What factors are likely to affect Multinational Industries’ hedging decision?
Solution. Risk aversion could lead MII to sell its receivables forward to hedge their dollar value. However, if MII has pound liabilities, they could provide a natural hedge and reduce (or eliminate) the amount necessary to hedge. The existence of a cheaper hedging alternative, such as borrowing pounds and converting them to dollars for the duration of the receivables, would also make undesirable the use of a forward contract. This latter situation assumes that interest rate parity is violated. The tax treatment of foreign exchange gains and losses on forward contracts could also affect the hedging decision.
Under some circumstances, a company may benefit at the expense of the local government without speculating. Such a circumstance would involve the judicious use of market imperfections or existing tax asymmetries, or both. In the case of an overvalued currency, such as the Mexican peso in 1982, if exchange controls are not imposed to prevent capital outflows and if hard currency can be acquired at the official exchange rate, then money can be moved out of the country via intercompany payments. For instance, a subsidiary can speed payments of intercompany accounts payable, make immediate purchases from other subsidiaries, or speed remittances to the parent. Unfortunately, governments are not unaware of these tactics. During a currency crisis, when hard currency is scarce, the local government can be expected to block such transfers or at least make them more expensive.
Another often-cited reason for market imperfection is that individual investors may not have equal access to capital markets. For example, because forward exchange markets exist only for the major currencies, hedging often requires local borrowing in heavily regulated capital markets. As a legal citizen of many nations, the MNC normally has greater access to these markets.
Similarly, if forward contract losses are treated as a cost of doing business, whereas gains are taxed at a lower capital gains rate, the firm can engage in tax arbitrage. In the absence of financial market imperfections or tax asymmetries, however, the net expected value of hedging over time should be zero. Despite the questionable value to shareholders of hedging balance sheet exposure or even transaction exposure, however, managers often try to reduce these exposures because they are evaluated, at least in part, on translation or transaction gains or losses.
In one area, at least, companies can reduce their exchange risk at no cost. This costless hedging technique is known as exposure netting.