Decision Analysis for Exchange Risk Management

Abstract

One of the factors which complicates financial decision making in a multinational enterprise is currency devaluations or revaluations in countries where subsidiaries are located. Since exchange rate changes affect the reported earnings, value of financial assets, and future earnings of the multinational corporation, it is imperative that the financial decision maker of such a firm develop a strategy to manage the foreign exchange risk assumed by the firm. It is the purpose of this article to develop relatively formal decision rules for managing the risk of exchange rate change. These rules are based on an analysis of a theoretical decision model of the exchange management process. The inherent uncertainty involved in exchange rate movements is the basic feature of the exchange risk situation. The nature of an optimal decision thus will depend on the attitudes of management toward risk and uncertainty. Four common attitudes will be assumed and examined: minimum variance, minimax, expected monetary value, and expected utility. Each yields a particular set of optimal rules for exchange risk adjustment. Three techniques are available for adjusting the exchange risk posture of the firm. These are (1) adjustment of funds flows, (2) forward contracts, and (3) exposure netting. Adjustment-of-funds-flow techniques involve an alteration in the planned funds flows of parent and/or subsidiaries, in amount and/or currency of denomination, with the view of reducing (or increasing) the local currency accounting exposure of the corporation. This exposure is defined as the difference in local currency assets translated to domestic currency at the current exchange rate and local currency liabilities translated at the same exchange rate. If the objective of management is to decrease exposure, the technique must increase local currency denominated liabilities or decrease local currency denominated assets. Techniques for increasing liabilities include local borrowing and stretching payables. Techniques for decreasing assets include reduction of cash balances and other liquid assets, reduction in investment in accounts receivable (either by tightening credit terms or factoring), and reduction in inventory investment (if inventories are translated at the current exchange rate). Each of these techniques generates local currency funds. If exposure is to be reduced, these funds must be used to acquire assets which are not exposed to the exchange risk. For example, if the parent corporation had planned to provide domestic currency funds to the subsidiary, locally generated funds can replace funds from the parent. Alternatively,