exposure is essentially the net cash flow position at any given time taken as a whole of the organization in each currency. In certain cases, a negative cash flow in one currency might be off-set by an equal and positive cash flow by a different division within the same organization. This event would fit the idealized scenario of those who subscribe to the currency diversification argument. Unfortunately, the probability of this perfect storm occurring is gaunt.

According to Madura (2008), “The sensitivity of the firm’s cash flows to exchange rate movements is referred to as economic exposure” (p. 289-290). Economic exposure is the result of internal conditions of the host country as they relate to the ability of countries to find less costly equivalent products elsewhere. Translation exposure results from the need to exchange currency (on paper) to create financial statements in the host country of the MNC. Some may argue that this will not affect the bottom line of the organization. However, the reduction of earnings on the balance sheet will ultimately reduce the valuation of the organization, thereby reducing the optimal capitalization. Exposure to exchange markets can have a significant effect on the organization. Organizations must carefully monitor their potential to be influenced by these markets.

References

Madura, J. (2008). International Financial Management (9th ed.). Ohio: Cengage Learning
Keyword: management cadre, global economy, international business, exchange rates, economic incentive, foreign investment