Reference no: EM13208726

Discuss the following topic: "Should a multinational firm risk overhedging?" Some have argued that exchange rate risk is irrelevant. One argument for exchange rate irrelevance is that according to purchasing power parity theory, exchange rate movements are just a response to differentials in price changes between countries. Therefore, the exchange rate effect is offset by the changes in prices. A second argument for exchange rate irrelevance is that investors in multinational firms can hedge exchange rate risk on their own. Another argument is that if a U.S.-based multinational firm is well diversified across numerous countries, its value will not be affected by exchange rate movements because of offsetting effects. Some critics also argue that if stakeholders (such as creditors or stockholders) are well diversified, they will be somewhat insulated against losses experienced by a multinational firm due to exchange rate risk.These contentions, in turn, have resulted in counterarguments from multinational firms. They argue creditors that provide loans to multinational firms can experience large losses if the multinational firms experience financial problems. Thus, creditors may prefer that the multinational firms maintain low exposure to exchange rate risk. Consequently, multinational firms that hedge their exposure to risk may be able to borrow funds at a lower cost.

Instructions:

1- To read the point and counter-point of this argument and express your own opinion on this topic :

Point: Yes

Multinational firms have some "unanticipated" transactions that occur without any advance notice. They should attempt to forecast the net cash flows in each currency due to unanticipated transactions based on the previous net cash flows for that currency in a previous period. Even though it would be impossible to forecast the volume of these unanticipated transactions per day, it may be possible to forecast the volume on a monthly basis. For example, if a multinational firm has net cash flows between 3,000,000 and 4,000,000 Philippine pesos every month, it may presume that it will receive at least 3,000,000 pesos in each of the next few months unless conditions change. Thus, it can hedge a position of 3,000,000 in pesos by selling that amount of pesos. Any amount of net cash flow beyond 3,000,000 pesos will not be hedged, but at least the multinational firm was able to hedge the minimum expected net cash flows.

Counter-point: No

Multinational firms should not hedge unanticipated transactions. When they overhedge the expected net cash flows in a foreign currency, they are still exposed to exchange rate risk. If they sell more currency short from forward contracts than their net cash flows, they will be adversely affected by an increase in the value of the currency. Their initial reasons for hedging were to protect against the weakness of the currency, but the overhedging described here would cause a shift in their exposure. Overhedging does not insulate a multinational firm against exchange rate risk. It just changes the means by which the multinational firm is exposed.