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International Financial Management and Multinational Enterprises

Abstract and Keywords

This article provides a selective, critical survey of the academic literature on the financial management policy of multinational enterprises (MNEs). The focus of much current research interest can be captured in two major themes which also dominate this analysis. The first is financial management policy in relation to the increasing volatility of real and financial asset prices in the international financial environment within which MNEs operate. This dictates one theme of this article: the impact of financial risk, in particular market risk, on MNEs and an appraisal of evolving financial risk management practices. The second theme is international market segmentation. The globalization of international business activity has evolved along with a trend towards increasing financial market integration, particularly in capital markets.

Keywords: international financial management, multinational enterprises, financial management, financial assets, globalization, international business activity, capital markets

20.1 Introduction

This chapter provides a selective, critical survey of the academic literature on the financial management policy of multinational enterprises (MNEs). The focus of much current research interest can be captured in two major themes which also dominate this analysis. The first is financial management policy in relation to the increasing volatility of real and financial asset prices in the international financial environment within which MNEs operate. This dictates one theme of this chapter: the impact of financial risk, in particular market risk,1 on MNEs and an appraisal of evolving financial risk management practices.

The second theme is international market segmentation (Choi and Rajan 1997). The globalization of international business activity has evolved along with a trend (p. 558) towards increasing financial market integration, particularly in capital markets. To a limited extent this has been accompanied by increased harmonization and standardization of both international regulatory and accounting practices (Roberts, Weetman, and Gordon 1998). Despite such trends, the asymmetric incidence of accounting standards, regulations, and taxation has had significant tactical and strategic financial management implications for MNEs (Choi and Levich 1990, 1997; Gray, Meek, and Roberts 1995; Meek, Roberts, and Gray 1995; Oxelheim et al. 1998). We evaluate the nature, incidence, and implications of such market segmentation for selected aspects of MNE financial management activity.

It is clear from the context of our analysis that we believe financial factors to have important implications for the comparative advantage of MNEs located in different jurisdictions, and also that financial management plays a critical role in deciding an MNE's competitive prosperity. This belief is supported by surveys of MNEs (Rawls and Smithson 1990; Marshall 2000). Marshall (2000) reports the results of a survey of the 200 largest MNEs which reveal that 87 per cent of Asian Pacific‐based MNEs, 68 per cent of UK‐based MNEs, and 55 per cent of the US‐based MNEs state that foreign exchange risk management is at least as important as business risk management. Nonetheless, to date no generally accepted theoretical underpinning has yet been provided demonstrating that financial factors alone are either necessary or sufficient to rationalize the existence of MNEs.2 We further discuss this issue in the context of modes of market entry and participation in a later section.

The remainder of the chapter is easily summarized. Section 2 discusses the enhanced importance of recent increases in asset price volatility, relating it to country risk and international investment appraisal. The classification and measurement of risk exposure is considered in section 3. Particular attention is given to recently developed techniques such as value‐at‐risk and cash‐flow‐at‐risk as well as advances in the empirical measurement of exposure. Section 4 is concerned with the management of financial risk by MNEs. In particular, a distinction is made between management policies designed primarily to hedge risk, and those intending to exploit its potential to create competitive advantage. This section also evaluates empirical studies of MNE risk management practices. Section 5 addresses issues relating to the effective implementation of a risk management system within the governance structure of an MNE. Brief concluding remarks follow together with some suggestions for future research.

20.2 Trends in Financial Market Risk

Our emphasis on financial risk and the evolution of MNE risk management practices has been motivated by a number of factors, the most important being the trend toward increasing global financial market integration (Lessard 1997) and the enhanced (p. 559) volatility in the financial market environment within which MNEs operate.3 We later evaluate studies which argue that these factors can confer certain advantages to internationalization of a firm's activities. In preparation for this analysis we briefly chronicle certain major recent developments in the global financial environment, which illustrate the increasing importance of market risk in global financial markets.

20.2.1 Exchange Rate Variability

Following the collapse of the Bretton Woods system of fixed exchange rates in the early 1970s, exchange rate fluctuations have become increasingly volatile, punctuated by occasional episodes of exchange rate crises. Between 1970 and mid 2007, the yen/US dollar exchange rate has moved from 361 to 114, and since 1981 to April 2007 the dollar first appreciated by 50 per cent and then subsequently depreciated by a similar amount against sterling. The crisis in the European Monetary System (ERM) in September 1992 led to significant falls in the value of sterling and the Italian lira, while the currencies of Thailand, Indonesia, Malaysia, the Philippines, and South Korea lost between one‐third and three‐quarters of their value in the second half of 1997. Recently, the USD/Euro rate has moved from 1.18 to 0.85 and back to 1.43 in the period since the euro's inception to October 2007. There have also been major movements in exchange rates following shifts in the monetary policy stance of certain governments, such as the tighter monetary policy followed in the early days of the Thatcher administration in the UK. Indeed, the average volatility of many currencies adopting floating exchange rate regimes is in the region of 10–15 per cent per year. If rates move adversely these movements could easily be sufficient to eliminate the average profit margin for a typical multinational corporation.

20.2.2 Interest Rate Variability

Interest rate volatility has similarly affected corporate funding costs, cash flows, and net asset values since the early 1970s. Inflationary pressures caused interest rates to increase in the first half of the 1970s in the US, and although they subsequently declined, a change in policy by the Federal Reserve caused a sharp increase in both the level and volatility of rates in 1979. Interest rates peaked in 1981, and then fell slowly. Since 1983, there have been at last five more US interest rate cycles and recently overnight rates have risen from a low of 1 per cent in May 2000 to a high of 5.25 per cent in August 2007. According to Jorion (1996), the rate increases in 1994 eliminated over $1.5 trillion from fixed income portfolios. Interest rates have also become more volatile since many central banks began to abandon targeting interest rates as a policy objective in favour of targeting money supply growth or inflation. In the UK, interest rates shot up in the late 1980s and early 1990s due to inflationary pressures caused by a relaxation in (p. 560) monetary policy, but then fell substantially subsequent to sterling's withdrawal from the ERM in September 1992.

