CHALLENGES IN FORECASTING EXCHANGE RATES BY MULTINATIONAL CORPORATIONS

CHALLENGES IN FORECASTING EXCHANGE RATES BY MULTINATIONAL CORPORATIONS IN GLOBAL FINANCE ERA AUTHOR 1 - MR. SC. MILORAD STAMENOVIC AUTHOR 2 - PROF. DR TATJANA CVETKOVSKI AUTHOR 3 - PROF. DR DINKO PRIMORAC

INTRODUCTION • Among all differences between MNCs and domestic companies, most important one is that MNC have operations worldwide • one of the most important financial issues is dealing with exchange rates and its forecasting • MNC needs to predict future currency movements in order to create environment for decision –making process • Cash flow predictions are closely related to exchange rates predictions • Financial decisions are based on forecasting exchange rate • Reporting of financial statements is obligation of MNC that needs to be accomplished per regulatory requirements (influenced by exchange rates/investment decisions)

WHEN MNC NEED TO FORCAST EXCHANGE RATE • Academic model of IRP, IFE or PPP lead to very strong explanation of exchange rates movements (Madura, Fox 2011) • In practice, theoretical forecasting abilities are not superior; actually, those abilities are on low level of forecasting accuracy • Purchasing power parity, Interest rate parity and International Fisher Effect effect are able to show approximately 10% of changes/variation into exchange rates (Madura J. , Fox R, 2011) • there is problem with underestimated extreme situations and its influence on exchange rate variations • “small” movements can be predicted, but “large” movements cannot be predicted with high level of certainty • MNC’s will much more appreciate forecasting of high movements (long term forecasting)

SIX BASIC CONCEPTS Madura and Fox are relaying on six basic concepts when some Multinational corporation is interested in forecasting future exchange rates: • Hedging decision • Short term financing decision • Short term investment decision • Capital budgeting decision • Earnings assessment • Long term financial decision

Three main types of exchange rate risks (Madura, Fox, 2007) Transaction risk, cash flow risk that deals with the effect of exchange rate moves – it influence to receivables (export contracts), payables (import contracts), or repatriation of dividend. Translation risk, balance sheet exchange rate risk – exchange rate moves to the valuation of foreign subsidiary, and in turn it affects parent company balance sheet. Economic risk, risk to the firm present value of future operating cash flows from exchange rate movements, Economic risk influence on exchange rate on revenues (domestic sales and exports) and operating expenses (cost of domestic inputs and imports).

HEDGING DECISION • Hedging decision is closely related to revealing potential risks which may influence on exchange rate (Papaioannou, 2006) • In practice, chosen hedging strategy mostly depends on frequency of certain type of risk and the size of the MNC (Papaioannou M, 2006). HEDGING TRANSACTION RISK • Transaction risk is often hedged strategically or tactically in order to prevent earnings and cash flows related to the firm views on future exchange rate movements • When using tactical hedging, transaction currency risk from receivable and payable transactions is based on short-term period. • When firm is using strategically hedging, then firm is considering procedures on long term basis.

HEDGING TRANSLATION RISK • Translation risk can be hedged on none systematically basis, mainly in cases of avoiding shock effect on net assets. • risks are mainly related to long term exposure on foreign market. Example could be debt structure of foreign subsidiaries. (Papaioannou M, 2006) • Hedging translation adjustment is used as method for minimizing adverse reactions of exchange rates on net income and cash flows (Bandopadhaya, et al, 2010) HEDGING ECONOMIC RISK • Economic risk is very difficult to be measured - it measures potential impact on the present value from one hand cash flows from the other. • E. g. When inflation rate is followed by exchange rate excursions due to PPP and MNC have subsidiary which is facing inflation above expected inflation rate - competitiveness of the firm can be found as a result of adjustment of exchange rate that is not in line with PPP

SHORT TERM FINANCING DECISION • Most of companies and especially MNC’s use short term financing decisions • Main reason is in reaching access to additional funding. • Decision should be brought on management level and all managers should be informed about potential risks of this type of decision making. • In addition, maximization of value of MNC is expected outcome of use of short term financing decisions (Madura J. , Fox R, 2007).

Short term investment decision • Short term decision is protecting need of Multinational corporations to have new investments that exceeds cash in short period of time. • Ideal situation will be adjustment of exhibiting of high interest rates and strengthening of respective value over time investment (Madura J. , Fox R, 2011).

CAPITAL BUDGETING DECISION • Capital budgeting decision need to be brought in order to investigate investments- especially foreign direct investments. • MNC have to take in account that there will be changes of exchange rates when referring to specific currency. • Analysis of capital budgeting can be managed only in case when all cash flows are estimated and translated to parent company in local currency. • Capital budgeting technique also allows MNC to find best possible solution for further investments.

EARNINGS ASSESSMENT • Multinational corporation parent company need to make decision whether earnings from their subsidiary will be further invested to foreign country or earnings will be sent back to parent company. • Main reason for such decision-making activity is related to exchange rate fluctuations and it could be observed trough translation of earnings into parent company. • As an outcome, result should be evaluated with measured earnings from foreign investment country (Madura J. , Fox R, 2011).

