Exchange-rate risk is the effect on profitability and ASSETS that can occur as a result of changes in EXCHANGE RATES. Exchange rates are the value of one country’s currency in terms of another country’s currency. As the value of one currency increases, the value of the other currency decreases. For most of the 1990s, the U.S. dollar appreciated against most of the other world currencies. As the dollar increased in value, U.S. companies doing business in other parts of the world saw their PROFITs, earned in other currencies, decrease when converted to dollars. For example, in 2000 Coca-Cola Company warned investors of declining profits from foreign operations due to appreciation of the dollar. By contrast, foreign companies earning profits in dollars saw their earnings increase when converted to their home country’s currency. Many factors influence exchange rates, including changing DEMAND for U.S. products and foreign products, changes in investment opportunities both in the United States and elsewhere, and changes in expectations of speculators in FOREIGN EXCHANGE markets. Most business manager try to make profits not by successfully predicting the direction of exchange rates but by selling their products and services. To reduce exchange-rate risk, managers
• hedge in foreign exchange markets
• diversify operations
• borrow in the currency used for investing
HEDGING involves buying or selling FUTURES currency contracts. Many exchanges (in the U.S., particularly the CHICAGO MERCANTILE EXCHANGE) offer currency futures contracts. A company, expecting payment in another currency six months from now, when the job is completed, could sell a futures contract for that amount of the currency. If, in the interim six months, the value of that currency declined, they will be able to buy back the futures contract at a lower price, offsetting the decline in value of the payment they receive. By diversifying operations, MULTINATIONAL CORPORATIONs (MNCs) can also reduce their exchange-rate risk. Many global automobile manufacturers have set up factories in the markets they sell in. By producing in markets where they sell, companies incur their costs and generate their revenue primarily in the host country’s currency. This reduces the impact of changing exchange-rate values. Similarly, MNCs reduce exchange-rate exposure by borrowing in the currency they are investing in. By borrowing in U.S. dollars, Japanese automobile manufacturers building plants in the United States incur their financial costs in the same currency as their received revenue. While most of this discussion has focused on MNCs involved in or exposed to exchange-rate risk, almost every business is vulnerable to changing exchange rates. In the early 1990s, when the U.S. dollar was declining, a Wall Street Journal article described the impact of the dollar decline against the Japanese yen in Troy, Ohio.
• Japanese automobiles were $2,000 more than comparable domestic models.
• The price of pearls and cameras also rose.
• Japanese robots used in the production of U.S. cars became more expensive.
• Farmers hoped the declining dollar would increase demand for local corn and soybeans.
• A local economic development officer speculated Japanese companies would be more interested in building factories in the area.