20.2.3 Equity Market Variability

Equity markets have also become extremely volatile. During the inflationary periods of the early 1970s, share prices increased significantly only to fall sharply during the bear market of 1974–1975 following a 300 per cent hike in the price of oil. At this time the S&P 500 share price index in the US dropped from a high of 119.87 to 62.34. A global recovery then ensued, with minor price reversals in 1982–1983, and the market peaked again in 1987 with the S&P index reaching 335.89. On Black Monday, 19 October 1987, prices plunged and US equities lost 23 per cent of their value, equivalent to over US$1 trillion in equity capital, and the S&P finally bottomedout at around 224. This was followed by another sustained recovery during the 1990s and in spring 2000 the S&P had reached 1,525 only to crash again to around 800 in the bear market which characterized equities in the aftermath of the burst in the so‐called bubble. Subsequently, the index has reached an all‐time high of above 1,560 by October 2007. The 1990s expansion in equity markets was sustained in most major economies worldwide with the exception of Japan, where the Nikkei index fell from 39,000 in 1989 to 17,000 in 1992 following the Kobe earthquake, a capital loss of US $2.7 trillion. Finally, from mid to end 1997, the stock markets of Bangkok, Jakarta, Kuala Lumpur, and Manila collectively lost US$370 billion, or 63 per cent of the four countries' combined GDP, while the Seoul stock market declined 60 per cent.

20.2.4 Commodity Price Variability and Other Sources of Increased Risk

Commodity prices, particularly those in primary product markets, have also been subject to large fluctuations since the 1970s, a trend established subsequent to the oil price rises of 1973–1974. The standard deviation of the GSCI commodity index has been 23.7 per cent p.a. in the five years to 2007 and even those indices which put less of an emphasis on oil prices, for example Rogers RMI have experienced standard deviations of around 20 per cent p.a. This variability appears to have generated spillover effects in other financial markets, particularly equity markets, thereby corroborating the view that it is fundamentally mistaken to treat financial markets in isolation from one another. Significant regulatory and legal changes, the globalization of the financial services industry, and the emergence of offshore financial centers have also contributed to increased financial risks. Finally, risk associated with the enhanced global nature of competition has become apparent. Systemic regional and global risk has resulted from increased levels of world trade, major changes in trade policy, the (p. 561) economic and political transition of the former Soviet bloc, economic developments in China and India, the growth of the EU, and the emergence of the Asian ‘tiger’ economies as economic powers.4

20.2.5 Country Risk

Increasing financial market volatility together with capital market integration has important consequences for both the issue of international investment appraisal, and also the appropriate measure of country risk. Country risk relates to uncertainties inherent in an MNE's operating environment arising not only from the volatility of financial asset prices but also the prospect of political, legal, macroeconomic, and socially engendered instability (Clark and Marois 1996; Di Gregorio 2005).5 As such, estimating country risk requires the ability to: (1) monitor country‐specific sources of environmental uncertainty; (2) convert the measurements into a risk premium; and then (3) evaluate individual MNE's exposure. The methodologies for country risk analysis have generally evolved from the finance‐based techniques used by ratings agencies to assess the creditworthiness of sovereign nations, with subsequent extensions by financial analysts to evaluate an individual MNE's country exposure as they relate to its business operations. Clark and Marois (1996) discuss the techniques utilized by the international banks, consultancies, and business information organizations such as the Economist Intelligence Unit, and those disseminated in publications such as the International Country Risk Guide (ICRG) which are widely utilized by both practitioners and academics (La Porta et al. 1997). Such measures typically employ a variety of objective economic, financial, and political information (GDP‐linked measures, investment statistics, levels of indebtedness, number of political uprisings, proxy measures of investor protection) which is designed to capture the major constituents of economic, financial, and political risk, and employ them to construct aggregate, composite country risk indices. These indices are then reformulated in order to act as discount factors which are then applied to the value of potential future real investments in a particular country. Riskier country environments receive higher discount rates, implying investments therein must satisfy a higher expected hurdle rate of return to be profitably undertaken.6

Unlike many other measures of risk utilized in financial risk management (such as those considered later in this chapter), existing country risk measures make no attempt to quantify either the probability or size of an adverse investment outcome, or predict the future stability of the investment environment. More telling perhaps is that evidence suggests that they are also ineffective in predicting environmental uncertainty (although it should be acknowledged that some ratings, for example those provided by Euromoney, and Institutional Investor are focused on financial risk). Oetzel, Bettis, and Zenner (2001) analyse the performance of eleven commonly utilized measures of country risk for seventeen countries over a nineteen‐year time horizon and conclude that no measure is successful in predicting periods of significant macroeconomic or political volatility. Di Gregorio (2005) concurs with this (p. 562) finding after employing the IRCG risk measures to predict major economic crises in seven major emerging markets in the decade between 1993 and 2003. Moreover, as highlighted by Di Gregorio (2005) extant country risk measures also suffer from certain conceptual difficulties which preclude their usefulness in assessing the international business risks associated with real, as opposed to financial, private investment appraisal decisions.

20.3 The Classification and Measurement of Risk Exposure

With increased volatility in financial markets, MNEs have learned that their value has become more subject to the risks occasioned by changes in their financial environment. There are a number of approaches MNEs have adopted to deal with this risk. Some early commentators (Rodriguez 1981) report that the overall strategy of many MNEs in foreign exchange risk management is defensive in that they attempt to minimize the impact of market risk.7 However, more recent analysis has identified that the key MNE objectives when managing market risk are cash flow management (Copeland and Joshi 1996; Cummins, Phillips, and Smith 1998; Marshall 2000) and the smoothing of earnings fluctuations (Marshall 2000). While both are important for UK‐ and US‐based MNEs, smoothing earnings is of particular relevance for the larger MNEs and those based in the Asia Pacific region, while cash flow management is held to be more important for MNEs with a high degree of internationalization. These findings for MNEs are consistent with previous single country studies of domestically domiciled firms in the UK and US (see Bodnar et al. 1995; Bodnar, Hayt, and Marston 1996, 1998; and Grant and Marshall 1997). One avenue for further exploration is to what extent the regional differences noted above can be explained by company characteristics.

20.3.1 Classifying a Multinational Firm's Exposure to Market Risk

The central question confronted by an MNE's financial director or treasury department is to what extent the value of the firm's cash flows or earnings are exposed to changes in financial asset prices. In the context of foreign exchange risk, three classifications are commonly adopted in the literature, namely transaction or contractual exposure, translation exposure, and economic or operating exposure. These classifications are not mutually exclusive, rather they are overlapping. They are also easily generalized to other sources of market risk. MNEs are normally exposed to more than one type, and there is still no general agreement as to which exposure (p. 563) needs to be emphasized from the financial management perspective, although several authors have taken a strong stance on this issue.

