The Role of Multinational Firms in Foreign Exchange Markets - dummies

The Role of Multinational Firms in Foreign Exchange Markets

By Ayse Evrensel

The term multinational firm refers to a wide range of domestic firms that are engaged in business with foreign countries in different ways. One point to remember is that, independent of the type of foreign involvement, all multinational businesses deal with exchange rates. Multinational companies have to buy or sell foreign currency as part of their daily business. Therefore, these companies face foreign exchange risk every day.

A short definition of foreign exchange risk is the possibility of losing money when you buy or sell currency because of unexpected changes in exchange rates.

Some multinational companies are export or import firms. These companies are engaged in selling domestic goods abroad or buying foreign goods. Therefore, an American company that exports to Germany is a multinational company. So is an American firm that imports from Germany. Exchange rates affect both types of firms.

For example, if the American firm bills the German importer in euros, the former receives its payments in euros. But an American firm can’t use euros in its daily business, so it sells euros as soon as it receives them. Conversely, the American firm may bill the German importer in dollars. Then it becomes the German importer’s responsibility to buy dollars and pay the American exporter.

Other domestic firms may be involved in the production of goods in foreign countries in a variety of ways.

Licensing means that a firm provides its technology to another firm abroad in exchange for a fee. Depending on the currency in which the fee is denominated, one of the firms faces the foreign exchange risk.

The September 17, 2012 issue of Pharmaceutical Business Review reported that the Canadian vaccine developer Medicago entered a licensing agreement with the American firm Philip Morris Products (PMP) to allow PMP to use Medicago’s proprietary vaccine-manufacturing technologies for developing and manufacturing pandemic and seasonal influenza vaccines in China. Medicago received fees totaling $7.5 million, as well as royalty payments on future sales of pandemic and seasonal influenza vaccines produced by PMP in China.

In this example, you know the amount of the licensing fee, but you don’t know the denomination PMP plans to use. If PMP pays the licensing fee from its dollar accounts in the United States, it doesn’t face an exchange rate risk. But Medicago, a Canadian firm, is going to receive periodic U.S. dollar–denominated payments.

If Medicago wants to convert these fees into Canadian dollars, it exposes itself to changes in exchange rates. Alternatively, if PMP pays the licensing fee out of its revenues in China by exchanging yuan into dollars (unless the Chinese government has restrictions on payments denominated in yuan), PMP and Medicago are both exposed to exchange rate risk.

Franchising implies that a domestic firm allows its production, sales, marketing, and management strategies to be used in a foreign market in exchange for a periodic payment. You see such chains as Starbucks, McDonald’s, and Pizza Hut around the world; to open these businesses in other countries, foreign firms need to have franchising agreements with these American companies.

The September 7, 2012 issue of Business Day reports that international franchises are opening new locations in Africa, where the demand for their products is strong, unlike in stagnant developed markets. Hilton Hotels, Kentucky Fried Chicken, and fashion retailer Mango are just a few companies that are expanding their franchising in Africa. The franchising industry employs an estimated 500,000 people in Africa, and nearly 700 brands operate franchises there.

If American firms are franchised in Africa, the American firms collect franchising fees from African owners of these franchises. If American firms want to receive their franchising payments in dollars, the African owners face the exchange rate risk. Because their revenues are in local currencies, they need to convert some of their revenues into dollars to pay the franchising fee.

Domestic firms engage in joint ventures with foreign firms. A joint venture is a business arrangement between two businesses to produce a particular good, where these firms share expenditures, revenues, and assets. For example, an American firm may enter a joint venture to test the waters before entering a foreign country on its own. Or an American company may want to use the existing distribution network of a foreign firm to sell its product abroad.

The September 24, 2012 issue of the Washington Post reported that breakfast giant Kellogg formed a joint venture to expand the distribution of its cereals and snacks in China in 2013. Kellogg plans to tap the infrastructure and local expertise of Wilmar International, a Singapore-based agribusiness.

In this case, Kellogg is likely to pay Wilmar for the privilege of using the latter’s infrastructure and expertise. Suppose Kellogg provides these payments in U.S. dollars. This form of payment shifts the exchange rate risk to Wilmar, which has to convert these U.S. dollars into a combination of Singapore dollars and Chinese yuan to pay for the expenses of including Kellogg in its network in Singapore and China.

Domestic firms may buy existing firms abroad, which involves the acquisition of existing foreign firms. An acquisition allows an American firm to enter a foreign market with an existing production facility and a distribution network.

The September 26, 2012 issue of Businessweek reported that Canada’s Onex Corporation was in talks to buy KraussMaffei AG, a German maker of machinery for processing plastics and rubber. Onex reportedly planned to pay €568 million for KraussMaffei, the company’s first European-based acquisition.

In this news article, the payment for the German company is discussed in euros. The Canadian buyer, Onex Corporation, faces exchange rate risk here, especially if acquisition payments are to be made in installments.

Domestic firms establish new subsidiaries in other countries. The term foreign direct investment (FDI) refers to establishing a new production facility, distribution network, management, and so forth in a foreign country.

On September 18, 2012, reported on the global appeal of Mexico for FDI. The country attracted more than $19 billion FDI in 2011, and half of this investment went toward manufacturing. Major automakers, such as General Motors, Nissan, Audi, Honda, and Mazda, recently announced plans to open plants in Mexico during the next few years.

Many other companies, including aluminum producer Alcoa, General Electric, Honeywell, Hawker Beechcraft, and Swedish appliance maker Electrolux, already have production facilities in Mexico.

These American, Japanese, and European firms are engaged in FDI, which indicates substantial new investment in a foreign country. Therefore, parent companies have to transfer funds denominated in foreign currency to the FDI-receiving country. Also, depending on the FDI-receiving country’s restrictions, parent companies may receive income/profits from their foreign operations denominated in foreign currency. All these activities imply exchange rate risk.