Corporate Risk Management and Multinational Tax

Currency Risk

There are three types of currency risk:

1. Transactional risk or exposure (receivables, dividends, etc.) is essentially cash flow risk.

2. Translational risk (balance sheet) results from the consolidation of group and subsidiary balance sheets, and deals with the exposure represented by foreign investment and debt structure.

3. Economic risk (present value of future operating cash flows) is an overall measure of the currency risk of the corporation.  This risk is focusing on the present value of future operating cash flows and how this changes as a result of changes in exchange rates.

Portfolio Risk

The political climate of foreign countries creates portfolio risks because governments and political systems are constantly unstable.   This has a direct impact on economic and business sectors. Political risk is considered a type of unsystematic risk associated with specific countries, which can be diversified away by investing in a broad range of countries, effectively accomplished with broad-based foreign mutual funds or exchange traded funds (ETFs).

Taxation

Foreign taxation poses another complication. Just as foreign investors with U.S. securities are subject to U.S. government taxes, foreign investors are also taxed on foreign-based securities. Taxes on foreign investments are typically withheld at the source country before an investor can realize any gains. Profits are then taxed again when the investor repatriates his/her funds. 

Fluctuations in the value of currencies can directly impact foreign investments, and these fluctuations affect the risks of investing. These risks work in two ways, in the investor’s favour or not.  For example, if a foreign investment portfolio generated a 12% rate of return last year, but your home currency lost 10% of its value. In this case, your net return will be enhanced when you convert your profits to U.S. dollars, since a declining dollar makes international investments more attractive.  But the reverse is also true; if a foreign stock declines but the value of the home currency strengthens sufficiently, it further dampens the returns of the foreign position. 

Minimizing Currency Risk

Despite the perceived dangers of foreign investing, an investor may reduce the risk of loss from fluctuations in exchange rates by hedging.

What Does Hedge Mean?

It is an investment to reduce the risk of adverse price movements in an asset. Normally, a hedge consists of taking an offsetting position in a related security, such as a futures contract.  For example, investors use this strategy of hedges when they are unsure of the market price in the future.

In the currency markets, speculators buy and sell foreign exchange futures to take advantage of changes in exchange rates. Investors can take long or short positions in their currency of choice depending on how they believe that currency will perform. For example, if a speculator believes that the euro will rise against the U.S. dollar, he or she will enter into a contract to buy the euro at some predetermined time in the future. This is called having a long position. Conversely, at the same time, the same speculator has taken a short position in the U.S. dollar. 
There are two possible outcomes with this hedging strategy. If the speculator is correct and the euro rises against the dollar, then the value of the contract will rise too, and the speculator will earn a profit. However, if the euro declines against the dollar, the value of the contract decreases. 

When the investors buy or sell a futures contract, as in the example above, the price of the good (in this case the currency) is fixed today, but payment is not made until later. Investors trading currency futures are asked to put up margin in the form of cash and the contracts are marked to market each day, so profits and losses on the contracts are calculated each day. Currency hedging can also be accomplished a different way. Rather than locking in a currency price for a later date, you can buy the currency immediately at the spot price instead.  In either scenario, investors end up buying the same currency, but in one scenario they do not pay for the asset up front.

What Does Derivative Mean?

Derivative is a security whose price is dependent upon or derived from one or more underlying assets. The derivative itself is merely a contract between two or more parties. Its value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes. Most derivatives are characterized by high leverage. 

Derivatives are generally used as an instrument to hedge risk, but can also be used for speculative purposes.  For example, a European investor purchasing shares of an American company.  By using U.S. dollars to do so would be exposed to exchange-rate risk while holding that stock. To hedge this risk, the investor could purchase currency futures to lock in a specified exchange rate for the future stock sale and currency conversion back into Euros.

Investing in the Currency Market

The value of currencies fluctuates with the global supply and demand for a specific currency. Demand for foreign stocks is also a demand for foreign currency, which has a positive effect on its price. Fortunately, there is an entire market dedicated to the trade of foreign currencies called the foreign exchange market (forex). This market has no central marketplace like the New York Stock Exchange; instead, all business is conducted electronically in what is considered one of the largest liquid markets in the world.

There are several ways to invest in the currency market, but some are riskier than others. Investors can trade currencies directly by setting up their own accounts or they can access currency investments through forex brokers. Investing in foreign stocks has a clear benefit in portfolio construction. As investors expand their investments overseas, they may wish to implement some hedging strategies to protect themselves from ongoing fluctuations in currency values. 

Example:

The Tsunemasa Tsukada, the chief manager for currencies and financial products in Tokyo stated that the investors in Tokyo are trying to reducing risk involved with currency by going into the yen and Swill Franc as the Mideast and Libya situation has been deteriorated.   Moreover, Asian stocks and currencies fell for the first time in three days as rising violence in the Middle East that drove oil price higher.

It can be seen from above that exchange rate play a vital role in economy especially with multinational investors.  The risks involved in currency have led many companies to shift their businesses for example, from Libya or other countries where the conflict is being taken place.  I can argue that the importance of having one business currency around the world might eliminate the confusion and stable the economy.