Mncs do increase their risk by borrowing foreign currencies, Corporate Finance

According to those who are in favor of borrowing, the MNCs can achieve lower financing costs and hence their competing ability is improved. But according to the international fisher effect, "the percentage change in the spot exchange rate of a currency in terms of another will, on average, equal to the differential of interest rates between the two countries". This is expressed in the below equation (Carey & Essayyad, 1990). 

Change in spot rate of foreign currency =

(1+ interest rate in the home country) – 1 /(1 + interest rate in the foreign country)

                Suppose a dollar debt can be obtained at 10% and a pound debt can be obtained at a cheaper 5%, according to the international fisher effect, the interest rate differences will be soon converted into appreciation on pound and depreciation on dollar, which implies that pounds are not cheap to borrow just because the interest rate on pound is lower comparatively. According to the international fisher effect, exchange rate in due course will balance the interest rate differentials.

Though international fisher effect has been proved to not work in reality by many, there are also evidences wherein it holds. For example, a study by Utami & Inanga (2009) has proved that international fisher effect holds for Indonesia. Hence this theory cannot be held aside. Hence the argument of those in favor of borrowing cannot hold when international fisher effect holds. The lower financing costs will be soon converted into exchange rate appreciation and depreciation, thus making both costs equal or at least approximately equal ultimately.

In addition, the international fisher effect has been known to hold at best in the long term compared to the short term. According to Bartram et al (2005), there is existence of foreign exchange rate risk because both PPP theory and international fisher effect holds in the long term much better. There are many other studies and research papers that prove the same as well. The foreign borrowing will be utilized especially by the MNCs for long term purposes. Hence it is again proved that the low cost of financing will be soon compensated through the changes in the respective exchange rates.

Thus the attractiveness of lower costs of financing will increase the foreign exposure of multinational companies, thus increasing their risk as well. With increased risk, the company would have to take precautionary measures such as hedging through various derivative instruments. This just increases the cost incurred by the firm and overall, with higher costs, the company's competitive ability is lowered in the global as well as domestic level thus leading to high failure chances for the business.       

 Thus I strongly believe that Multinational Corporations increase risk when borrowing foreign currencies. 

Posted Date: 10/1/2012 8:04:59 AM | Location : United States







Related Discussions:- Mncs do increase their risk by borrowing foreign currencies, Assignment Help, Ask Question on Mncs do increase their risk by borrowing foreign currencies, Get Answer, Expert's Help, Mncs do increase their risk by borrowing foreign currencies Discussions

Write discussion on Mncs do increase their risk by borrowing foreign currencies
Your posts are moderated
Related Questions

how can i rank a project when there are conflict between IRR & NPV

Question: (a) What are the differences and similarities between futures and forwards? (a) Distinguish between exchange traded instruments and over the counter instruments

Question 1: Capital Expenditure Decisions and Investment Criteria (30 MARKS) In recent years Morten Ltd, a company that manufactures and markets a range of p

how would the use of the concept of value added reduce the problem of agency conflict

The Vodafone Corporation arranged a one-year, $1.5 million loan to fund a foreign project. The loan was denominated in Euros and carried a 10% nominal rate. The exchange rate at

Q. Establishing the scale and cost of phoenix activity? In 1996, the Australian Securities Commission (ASC, now ASIC) quantified the annual loss to Australian businesses due to

(a) Accurate estimation is crucial for effective planning and control and is related with time, information, experience of estimator, techniques used and funding. Discuss the thre

Question 1: (a) Explain and comment on the various rationales presented to support the combination of two companies in a merger or takeover. (b) What are two theoretical r