Contractual exposure arises from a MNE's fixed contractual obligations: accounts payable/receivable, long‐term purchase/sale contracts, and financial positions expressed in foreign currency. If the source of information on contractual exposure is accounting data, then it becomes relatively transparent and easy to quantify for most types of market risk. Moreover, contractual cash flows are fixed either in domestic (reference) currency units or in units of the firm's output. Their nominal value in domestic currency then changes in the same proportion as the change in the exchange rate, foreign currency price, or amount sold, other things begin equal. Alternatively stated, contractual exposures have an elasticity of one.

Empirical studies of MNEs based in the UK, US, and Asia Pacific suggest that most tend to focus upon the management of contractual rather than translation or economic exposure. Khoury and Chan (1988), Berkman and Bradbury (1996), Berkman, Bradbury, and Magan (1997), Duangploy, Bakay, and Belk (1997), Joseph (2000), and Marshall (2000) all report that MNE foreign exchange risk management focuses on contractual exposure. This emphasis is understandable in view of the immediate impact of contractual risk on cash flows and earnings, and the relative ease with which such exposure can be measured.

There is a wide‐ranging debate as to whether translation exposures, the effect of unexpected foreign exchange fluctuations upon a MNE subsidiary's financial statements, should be actively managed. Many authors (Sercu and Uppal 1995; and Shapiro 1999; among others), argue that as translation exposure is purely an accounting concept with no impact on future cash flows it need not be actively managed. However, evidence in Bodnar et al. (1996, 1998) for the USA, Collier et al. (1992), Joseph (2000) and Hagelin and Pramborg (2006) for the EU, Bodnar, de Jong, and Macrae (2003) for both the above regions, and Marshall (2000) for all the above plus the Asia Pacific, confirm that translation exposure is actively managed by many MNEs, particularly in the Asia Pacific.8 We conjecture that the decision to manage such exposure is influenced by market segmentation considerations, in particular differential financial reporting requirements in the reporting country, which will affect the MNE's financial statements (Hakkarainen et al. 1998).9 Hagelin and Pramborg (2006) conjecture that translation exposure is hedged by firms to avoid violating loan covenants in debt contracts which would lead to a reduction in borrowing capacity. The importance Asia Pacific MNEs attribute to translation exposure could also be explained by survey timing, especially in relation to the relative strength of the reporting currency in the context of this parameter's influence on the value of overseas assets and liabilities.

Glaum (1990), and Kohn (1990) Sercu and Uppal (1995), Buckley (2000) all maintain that a central, if not the most important, risk management activity for an MNE is the management of economic exposure. Moreover, the importance of this type of exposure is recognized by MNEs. In this context, it is perhaps surprising that it has not been more systematically managed. In an early survey, Blin, Greenbaum, and Jacobs (1980) found that adjustment was made for economic exposure in less (p. 564) than one‐third of companies. One possible explanation is that the complexity of the relationship between asset price volatility and MNE competitiveness makes economic exposure very difficult to quantify, as it requires a detailed understanding of the firm's competitive position. Von Ungern‐Sternberg and von Weizsäcker (1990) and Marston (2001) demonstrate that economic exposure is influenced by the demand elasticity for products, the behaviour of a MNE's marginal costs and the output reaction of competitors. Allayannis and Ihrig (2001) focus on competitive aspects, addressing the importance of industry structures in product and input markets for competitive exposure. Bodnar, Dumas, and Marston (2002) model the link between economic exposure and exchange rate pass‐through. Finally, Oxelheim and Wihlborg (1987, 1989a and b, 2005) stress the importance of the macroeconomic environment in which an MNE operates for the exposures it faces.10

We consider some recent developments in the complex task of measuring economic exposure in the following section. However, despite these advances, Marshall's (2000) survey results indicate that it generally continues to receive less risk management emphasis than other forms of exposure. The exception is for the MNEs based in the Asia Pacific, where the 1997 financial crisis may have initially eroded competitive advantage beyond the realm of managing transaction and translation exposures.

20.3.2 Quantifying MNE Exposure to Market Risk

There are several mechanisms available to MNE treasury departments for quantifying exposure to market risk. As many of these techniques are relatively recent, we will discuss them in some detail. Broadly speaking, they can be divided into two types: internal and market‐based measures. We begin with the former. Internal Measures of Market Risk: Value at Risk (VaR)

Most of the recently developed internal techniques for measuring financial risk recognize that market risk should not be considered as exposure to individual financial asset price changes, but rather as exposure to an integrated set of inter‐related asset price changes. Moreover, any proposed definition must be both easily understood, and easily communicated to the MNE's senior management. This has led to the development of probability‐based summary measures of exposure, the most notable being value‐at‐risk (VaR).

VaR is a valuation technique based upon the current net asset value of the portfolio. It is specified in terms of a confidence level (Jorion 1996), and enables the risk manager to calculate the maximum that the corporation can lose over a specified time horizon at a specified probability level. This calculation is undertaken using historical simulation of past data, Monte Carlo simulation, or analytic variance‐covariance methods. The method chosen should depend on the composition of the portfolio and the desired time horizon. The calculated VaR is then translated in to a probability statement about likely changes in portfolio valuation resulting from financial asset (p. 565) price changes over a given time period. For example, the risk manager should be able to define the maximum loss for a one‐day, one‐week, one‐month period that the firm will incur with 95 per cent probability (implying that this loss should be exceeded on only five occasions in one hundred). The Relevance of VaR

The VaR concept, while not a panacea for risk measurement difficulties, has been embraced by many multinational corporations, particularly those where the MNE's value is linked closely to the current net asset value of its portfolio. These firms are market value driven, with business assets marked to market daily. Typically securities and derivatives trading is a primary business focus, and the company's investment horizon is measured over short time periods. They would, therefore, have a keen interest in managing the volatility of their current asset value. Hence, VaR is particularly suitable for financial institutions, institutional investors, and the treasury divisions located in manufacturing corporations where such trading divisions function as profit centres. An example of the later is British Petroleum, where BP Finance not only manages the company's natural financial risk exposures, but is also expected to trade foreign exchange and interest rate financial instruments with the intention of contributing to BP's profits. Alternatives to VaR: Cash Flow at Risk

For other multinational corporations, however, the VaR approach is potentially less relevant. These corporations can be characterized as cash flow driven, and their value is linked closely to the judicial exercise of the real growth options arising from their investment and research and development activities. In these corporations, business assets are marked to market infrequently, derivatives are used only as tools to manage financial risks, and investment horizons are measured in months or even years. Their primary focus therefore is to manage cash flow volatility so that they can judicially exercise their growth options at the appropriate time.