Long term financial decision • MNC financial decision is mostly defined by the interest rates • Cost of long term investment is based on percentage change in exchange rate on currency during loan duration (and on quoted interest rate). • In practice, bonds denominated in foreign currencies have lower yields in U. S. corporations mainly consider issuing bonds in these currencies. • There should be noted that this is not always case. • E. g. Multinational Corporations as Disney, Hewlett Packard and IBM, issued bonds n Japanese yen in order to capitalize because yen has lower interest rate. • There is no guarantee that the bond will be less worth then U. S. dollar bond that is denominated (Madura J. , Fox R, 2007).

RISKS ON SIDE OF MNC RELATED WITH EXCHANGE RATE VARIATION AND EXCHANGE RATE MANAGEMENT Risk related with exchange rate variation: • A common types of exchange rate risk relates to the effect of unexpected exchange rate changes on the value of the firm are following (Papaioannou M, 2006) • Direct – result of un-hedged exposure • Indirect loss – in the firms cash flows, assets and liabilities, net profit, in turn, its stock market value from a exchange rate move

MEASURMENT OF EXCHANGE RATE RISK • Measuring of currency risk may appear difficult, at least with regards to translation and economic risk. (Papaioannou M, 2006) • Transaction exposure is related to cash flow risk. Cash flow will further influence on transaction accounts on side of receivables i. e. export contracts or potentially dividends repatriation. Changing of exchange rate in currency of denomination will further result in direct transaction exchange rate risk for company. (Papaioannou M, 2006) • According to Bandopadhaya, et all (2010), two methods are commonly used for measuring exposure of transactions (2): 1. Net translation exposure measurement 2. Value at risk measurement (VAR)

NET TRANSLATION EXPOSURE MEASUREMENT • This type of risk measuring is used when MNC need to make consolidation from inflows and outflows in foreign subsidiary on currency by currency basis according (Bandopadhaya, et all, 2010). • Advantage of this method is in fact that MNC will be able to identify expected net positions in foreign currency for observed following periods. • After net currency flow is determinated, it can be used as a whole or as a range for specific currency. • Afterwards MNC need to consider ratio between all currencies and to compare with currencies variability and with correlations among currencies Bandopadhyaya, et al, 2010).

VALUE AT RISK • Va. R does not show what happens to exposure (100 -z)% point of confidence – worst case scenario. Because of that, companies often use risk management methods such as stop loss or they put some operational limits. • VAR calculation depends on three parameters (Papaioannou M, 2006): 1. Estimated time for position duration, typically 1 day 2. The confidence level when estimated is planned to be done. Usually it is around 95 -99% 3. Currency that is used for VAR denomination

VALUE AT RISK For Va. R calculation there are many different models, but most used ones are following : 1. The Historical simulation – assumes that currency returns on companies foreign exchange position will have the same distribution as previous was 2. The Variance covariance model – assumes that currency returns on previous position and also that the change of value is linearly dependent on all returns 3. Monte Carlo simulation – assumes that future currency returns will be randomly distributed

EXCHANGE RATE FORCASTING Main approaches of forecasting foreign exchange rates are (Madura J. , Fox R, 2011): 1. Fundamental approach 2. Technical approach 3. Market based 4. Mixed

EXCHANGE RATE FORCASTING • For operation of measuring translation gains and losses and also translation operating exposure MNC need to make accurate estimation of future exchange rates. • In a case of Hedged position, there is option in which such situation could lead to losses in future if exchange rates are constantly differ from forecasted ones. • If analysis is based on empirical results, we can say that results are not still on satisfactory level according to numerous literatures. • General opinion is that spot exchange rate is random-walk and structural exchange rate models are not able to forecast this simple random-walk model.

CONCLUSION • MNCs need to monitor and forecast foreign exchange in order to have clear assessment in regards of their current and future business conditions. • Without sophisticated analyzing of exchange rate movements, MNC will be completely out of data which are of outmost importance for its strategic business activities. • In this paper there is described relation between decision of management for investments, loans, hedging, budgeting on short and long run on one side and further measuring of specific risk exposure of MNCs. • Also, in paper are displayed systems for risk measurement which are highly important for resolving this specific risk issue.

CONCLUSION • MNC management is at high pressure in order to bring appropriate determination of future currency fluctuation. • As most of economics literature states, long term and short term forecasting needs to be done with different analyzing techniques with usage of different models – but long term forecasting is something that is not so reliable for decision making processes. • In managing risks, MNC often use hedging strategies, and specific hedging strategy depends from respective situation. • Hedging strategies becomes very complicated because they are developed to address transaction, translation and also economic risk. • As these risks are something that influence all companies (not considering size of companies) - there is increased number of users of hedging strategies and there is higher demand for hedging protection and also greater variety of hedging instruments (Papaioannou M, 2006).

THANK YOU! Milorad Stamenovic m. stamenovic@rocketmail. com +381 63 273 978