Translation risk arises due to variance in exchange rate used in expressing the portfolio components in the books of multinational firms. The higher the portfolio components in the books of the company, the higher the translation risk. Bearing in mind, this kind of risk, several ways have been suggested, and most of them adopted to cushion the multinational against this type of risk. This article will briefly discuss the available ways of cushioning a company against this risk.
This type of risks is mostly felt by companies that operated cross border businesses and particularly where a single currency is accepted as medium of exchange like it is accepted for in a currency union jurisdiction.
The most commonly applied techniques are the financial hedging method. This method utilizes the financial instruments in curbing this risk. The most applied financial instruments are applied as follows;
Hedging transaction exposure using forward contracts in which the company forecasts the expected future transactions in which it’s expected to pay or receive a well-defined amount. The company will then define a specific price that will be paid or received for that date irrespective of the exchange rate that will be prevailing at that time. This provides a true certainty and prevents the company against losses that may arise due to unpredictable exchange rate surges at the future date. This is well defined at the transactional contract that wiping out any chances of default when that transaction dates checks in.
Companies also apply futures contract which are inherently different form forward contract in that their distinct features define the transactional contract sizes, currencies applicable, initiating collaterals maturity dates and other defined features. Given that futures contract arises with these defined parameters, it’s hard to declare a certainty against cushioning from this translational risk.
Multinational also adopt money market hedges to cushioning themselves against this translational risk, whereby they utilize the covered interest rate parity. This strategy provides that the forward price should be equal to the current spot exchange rate multiplied with the ratio of the two currencies in question riskless returns. This strategy converts the liability into a local currency and writes off all unseen exchange risks.
Companies that deal with multiple currencies have also adopted the options strategy, in which foreign currency options have upfront fee giving the owner the right but not an obligation to either transact the domestic currency for foreign currency or vice versa at a specified price, quantity and defined period in the future. The options strategy provides a leeway to avoid the risk in case it will have far reaching effect as it only gives a right but not an obligation. It’s the mostly adopted strategy by many companies. This options strategy unlike the other discussed above gives a nonlinear results as they will allow for the avoidance of downside risks without minimizing the benefits from the upside risks.
Several types of options are applied depending on the transactional time and the expected payoff or possibility of a payoff. Average rate options, commonly known as look back option, has a defined pay off price and not the spot price, it applies an average spot price over the lifetime of the contract. Companies that apply this type of strategy are those that have a steady and predictable stream of inflows and outflows in a specified currency or currencies over the specified lifetime. A large average rate option will act a good hedge for the entire specified stream of inflows or outflows over the specified period.
Another option type used is the basket rate option in which the multinational corporations avoid buying currencies individually and opt to buy options based on some weighted average of currencies that match its transaction pattern. Since the currencies are not correlated, the weighted average exchange rate is definitely less volatile making it a more favorable and profitable option.
Regardless of these suggested and applicable ways of hedging against translational risk, multinationals still encounter this risk in a significantly big way. Most of them have only been able to reduce but not eliminate this type of risk.
Insurance companies have been keenly evaluating the pros of covering this risk at a premium and most companies are likely to accept if packaged at their advantage.
Multinational companies which have been hardly hit by this type of risk have also adopted the strategy of establishing their businesses in territories that have a single currency such as the European Union where they will not suffer from this type of risk. These multinational corporations have also championed for the establishment of currency union where a single currency will be generally accepted for all the cross border transactions. Such currency unions will reduce the resources directed in evaluating this type of risk and especially for corporations that have business establishments in multiple states applying different currencies.
This risk can be totally written off but through advancement in global business it can be reduced to an acceptable level. In a nutshell, translational risk hedging is a topic that has continued to evolve with its own solutions and challenges.
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