Solved Essay! Explain how Volkswagen’s failure to fully protect itself against foreign exchange fluctuations had a

Expert Answer

Recently, both company as well as media have claimed that short currency exchange rate fluctuations are negatively affecting the stock returns of the firms.

However, most previous studies focusing on companies in the US and Asia have been unable to find empirical support for a statistically significant linkage between firm value and exchange rate risk. By using a quantitative method with a deductive approach, the present research investigates currency exchange rate movements impact the stock return of European based car companies with market interests in the US.

In addition, three macroeconomic factors:

• GDP,
• stock market index and
• Oil price

form the basis of any such exchange movements. By analyzing the annual report of the companies, we found that derivatives instruments such as currency option, foreign exchange forwards, currency futures and currency swaps were used to hedge exchange risk. This might be one of the reasons why it was difficult to capture exchange rate risk.

Another reason is the company is more exposed to exchange risk due to its large exporting activitycompared to the other similar companies.

Companies with overseas branches, or those that trade internationally, are at the mercy of global currency fluctuations. As is the case with private investments, changes in conversion rates can wipe out profits or increase gains.

When a firm has shareholders to report to, and the figures can run into millions, then it can have a serious impact on profits and losses. The rapidly changing currency landscape can have the potential to make businesses reluctant to set firm figures in contracts months before a deal takes place. If a US-based firm makes EUR 10 million, they can end up with much more or less than they thought depending on the movement of the EUR/USD exchange rate. For example, in June 2011 it would have been worth $14.4 million, but in June 2012 it would have been worth $2 million less.

These issues also exist when discussing contracts with international clients. Although something may seem like a good deal when it is first written down, it can turn bad a few months later when the contract is fulfilled.

Foreign currency effects are estimated to negatively impact net revenue growth by approximately 200-300 basis points in the first quarter

What can firms do?

As with private investors, business essentially have four options to counteract their currency exposure.

The simplest approach is just to monitor the changes, and this can be the best option if companies do not think that they are at a particularly high risk from exchange rate fluctuations.

Another option is to lock into an exchange rate for a fixed period of time by setting up a forward contract. If the exposure estimates are correct, this can be a beneficial approach. Some businesses will also purchase currency in advance if they know that they will be making big purchases and are concerned about volatility.

A third option is to hedge against this exposure via derivatives. Although this may be the most complicated option, it can be effective in limiting exposure to volatility. It can also give a clearer picture of how a company’s overseas operations are really performing.

Finally, firms can choose to manage their currency exposure through business practices. Having a truly international company can help with this as, theoretically, losses made when one currency falls will be recovered when another rises. Where contracts are concerned businesses can also set up clauses that reduce this exposure. In many cases this comes in the form of an agreement to protect the client and the company should exchange rate movements exceed the agreed-upon level. Some businesses also agree on setting all contracts in their core currency, protecting them from any exposure as they will always be paid the same relative amount.

Dealing with currency exposure is all about managing risk, as fluctuations are by their very nature unpredictable. However, while private investors only have their own savings to worry about if they fail to manage this risk appropriately, businesses face angry shareholders and a drop in share value – as well as a drop in profits.

(Source:Diva portal and Euroinvestor)