Corroboration of such an interpretation is provided by the surveys of MNEs mentioned earlier, which concluded that a majority of MNEs stated that their primary risk management objective was to reduce cash flow volatility. The issue then becomes how best to translate this information into a summary, operational measure of financial exposure which focuses on the impact of price changes on the firm's cash flows: in other words,a cash flow analogue to VaR. This would relate the magnitude and timing of cash inflows to a corporation's contractually committed liabilities and investment opportunities, as suggested by Froot, Scharfstein, and Stein (1993). Dowd (1998) refers to this as cash flow at risk, while Smithson (1998) terms it cash flow sensitivity analysis, proposing the following cash flow based measure of exposure: A corporation's consolidated exposure to financial risk is the probability that the company will fail to satisfy its performance targets over a specified time period as the result of unexpected changes in financial asset prices.

(p. 566)

The practical relevance of these internal risk measurement procedures revolves around identifying the appropriate procedures for their implementation. Smithson (1998) argues that the desired model must be sufficiently rich to capture the interactions between commodity inputs, product prices, foreign and domestic operations, and contractual payment obligations. The corporation's planning model could provide a useful place to begin this exercise, but it would have to be supplemented to address two critical shortcomings. First, appropriate simulation exercises would have to be undertaken with variable prices in order to model realistically the various pricing scenarios that the firm is likely to face in the future. Second, an acceptable method would have to be found for modeling the relationship between the impact of market risk and MNE cash flows.11 This is complex because the operating cash flows of the corporation depend on both the economic environment the firm faces, and how, given this competitive environment, the corporation's strategy is impacted by unexpected changes in financial asset prices, including the exchange rate. Empirical Market Based Measures of Financial Risk Exposure

As their name suggests, market‐based measures of financial risk utilize market determined values of financial data to measure the market's perception of how changes in the corporation's value (or other pre‐selected measure of financial performance) are related to changes in the prices of financial assets. Market‐based approaches to risk measurement vary in the details of their implementation, but are characterized by the use of econometric and/or statistical models to estimate the sensitivity of a corporation's earnings, cash flow or share price (returns) to movements in the value of selected financial asset prices. In the context of the present discussion, particular emphasis is given to the exchange rate. A representative characterization of such models is provided by Jorion's (1990) extension of Adler and Dumas's (1984) capital market approach, and can be depicted as follows: 
International Financial Management and Multinational Enterprises
(1) Here Ri t represents the total return to firm i within period t; R mt the overall stock market return in the same period, t; βi the sensitivity of changes in firm i's return to variations in market returns; Ωt the financial asset (i.e. exchange rate) variation in period t; δi firm i's exposure to financial asset (exchange rate) movements in period t, controlling for the impact of such changes on the overall market return; and v it an i.i.d. error term.

The above specification has been subject to numerous important theoretical modifications and refinements in the literature to address various criticisms levelled at the initial framework. An extensive and insightful survey of such issues by Muller and Verschoor (2006) indicates that they include: (1) how to deal with evidence of positive autocorrelation in exchange rate series; (2) how to accommodate potential multicollinearity between R mt and Ωt, the market and exchange rate risk factors; (3) whether it is appropriate to include business cycle variables and, if so, the manner in which this should be done; (4) the optimal specification for modelling and (p. 567) estimating potential time variation in δi, the empirical coefficient measuring exchange rate exposure; (5) how to handle observed asymmetries and non‐linearities in a MNE's response to exchange rate exposure in relation to: positive versus negative exchange rate shocks, large versus small rate movements, movements in asset price levels versus changes in volatility, and the timing of firm announcements which contain value relevant information.12 While much progress has been made in these areas, further theoretical refinements to market based models will enhance our understanding of the important time variations and non‐linearities inherent in measuring exchange rate exposure.

Finally, market based models can also be used to estimate the exposures of the MNE's main competitors, providing an input into a firm's strategic decision‐making, and contributing insights into its competitive environment. Whether the firm chooses to use internal or empirical market‐based systems, or some combination of both, the following section considers an appropriate organizing framework within which an MNE can coordinate its risk management policies.

20.4 The Management of Financial Risk Exposure by MNEs

Froot (1994) highlights the lack of a comprehensive framework for the MNE's management of market risk exposures. Clearly, any risk management strategy should be undertaken if and only if it increases the expected discounted value of the MNE's cash flows or earnings. It is of critical importance, however, to distinguish between two classes of risk management policies. In the first class are those policies commonly denoted hedging, which serve purely to reduce the long term volatility of the MNE's cash flows or earnings, thereby reducing the expected costs of financial distress. The second class consists of policies designed to respond to financial risk by tactically and/or strategically exploiting asset price volatility to create competitive advantage. The emphasis in the financial risk management literature is customarily placed on the hedging aspects. We believe this focus on hedging may have generated a misplaced emphasis in the empirical literature which attempts to identify MNE's risk management practices, a point to which we return below. At this point, it is sufficient to note that using exposure to financial price volatility to create competitive advantage requires adjustments in operational decisions which involve a complex set of tactical, strategic, and organizational issues additional to hedging. We note that neither the hedging nor the responsive motives for dealing with financial risk rely on the MNE's management exhibiting risk adverse behaviour.

In view of these considerations, it is clear that in practice MNEs would adopt a variety of risk management techniques, usually identified in the literature under the categories of internal and external (Hakkarainen et al. 1998). Internal techniques (p. 568) are an integral component of the MNE's financial management, and do not give rise to special contractual arrangements outside the core–subsidiary network. For short‐run risk management considerations, the major internal techniques identified in the literature are balance sheet hedging, leading and lagging, netting of cash flows, and currency invoicing and pass‐through pricing policy (Menon 1995; Bowe and Saltvedt 2004; Flodén and Wilander 2006). To generate flexibility in the management of medium and longer term cash flow or earnings volatility, the literature highlights both foreign currency denominated debt (Chowdhry 1995; Huffman and Makar 2004) and the real options inherent in appropriate international diversification of manufacturing, distribution and sales, which confer the MNE with enhanced operational flexibility, thereby enhancing its competitive advantage (Kogut and Kulatilka 1994; Allen and Pantzalis 1996; Buckley and Casson 1998; Rangan 1998).13

External techniques use bilateral external contractual arrangements for risk management purposes, and focus on the management of financial risk using off‐balance sheet financial instruments, generally known as derivatives: forwards, futures, swaps, and options. These instruments provide the building blocks that enable MNEs to use both standardized exchange‐traded instruments and customized financial products obtained in over‐the‐counter markets, to manage the risks associated with currency, interest rate, and commodity price fluctuations far more flexibly, cheaply, and efficiently than is possible with on‐balance sheet strategies. We begin with a discussion of the more conventional hedging motives.

