Suppose that you are a manager for a large multinational financing company that

Question

Suppose that you are a manager for a large multinational financing company that provides financing for overseas capital project for both U.S. and foreign firms. Your firm has received a finnancing request from aMexican corporation for funds to finance a new capital project. What makes this financing agreement unique is that the Mexican corporation does not want the financing immediately , but in rather wishes to recieve it in 90 days.

If the financing provided is made in Mexican pesos does your firmand /or the Mexican corporation face foreign exchange risk ? why or why not?

Explanation / Answer

Foreign exchange risk arises from fluctuation in the exchange rate between two currencies. In this problem, two firms are there. First one is in USA. It is a multinational financing firm. It has received a request from a Mexican firm to provide some loan to them in pesos. Here pesos is the currency of Mexico. Currency of USA is doller.

Suppose loan required is 1,000,000. At present one doller is equal to 10 pesos. So US financier has to spent $1,000,000 to pay this loan in pesos . Now the Mexican firm does not want to take the loan now. It will be taken after 90 days. If exchange rate fluctuate, then US finacier will encounter exchange rate risk. It will happen, if doller value depreciates.after six month. Supose after three month, one doller is equivalent to 5 pesos. So to get 1,000,000 now Us finacier will spend 1,000,000/5=$200,0000. It is doubled. So US financier will suffer. Not only this, interest on loan will be received in pesos. When it is converted in doller much less amount will be received.

US financier is suffering loss since the loan has been provided in foreign currency. But situation is different for Mexican corporation. It will get loan in domestic currency. So currency conversion is required. Also loan interest will be paid in domestic currency. So fluctuation in exchange rate will not affect it. This corporation has no exchange rate risk.

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