The Extra Strong Dollar: What that means for MNCs

 On July 12th, something unprecedented happened. The Euro reached parity with the US Dollar, meaning that 1 Euro is now worth 1 Dollar. For the 20 or so years the Euro has been around, it has never reached parity with the Dollar, but now that has changed. One reason why this has occurred is because the Federal Reserve has been steadily increasing interest rates in the US in order to combat inflation, while Europe has remained inactive in comparison. Another issue is that the ongoing Russian invasion of Ukraine has caused mass capital investment flight out of European markets & into American ones, increasing demand for Dollars and pushing up its value, thus making it stronger relative to the Euro.

This stronger dollar has its advantages and disadvantages. A key disadvantage for multinational companies is that big currency fluctuations can have a significant impact on profitability. American companies with large international footholds will take a hit from converting their foreign sales back into dollars. The opposite can be said for non-American companies who have set up shop in the US. This is known as translation exposure, wherein fluctuating exchange rates cause changes  when converting line items in financial statements from the local currency of a foreign subsidiary into the reporting currency of the parent company. 

For a better visualization, this graph shows how other currencies have dropped against the dollar. Since the end of 2021, the Eurozone has fallen by 12% against the dollar. Significant trading partners to the US like Britain and Japan, have fallen around 13% and 17% respectively. This huge drop off could have serious implications for trade relations between these countries as they will most likely reduce their imports from the US. American consumers can take advantage of this situation by importing more British and Japanese goods, among other countries. Also, other analysts have suggested now is as good a time as ever to vacation to these destinations as your dollar can now buy more than it ever could previously. However, to reiterate companies with  massive international exposure face more problems when converting a Yen or a Euro into Dollars. 

*Source of graph: New York Times

There are a variety of ways in which companies can mitigate foreign exchange risk. a) One way is to build a natural foreign exchange hedge, which occurs when  a company is able to match revenues and costs in foreign currencies such that the net exposure is minimized or eliminated.For example, an American company operating in the UK and generating Pound income may attempt to source some of its product from the UK for its domestic business , in order to utilize these Pounds. 

A more complicated but well-known approach is to have hedging arrangements via financial instruments. b) Forward exchange rate contracts are arrangements that companies can make that allow them to buy or sell a certain amount of foreign currency on a specific future date. Companies enter these contracts with a third party (usually banks) and gain protection from subsequent fluctuations in a foreign currency's exchange rate. Forward exchange contracts allows for the hedging of a foreign exchange position, in order to avoid a loss on a specific transaction. The benefits of such a protection can only manifest if transactions (customer receipts or supplier payments) take place on the expected date.

c) Currency options differ to forward exchange contracts in that they aren't obligations but the company has the right to buy or sell a currency at a specific rate on or before a specific date. Since currency options are more flexible, the company would have to pay an option premium. Because of this flexibility, if the option's exchange rate is more favorable than the current spot market rate, the investor would exercise the option and benefit from the option. If the spot market rate was less favorable, then the investor would let the option expire worthless and conduct the foreign exchange trade in the spot market.

In conclusion, if a company does decide to hedge to mitigate foreign exchange risk, it is pertinent to have a strong financial forecasting system and a strong understanding of the foreign exchange exposure. Now more than ever due to the strengthening Dollar, companies must find creative solutions to mitigate the losses that occur from converting one currency to another.