20.4.1 Risk Management and Motives for Hedging Financial Risk

Theories of optimal hedging are designed to demonstrate how financial risk management can increase firm value in the presence of capital market imperfections by reducing the volatility of cash flows or earnings. The relation between the present value of a corporation's cash flow and its financial policies was demonstrated in a classic paper by Modigliani and Miller (1958), which developed the seminal ‘M&M’ propositions. These propositions imply that in the absence of capital market imperfections, investors can undertake their own hedging policies just as effectively as the firm's managers, by holding diversified investment portfolios. The relevance of the M&M proposition for strategic risk management becomes evident by considering its corollary: a necessary condition for strategic risk management to affect firm value is that it impacts upon the firm's cash flows, taxes, transaction costs, or investment decision (s). While necessary, this is not sufficient. Given the incentives created by capital market imperfections, a corporation's choice to use derivative instruments depends also on its level of financial risk exposure, the availability of internal hedging mechanisms, and the costs of managing financial risk. In the following section we adopt a framework developed by Geczy, Minton, and Schrand (1997) in order to organize the various theories explaining a firm's hedging strategy.

(p. 569) Managers

Managers of international firms invest much of their human capital or intangible wealth in the corporation. They may also hold significant amounts of common shares. If management are averse to bearing uncompensated risk, the value of these two components of their wealth will be significantly adversely affected by volatility in the corporation's earnings. As hedging reduces the volatility of the value of the firm, management will direct the firm to hedge if it can do so at a lower cost than compensating the managers for bearing the additional risk through, for example, a management compensation scheme containing share options (Stultz 1984; Smith and Stultz 1985). DeMarzo and Duffie (1995) suggest an alternative but complementary argument focusing upon managerial reputation. A corporation's value is determined both by the quality of managerial decisions relating to its core business competencies, and also by financial risk, which impacts on the firm's earnings but which lies outside the domain of managerial control. Managers may choose to manage the effect of financial risk through hedging, as the information content of corporate earnings as a signal of managerial ability is thereby enhanced. Managerial labour markets and the market for corporate control are then more able to isolate the effects of good luck from effective managerial judgment when assessing management's performance. Bondholders

Bondholders of the corporation have an incentive to support strategic risk management activity in order to reduce the probability, and therefore the expected costs of financial distress (or bankruptcy). Financial distress arises when the firm's income stream is insufficient to cover its liabilities, or its probability of default rises to due increased volatility in its income stream. The associated costs include not only the direct costs associated with bankruptcy or liquidation, but also the indirect costs of a deterioration or loss of long‐term relationships with suppliers and customers or a reduction in the firm's borrowing capacity through a downgrading of its credit rating. We note that a risk management strategy will only reduce expected financial distress costs if the firm can credibly commit to following a hedging strategy, through for example bond covenants or credit agreements.

As first demonstrated by Myers (1977), financial distress costs also induce suboptimal investment decisions (see also Bessembinder 1991). As the perception that the firm may encounter financial distress increases with enhanced cash flow or earnings volatility, such volatility not only augments the probability that an MNE will require access to external capital markets but also makes it more difficult and costly to raise external finance. This leads to capital rationing constraints and the consequent rejection of profitable investment opportunities. Froot, Scharfstein, and Stein (1993) develop this argument, noting that hedging cash flow variability mitigates this underinvestment problem by reducing not only the costs of raising finance externally, but also the firm's reliance on external funds. As such, the extent of hedging will depend upon both the presence of profitable investment opportunities for the MNE and the requisite amount of direct investment relative to the level of funds generated internally.

(p. 570) Equityholders

Smith and Stultz (1985) were the first to demonstrate that risk management can increase shareholders’ expected wealth when the firm operates in a fiscal environment where corporate tax rates increase more than in proportion to corporate income. This is known as a convex tax liability schedule. The existence of tax preference items, such as various forms of tax credits, which are subtracted from pre‐tax income, indirectly create convexity in the tax liability schedule, since the present value of unused tax shields decreases as they are postponed to future periods. As Mian (1996) among others has pointed out, by reducing the variance of corporate earnings, risk management increases the expected value of tax shields because the probability of using preference items increases with the level of a firm's taxable income. DeMarzo and Duffie (1991) have also shown that equityholders in the corporation will support risk management when the firm's managers have better information about the risks which affect the corporation's earnings. As hedging reduces the volatility of the firm's earnings, it also enables shareholders to better distinguish the effects of luck and managerial ability on share performance, and consequently make better informed portfolio optimization decisions.

We now consider those financial risk management policies which are motivated primarily by a desire to respond to real and financial asset price volatility in order to exploit an MNE's comparative and competitive advantage. This risk management response incorporates both a tactical and a strategic dimension, and we begin with the former.

20.4.2 Risk Management to Create Competitive Advantage

Many of the tactical responses to financial risk, especially over short time horizons, involve the exploitation of arbitrage opportunities which create a comparative advantage for certain MNEs in a particular segment of the international capital markets (see Oxelheim et al. 1998). These situations arise as a result of international financial market segmentation in one form or another, and can be utilized by MNEs to create a competitive advantage, for example by reducing corporate funding costs, or the costs of capital, in a manner not open to single country firms. Reducing Funding Costs by Arbitraging Markets

The appropriate use of derivative instruments can exploit artificial market segmentation caused by an asymmetric incidence of governmental regulation or tax treatment. Barriers to entry are standard in many international capital markets. For example, prior to 1992, the Subcommittee for Foreign Issues of the Central Capital Markets Committee regulated the timing and amount of new issues in the German external bond markets by establishing monthly quotas for deutschmark‐denominated bond issuance. Since the supply of securities was thereby artificially restricted, their price was higher than the market determined price, and accordingly the instruments (p. 571) carried below market interest rates. The corporations or other end users with privileged access to the market could exploit this anomaly through judicious borrowing combined with the appropriate derivative positions.

