MANAGING EXCHANGE RATE RISK OF A MNC Mexico and United States PRINCE MOHAMMAD BIN FAHAD UNIVERSITY College of Business Administration MANAGING EXCHANGE RATE RISK OF A MNC Mexico and United States A Case Analysis Prepared By: Mohammed Ibrahim Al-Shdoukhi 200700540 Ali Al-sulaiman 200700672

The MNC is engaged in manufacturing steel The MNC is engaged in manufacturing steel. The steel will be used by Mexican manufacturing companies as input to their final products as body parts of cars, machinery, equipment and other similar uses. The MNC will establish a new foreign subsidiary in Mexico. The MNC will benefit from the cheap labor cost in Mexico. Having a plant in Mexico means that transportation expenses will be minimized. The MNC will also be closer to the customers; this results in cheaper, more time efficient of getting the goods to the customer.

Mexico Foreign Trade Relations and Barriers Mexico’s trade policy is one of the most open in the world as evidenced by its growing commitments to trade integration and liberalization through memberships in free trade agreements (FTSs). Mexico has a total of 12 free trade agreements involving 44 countries.   The steel industry in North America is faced with border issues. Regulatory mandate by the government includes; Load limits- load weight restrictions Trucking hours of service rules Rail Issues Steel Import Permits and Licenses Harmonized Tariff System (HTS) Codes Cargo Insurance Freight Forwarding Mill Certificates

A higher Mexican Peso to US Dollars exchange rate means the strengthening of US Dollars against the Mexican Peso. One of the main reasons why the Mexican peso weakened against the U.S. dollar is the announcement of US expectations of sluggish growth in the world's largest economy and Mexico's main trading partner. The Mexican peso performance is very dependent on the global investor sentiment about the European debt crisis and prospects for US economic growth. Despite Mexico’s good economic fundamentals like strong growth rate, relatively high interest rate, low inflation and healthy fiscal policy, the Mexican peso continues to be weak

The MNC will obtain a contract to sell MXN 10,000,000 in 30 days. Hedging Exposure to Receivables of MXN 10, 000,000 in 30 days foreign exchange rate is expected to depreciate Forward/Futures Hedge- Sell a currency futures/forward contract representing the currency and amount related to the receivables. The MNC will obtain a contract to sell MXN 10,000,000 in 30 days. If the forward rate is USD 0.076075, the expected dollars to receive in 30 days is USD 760,750 (USD0.076075 x 10,000,000). The MNC is protected against fluctuations in exchange rate in the future because it has already a contract to sell MXN peso at an agreed rate after 30 days.

Hedging Exposure to Receivables of MXN 10, 000,000 in 30 days foreign exchange rate is expected to depreciate Money Market Hedge- Borrow currency denominating receivables and convert to home currency. Invest these funds. The MNC will borrow today MXN Peso, if the bank rate is 4% in 30 days, the MNC can borrow today MXN 9,615,384.615 (10,000,000 / (1+.04). The MXN 10,000,000 receivables in 30 days will be used to pay for the loan when it becomes due in 30 days. The funds borrowed can be used to support operations and it can also be invested to earn profits. Given the spot rate of USD 0.0766918, the amount of dollars that can be invested would be USD 737,421.1538 (MXN 9,615,384.615 x USD 0.0766918). This amount can be invested for 30 days assuming the bank rate is 3% in 30 days giving USD 759,543.7885 (USD 737,421.1538 x 1.03).

Hedging Exposure to Receivables of MXN 10, 000,000 in 30 days foreign exchange rate is expected to depreciate Currency Option Hedge- Purchase a currency put option representing the currency and amount related to the receivables. The MNC can purchase a put option on the MXN 10,000,000, given the exercise price of USD 0.076075 and a premium of $0.01and the expiration date is 30 days. At any spot rate less than or equal to USD 0.076075, the MNC will exercise the put option. At any spot rate more than USD 0.076075, the MNC will let the option expire and will sell the MXN peso at the prevailing spot rate in the foreign exchange market.

Hedging Exposure to Payables of MXN 2,000,000 in 30 days foreign exchange rate is expected to appreciate Forward/Futures Hedge- Buy a currency futures/forward contract representing the currency and amount related to the payables. The MNC will obtain a contract to buy MXN 2,000,000 in 30 days. If the forward rate is USD 0.076075, the expected dollars cost is USD 152,150 (USD0.076075 x 2,000,000). The MNC is protected against fluctuations in exchange rate in the future because it has already a contract to buy MXN peso at an agreed rate after 30 days.

Hedging Exposure to Payables of MXN 2,000,000 in 30 days foreign exchange rate is expected to appreciate Money Market Hedge- Borrow home currency and convert to currency denominating payables. Invest these funds until they are needed to cover the payables. The MNC will need to deposit MXN Peso to cover the payables in 30 days. If the rate in 30 days is 4%, the amount of MXN Peso needed to cover the MXN 2,000,000 in 30 days is MXN 1,923,076.923 (2,000,000/(1+.04). The MNC will have to borrow dollars to make up the deposit if the spot rate is USD 0.0766918, the amount of dollars to be borrowed is USD 147,484.2308 (USD 0.0766918 x MXN 1,923,076.923). If the dollar rate is 3%, the MNC will have to pay a total loan of USD 151,908.7577 (USD 147,484.2308 x 1.03) after 30 days.

Hedging Exposure to Payables of MXN 2,000,000 in 30 days foreign exchange rate is expected to appreciate Currency Option Hedge- Purchase a currency call option representing the currency and amount related to the payables. The MNC can purchase a call option on the MXN 2,000,000, given the exercise price of USD 0.076075 and a premium of $0.01and the expiration date is 30 days. At any spot rate less than USD 0.076075, the MNC will not exercise the call option. At any spot rate more than or equal to USD 0.076075, the MNC will exercise the call option, the cost of hedging is equal to USD 0.076075 plus the premium of $0.01.

Summary and Conclusion The MNC located in the United States will be paying and receiving Mexican Peso when doing business in Mexico. The fluctuating exchange rate exposes the MNC to exchange rate risk, which if not managed effectively may lead to significant losses and affects the profitability of the MNC. There are several techniques that the MNC can use to hedge its transaction exposures, futures/forward hedge, money market hedge and currency options hedge. If I were the manager of the MNC, I will choose the currency option hedge because option can only eliminate the downside risk while retaining the upside potential.