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
Continue with the Strategy of choice - Calculate the Net Present Value (NPV) - Determine the Internal Rate of Return (IRR) - Set Electrolux’s Required Rate of Return (RRR) E

Question: a) Provide an analytical derivation of the Capital Asset Pricing Model (CAPM) and supplement your analysis with diagrammatic illustrations where appropriate. b) T

Preview division divides M proportional to preview demand, i.e., each SKU n 2N gets fraction This method is included because it is used by the case company, in combination

The Minister of Finance decides to review the existing legislation regulating banks and non-banking entities. You have been appointed as Advisor to the Minister to work on the pro

Question: a) Using illustrative and numerical examples, differentiate between arbitraging and speculation in the context of foreign exchange market. b) One year borrowing

Question: a) Differentiate between interest and currency swaps. b) You are the corporate treasurer of Quinnie International Inc. Your firm, rated as AAA, is able to raise

I purchased an answers document from your site 5 hours ago and it isn''t still delivered. It said that it would take up to 2 hours but it isn''t still delivered. When will it be de

A owns all of the X stock with a basis of $200. A's three sons own all of the Y stock equally. X and Y each have E&P of $100, respectively. A sells one half of the X stock to Y

Question: 1929/ 2009: a remake of the worst financial crisis affecting the whole world? Central Banks and Governments are implementing all sorts of rescue plans incorporatin

Your boss is trying to figure out when to replace an important piece of machinery in your main production facility.  The Siemens NR550, costs $5.45 million brand new and generally