Differences in national taxation practices can also present arbitrage opportunities; these can again be exploited through derivative portfolios and other balance sheet strategies (Kramer et al. 1993).14 Withholding taxes on offshore borrowings in certain countries give rise to such opportunities. In the 1980s the Australian government levied a withholding tax on interest payments made by Australian companies on all offshore borrowings denominated in Australian dollars. This tax, combined with high interest rates in Australia and a relatively stable currency prompted a substantial volume of currency swap‐driven Australian dollar eurobond issues in early 1986. A similar situation arose in New Zealand in 1990.15 The EC (2001), building upon the Devereux and Griffith (1998) analysis of effective tax burdens, identify significant corporate tax regime differences across the EU, with variations in the effective tax burden of up to 30 per cent. This violation of FDI tax neutrality serves to generate significant value enhancing opportunities for both accessing capital markets and investment. One example, is where differences in tax regimes provide incentives to raise capital funds in one country to finance investment in another. Historically, generous capital consumption allowances in some European countries, such as France, implied that interest expenses provided only a minimal tax shield in those countries. A MNE's incentive is then to raise finance in a country where interest expenses provide a considerable tax shield, and to invest the funds in a jurisdiction with high depreciation allowances.16 This situation mirrors Oxelheim's (2001) Nordic region study, which concludes that the existence of significant residual cross‐border tax wedges creates a competitive advantages for accessing funding in certain market segments. Other comprehensive analysis of the impact of tax discrepancies on FDI document that the tax elasticity of FDI differs not only according to country size and agglomeration externalities, but also according to whether a country operates a tax exemption or a tax system (Hines 1999).

Froot (1989, 1990) argues that MNEs based in countries whose currencies have undergone significant real appreciation can benefit from a reduced liquidity premium in that currency. This generates a window of opportunity enabling them to place a higher value on overseas investments, thereby acting as a stimulus for overseas asset acquisition or capital expenditure. Such opportunities may not be reciprocally shared by overseas competitors (Kester and Luehrman 1989). However, it still remains an open question why this should take the form of real, as opposed to portfolio investment. Reducing Funding Costs Through Embedded Options

MNEs may also be able to reduce their funding costs by issuing hybrid debt, essentially debt which contains an implicit or embedded option: for example a bond with an equity warrant attached, a convertible bond, or a callable bond. There is some evidence to suggest that historically this option feature of the debt has been (p. 572) under‐priced by investors in the terms of the debt contract. Astute financial management would lead the corporation to sell an asset (perhaps another option) with the same or similar features after issuing such a bond. Following amortization of the price received for this asset, the corporation has effectively issued debt at below market rates. Reducing Funding Costs by Reducing Information Costs

Information acquisition and processing costs, and those associated with the provision of liquidity, are a natural outcome of raising finance in any capital market. In the context of corporate funding requirements, there is some evidence that the choice of location for an MNE sourcing equity capital is influenced by differential international accounting and regulatory disclosure requirements. For example, by cross‐listing, an MNE may be able to reduce the agency costs of external finance through signaling its quality through a commitment to high corporate governance and disclosure standards (Huddart, Hughes, and Brunnermeir 1999; Oxelheim, Randøy, and Stonehill 2001). Saudagaran and Biddle (1995) analyse over 450 internationally traded MNEs listed on nine stock exchanges in eight countries at the end of 1992 and find that choice of listing location is significantly determined by financial disclosure variables, in addition to an MNE's business profile, measured by the level of exports from the MNE to the listing locality. In an extensive study, Pagano, Roëll, and Zechner (2002) show that the European equity markets with the weakest investor protection and least transparent accounting standards have been the least able to attract or retain foreign listings.17 They also provide evidence to corroborate the perspective that companies cross‐list in markets which are larger and more liquid than their domestics market, while high trading costs appear to discourage listings. Finally, MNEs may also crosslist to capitalize on their reputation in a product market or even to obtain arbitrage profit from a relative temporary misalignment of the equity price in the foreign and domestic markets.

20.4.3 Market Segmentation, Competitive Advantage, and Costs of Capital

The evidence is now fairly convincing that models which are based upon complete international capital market integration have difficulty in explaining the extant pattern of the international distribution of portfolio holdings or the behaviour of financial asset returns. (See Cooper and Kalpanis 1986, 1994; Jorion and Schwartz 1986; Hietela 1989; French and Poterba 1991; Tessar and Werner 1995.) It follows that in order to generate a framework for international capital market decision making, it is necessary not only to introduce differential costs of international investment which induce market segmentation into international investment models (Black 1974; Stultz 1981), but also to modify the standard capital budgeting rules found in (p. 573) corporate finance (Adler and Dumas 1975a, b, 1983; and Stapleton and Subrahmanyan 1977).

The implication is that it is necessary to address issues arising from market segmentation when calculating the costs of capital for a MNE's international real investment decisions. Many existing models either assume complete market integration or complete segmentation or introduce it in an ad hoc fashion (Errunza and Losq 1985; Stultz 1995; and Godfrey and Espinosa 1996).18 Cooper and Kaplanis (2000) by deriving optimal capital budgeting rules in an extension of the Stultz (1981) model, is the only example in the literature with which we are familiar that provides a robust framework for devising corporate finance decision rules for MNEs in segmented markets.

In this model, differential costs of access to capital arises not from money illusion, or segmentation between money and bond markets (which induces different effective real interest rates to companies domiciled in different countries),19 but from equity market segmentation. Required returns differ for MNEs undertaking the same investment as the investment has different marginal risks and returns for their investor clients. This in turn affects MNEs' international competitiveness and motives for FDI as shown by Lessard (1991).20 An interesting avenue for future research is suggested here, in that in principle one could estimate the required rates of return for alternative projects, (which will depend on the MNE making the investment), and link this back to motives for FDI and its impact upon competition in product markets.

Oxelheim, Randøy, and Stonehill (2001) incorporate finance‐specific factors within the standard OLI (ownership, location and internationalisation) international business paradigm. They identify a number of proactive financial strategies, which they maintain enable a MNE to obtain access to competitively‐priced sources of equity capital. One example they consider is cross‐listing, which they claim can be perceived as a financial ownership advantage, and is often a strategic prelude providing a signal of future FDI (Oxelheim et al. 2001). For example, the 1993 Daimler‐Benz listing on the NYSE preceded a multi‐billion dollar euro‐equity issue to help finance a new car plant in Alabama and was an antecedent to the eventual merger with Chrysler in 1998. Furthermore, by broadening the investor base, cross‐listing may enhance liquidity in the listed shares, thereby reducing the firm's cost of capital. Pagano, Roëll, and Zechner (2002) analyse an extensive pattern of global cross‐listings. They argue that the decision to list overseas is a function of company‐specific factors, but they find some evidence of industry clustering, with companies often choosing to list where several companies from their industry sector are already listed. This suggests that informational criteria may have some role in this decision. Blass and Yafah (2000) claim that the high incidence of Israeli and Dutch technology companies listing on NASDAQ has been linked to the US location of analysts with superior technological knowledge of the industry. Such analyst involvement may impact favourably upon the terms and conditions at which equity capital is made available by reducing primary market informational asymmetries.

