Introduction
The international business environment is complex, dynamic and uncertain, posing challenges for the companies operating in it. Since MNCs extend operations and own assets and liabilities in more than one country, it is imperative for them to understand the underlying risks – financial as well as operational – of the country they plan to expand to. This report provides a comprehensive analysis of the currency risk, and two other associated risks – commodity risk and interest rate risk, faced by MNCs operating in the UK as well as potential hedging strategies that could be used by the same to offset these risks.
Currency risk (also known as exchange-rate risk), is the risk that arises from the fluctuation of exchange rates. It is one of the main challenges for MNCs conducting business in the UK due to their nature of ownership assets or operations across national borders, which may create unpredictable losses/profits for the same. (Chen, 2018).
The transaction risk faced by MNCs pertains to their obligation to conduct payments (incoming or outgoing) in future, expressed in the form of the foreign currency.
The translation risk refers to the risk arising from inaccurately reporting financial statements as the foreign assets and liabilities of MNCs are subject to exchange rate fluctuation. The degree of exposure to this risk has a positive correlation with the proportion of foreign assets and liabilities owned by the company. Economic Risk refers to the unforeseen volatility and its impacts on the future cash Flows and market value of the company. (Picardo, 2017).
UK’s Brexit related political and economic uncertainty increases MNC’s exposure to the aforementioned types of risk, to a threatening extent. Sterling is down by over 10% since the Brexit vote in June 2016. (Srivastava, 2018). In comparison to the US dollar, fell to a 20-month low at $1.25, after a media report that highlighted the rising support of the no-confidence motion vote in Theresa May’s leadership. A 1% change in a day, for a major currency like the Sterling, indicates high volatility. (Finn, 2018). Amidst Brexit-related political and economic uncertainty, it is challenging and unclear for MNCs to forecast such unpredictable exchange rate fluctuations, deeming currency risk exposure to businesses in the UK as ‘High’ Risk.
Hedging Strategy: Hedging through Options is one of the more sophisticated hedging strategies for minimising currency risk that could possibly be used by MNCs operating in the UK. An options contract implies that the buyer of the option is granted the right, but not the obligation, to purchase or sell the respective currency at a specified rate (strike price), on an agreed rate in the future. Call options are one way MNCs are recommended to hedge against fluctuating exchange rates as upon maturity of the contract, the buyer has the choice to exercise the option, depending on whether the spot rate is more/less than the strike price. (Chang and Wong, 2003). If the spot rate exceeds the strike price, the buyer of the option (MNCs) will exercise the option and buy the currency at the strike price. (add advantages) The options hedging strategy requires a premium payable which can be relatively expensive in comparison to other hedging strategies.
Commodity price risk is the financial risk faced by businesses that affect their financial performance and profitability due to fluctuations in commodity prices. Commodities include all the raw materials used by the business in its value chain and as such has a direct bearing on the cost of production. Hence, making it imperative for a business to manage the exposure to commodity price fluctuations across the value chain to safeguard profitability and financial performance. A large number of commodities are used by businesses, the world over, but this report aims to focus on one of the most widely used commodities in the UK – gas. In February 2018, a cold storm called “Beast from the East” led to the rise in gas prices, reaching a 10 year high (Chen, 2018). It was observed that from January to March 2018, the monthly average prices for gas rose from $50.44 to 64.30. (Clarence, 2018). The industries that are affected by the commodity risk of gas are usually in the manufacturing sector like chemical manufacturing, food manufacturing. This commodity risk exposure for companies operating in the UK is deemed to be ‘Medium Risk’.
Hedging Strategy –
Vertical Integration is a strategy in which a firm acquires business operations within its production vertical. MNCs operating in the UK, are advised to engage in backward vertical integration, back to the production process. (Kenton, 2018).
- The rise in the price of the commodity is beneficial for the supplier as it increases its profits, but not for the company, as it increases its cost of production.
- Declining commodity price is beneficial for the company, as it reduces the cost of production, but not for the supplier, as it reduces the profits made by the supplier.
Therefore, an increase in the price of the commodity may increase the cost incurred by the company, but at the same time, it also increases the supplier’s revenue. By merging or acquiring the supplier, the company can significantly offset commodity price risk. Though vertical integration provides effective cost control, a greater degree of supply control and offsets commodity risks, its core disadvantage is that it comes with the high cost of acquiring/merging with suppliers.
Interest rate risk is the risk that fluctuating interest rates will negatively affect the value of investment and interest payments. The bank of England increased interest rates from 0.5% emergency levels to 0.75% base rate, in August 2018, the first time in a decade. (BBC News, 2018). Even though this makes investments attractive in the UK, it increases the cost of borrowing for business operating in the UK. In addition, it can affect the WACC, subsequently resulting in distorted NPV calculations (Garrett, 2016). Rising interest rates promote savings, instead of spending, which is worrisome for MNCs. Due to the relative stability prior to the 2018 increase, interest rates in the UK have been relatively stable hence deeming the interest risk faced by MNCs in the UK as ‘Low Risk’.
Hedging Strategy – Plain Vanilla Swaps
Interest rate swaps are an over-the-counter agreement between counterparties to exchange sets interest payments under a notional principal amount. (Norris, 2018). A plain vanilla swap involves one party is paying a fixed interest rate and receiving a floating rate and the other is paying a floating rate and receiving a fixed rate but only the netted difference between the interest payments changes hands. (Garrett, 2016). By doing this, both businesses can capitalize on fluctuations in different markets and offsetting their risks simultaneously. However, the disadvantages of using interest rate swaps are that the swap market can suffer from a lack of liquidity, and MNCs are dependent on intermediaries to find a good deal with counterparties.
Conclusion
Through the course of the report currency risks, commodity risks and interest rate risks in the UK were analysed and in accordance to this hedging strategies were recommended to MNCs. As of today, the risks faced by the UK, heightened by the political and economic uncertainty caused by Brexit, make the UK a relatively less attractive destination for investment. However, MNC’s that plan to expand to the UK should apply the relevant hedging strategies to offset their risk exposure.