(p. 574) 20.4.4 Market Segmentation and Strategy: The Choice of Participation Mode

The consequences of international capital market segmentation are relevant not only in terms of investment evaluation as addressed in the previous section, but also in terms of its impact upon modes of market participation and entry. Consider the choice of alternatives to full equity ownership such as: joint ventures, strategic alliances, licensing agreements, project finance, or incentive management contracts. These financial arrangements are customarily viewed as motivated by the need to provide contractual structures which align incentives for those participants who are able to influence outcomes. Our view is that financial factors are possibly a major if largely neglected component in the determination of these contractual structures. Devoting further attention to this issue is perhaps more important in the context of recent evidence that certain mergers and acquisitions often reduce corporate value (for example, Berger and Ofek 1995).

To take a particular example, consider market entry or participation by an MNE through a joint venture. The motives and gains for joint ventures have been rationalized in terms of: synergy sharing (McConnell and Nantell 1985; Berkovitch and Narayanan 1993; Maquiera, Megginson, and Nail 1998); the efficient governance of expropriation threats, hold‐up problems, or other transactional barriers arising for example from asset specificity (Klein, Crawford, and Alchian 1978; Williamson 1979, 1983; Alchian and Woodward 1987); or efficient risk sharing between upstream and downstream firms (Weston, Chung, and Hoag 1990).21

An additional, complementary rationale relates to their use as financing vehicles (Johnson and Houston 2000), in particular for vertical joint ventures. Under a market length contract the supplier typically owns and finances the productive capacity. Using standard asymmetric information arguments (Myers and Majluf 1984), one can demonstrate that firms may face constraints in raising external financing which leads them to refuse orders from buyers which require new production capacity if the seller has exhausted internal sources of funds. This is a standard underinvestment problem. Organizing a market participation or new entry as a vertical joint venture enables the supplier to provide non‐financial resources while the buyer provides financing. This financing is provided at lower cost than another provider, as the buyer can more easily monitor the joint venture, and has more secure collateral. To test this motive one could refer to the literature on finance constraints and investment (Fazzari, Hubbard, and Peterson 1988) to find proxy variables for firms facing financing constraints. For example it has been claimed that firms which pay little or no dividends in the period immediately prior to the joint venture may be ‘internal funds constrained’. A similar logic could be applied to the analysis of strategic alliances, although the fact that they do not involve equity investments or the creation of a third organizational form suggests that they have less well‐defined property rights (Chan et al. 1997). We believe that an extension of the approach suggested in the analysis of this section would contribute to recent debates in the (p. 575) financial strategy literature (Lane, Canella, and Lubatkin 1998; Amihud and Lev 1999; Denis, Denis, and Sarin 1999; Lane, Canella, and Lubatkin 1999) in relation to the appropriate domain and explanatory power of agency theory and observed financial contracting arrangements. Prior empirical studies customarily apply agency theory to corporate strategy and investigate corporate diversification and/or acquisitions as a particular form of external corporate development. Such research does not generally examine the specific role of strategic assets or the contractual provisions governing international business relationships that help to guarantee the value‐enhancing productive activities of partner firms. These would all be profitable areas for future research.

20.4.5 Empirical Evidence on MNEs' Financial Management Approaches

Evidence indicates that the vast majority of large MNEs use both internal and external risk management instruments (Stanley and Block 1980; Khoury and Chan 1988; Tufano 1996; Hakkarainen et al. 1998). The choice of instrument reflects both the types of exposure they face, and certain characteristics of the firm, in particular its size and degree of internationalization.22 Moreover, the use of external hedging instruments by MNEs is much more widespread than for domestic firms, as evidenced by comparing the survey results in Joseph (2000) with those of, for example, Bodnar et al. (1995).

In terms of internal techniques, Joseph (2000) discovers the following. For contractual exposure, inter‐company netting and home currency invoicing are the most commonly used hedging techniques; for translation and economic exposure matching currency inflows and outflows and asset/liability management are the dominant hedging techniques. Phillips (1995), Joseph (2000), and Marshall (2000) all report that forward contracts are the main external method for managing contractual exposure, while Joseph (2000) indicates that foreign currency borrowing and lending is the primary method for hedging translation and economic exposure, especially the former. The use of foreign exchange options and futures are relatively low for all classes of exposure, although options are more widely used than futures (Glaum and Belk 1992; Phillips 1995; Joseph 2000). The low use of futures may be due to the daily settlement characteristic of these contracts which may impact adversely on liquidity and cash flow management.

We are now in a position to ask to what extent is the available empirical evidence on the use of risk management techniques consistent with the motives which have been identified? As the recent evidence indicates both that external techniques play a more important role in risk management than internal techniques, and that the explanatory power of empirical procedures is much stronger for external techniques, we focus on evidence relating thereto.23 Concerning managerial motives for hedging, (p. 576) Geczy, Minton, and Schrand (1997) argue that empirical proxies for managerial risk aversion are positively correlated with derivatives usage, while Francis and Stephan (1990) using multivariate and time series empirical techniques, found strong evidence for the managerial signaling arguments. Both sets of results are in accordance with a priori theoretical expectations.

The available evidence is also broadly consistent with the use of risk management tools to avoid the costs of financial distress as advocated by Smith and Stultz (1985) and resolve the underinvestment problem formulated by Froot, Scharfstein, and Stein (1993). Noting that most empirical studies of MNE hedging behaviour analyse multiple theoretical models, with respect to the former, a significant relationship is generally found between a corporation's derivative usage and the following variables: its level of debt service coverage (negative), its leverage (positive), its level of foreign operations (positive), and changes in its credit rating (negative), with signs as predicted. Given the difficulties in measuring expected investment, tests of the underinvestment hypothesis customarily incorporate a series of proxies for the MNEs investment opportunity set such as the ratios of R&D expenses to sales, and book to market ratios (Geczy, Minton, and Schrand 1997; Gay and Nam 1998) as well as imperfect capital market and costly external finance measures. Allayannis and Ofek (2001) and Allayannis and Weston (2001) also support certain implications of the under‐investment perspective, namely that increased growth opportunities and enhanced leverage are positively related to the use of derivatives.

Does financial risk management generate tangible benefits for equityholders? Muller and Verschoor (2006) provide an excellent survey of the documented empirical impact of corporate exchange rate risk management upon shareholder value in the context of the market based models previously outlined. They conclude that while the majority of the evidence suggests that exchange rate exposure impacts shareholder wealth, particular attention should be given to the specification of the empirical variables incorporated in the estimated models. They highlight the following issues as being of particular relevance. First, studies show that the impact of exchange rate risk exposure on shareholder returns decreases when calculated: (1) at a portfolio as opposed to the individual firm level; (2) using monthly as opposed to daily data; (3) using shorter as opposed to longer time horizons. Second, as noted by Bodnar and Wong (2003) the definition of the market risk factor in specifications such as equation (1), for example the use of equally‐weighted, value‐weighted or firm‐size matched portfolios as a proxy for the market portfolio, affects the sign, magnitude and significance of the estimated exposures. Third, the definition of the appropriate exchange rate risk factor(s), that is the use of bilateral currency exchange rates as opposed to an appropriate trade weighted currency index (possibly region‐specific) needs careful consideration. Fourth, whether simple market model such as equation (1) should be augmented by a multifactor empirical specification, and if so, which macroeconomic variables should be incorporated into the latter formulation (Gao 2000). Fifth, the manner by which shareholders learn about the effectiveness of a (p. 577) firm's financial management strategy through the release of accounting and other information needs to be explicitly considered, as there is some evidence that firm returns in the current period are more influenced by lagged than contemporaneous exchange rate exposure measures (Bartov and Bodnar 1994, and He and Ng; 1998). Finally, as data on actual hedging behaviour is difficult to obtain, very few studies adequately control for the impact of a firm's existing financial risk management strategy on their estimated measures of exchange rate exposure. Thus, empirically insignificant exposure coefficient measures may simply be attributable to the fact that the MNE's exposure is already effectively hedged. Pantzalis, Simkins, and Laux (2001) and Williamson (2001) among others, corroborate the view that MNE's exhibiting a greater breadth of overseas operations evidence lower measured currency risk exposure. Unanswered questions, therefore, still remain as to precisely how an MNE's risk management strategy impacts upon its exchange rate exposure, and more work is needed in this area.

We should also note that while mixed, the available evidence is also weakly consistent with the view that risk management is used to increase shareholder wealth by taking advantage of tax related benefits. Positive relationships have been uncovered between both tax loss carry‐forwards and tax credits and the use of derivatives. Graham and Rogers (2002), while finding no evidence that firms hedge in order to benefit from tax schedule convexities, document motivations arising from the ability to increase MNE corporate debt capacity. They calculate the ensuing benefits from tax deductions to be 1.1 per cent of firm value on average.

Overall, these results are encouraging in the sense that not only do theoretical arguments demonstrate how corporations should be managing risk in order to maximize their shareholders wealth, but empirical evidence demonstrates they appear to be behaving in accordance with the theory. However, one interesting finding which we believe merits further research is contained in Joseph (2000), who argues that the use of certain risk management techniques is (surprisingly) associated with an increase in variability of certain financial measures. Apart from the implications for leverage in some hedging decisions, the maturity mismatch of exposures and certain derivatives,24 and the concerns related to the non‐linearity of options payoffs raised by Giddy and Dufey (1995),25 the rationale for these findings is not addressed in the existing theoretical or empirical literature. In the light of previous discussion, we conjecture that one possible explanation may lie in the distinction introduced earlier between risk management techniques which respond to volatility to create competitive advantage, and those which are intended explicitly for hedging purposes. If the MNEs are using external techniques to secure funding or cost of capital advantages, then their use may clearly increase the volatility of cash flows or earnings in the short term. Much more extensive analysis is required to ascertain how an MNEs risk management methods impact on a firm's value sensitivity to asset price fluctuations, or alternatively stated, which corporations should actively engage in active financial risk management strategies such as external hedging to enhance corporate value.

(p. 578) 20.5 Implementing an Effective Risk Management Strategy Within an MNE

Implementing an effective risk management strategy within an MNE basically involves establishing corporate governance processes which deliver the requisite knowledge and ensure appropriate accountability. Once the objective of financial management activity is clarified, and financial risks have been identified and measured, it is important they are not considered in isolation, but rather form part of some integrated corporate strategy for dealing with risk. Smithson (1998) suggests how this might be achieved. The framework he proposes is now presented in increasing order of strategic complexity in terms of management requirements.

  1. 1. Integrate market risks: Many non‐financial firms such as Intel, Hewlett‐Packard, and Hyundai attempt to implement a portfolio measure of risk by combining all the sources of risk arising from changes in financial prices, and considering their net impact. However, according to Bodnar, Hayt, and Marston (1996), two out of three derivatives users still manage risk on a transaction by transaction basis. Corroboration of this finding is provided in another survey, which concluded that of over 500 multinational firms, only one quarter had centralized treasury operations.

  2. 2. Integrate market risk and insurance: Effectively this requires the combination of these two risk management functions, and involves a realization that the distinction between financial risk and insurance is becoming blurred. Indeed, certain insurance corporations such as Swiss Re and Cigna Property & Casualty now offer insurance policies resembling options on financial price variables. MNEs such as Honeywell and Union Carbide are proponents of such a risk management strategy, and have integrated financial price risk management with the corporation's insurance activities.

  3. 3. Integrate financial with manufacturing and marketing risks: This is the most complex approach to risk management, and involves integrating the treasury department's activities, decisions on how best to handle liquidity, operational and legal risk, and the firm's core businesses. Smithson (1998) notes that the most prominent example of this practice is Merck & Company, which requires that the treasury function become an integral part of managing the corporation rather than simply providing the financing once business decisions have been made. Such a system of ‘enterprise‐wide risk management' potentially involves major structural changes, and commitments of managerial time. Oldfield and Santomero (1995) suggest that this requires a comprehensive review of all the major business activities along the following lines. First, the specific risks of each business activity must be identified and measured, where possible. Second, risk management must ‘begin at the point nearest to the assumption of risk’ in order to ensure that management control is maintained, data is generated in a consistent fashion, and needless exposure to risk is eliminated. Finally, senior management (the Board of Directors) must have a clearly formulated and effective overall risk management strategy, closely integrated into the corporation's business planning and management control processes.26

(p. 579)

20.5.1 Monitoring and Evaluation of the Corporate Risk Management Strategy

The data derived from the selected risk management strategy must be used as an informational input into a centralized system of evaluation and performance monitoring. It is crucial that this system of monitoring and evaluation should be independent of the activity itself, and that whatever the strategy selected, corporate management be constantly appraised of the value of the portfolio of risk management instruments. The analytics of such a system have been concisely summarized by Dowd (1998), and include: (1) data verification procedures; (2) systems to monitor compliance with constraints imposed on those taking decisions (for example position limits on traders); (3) systems to acquire and analyse data for performance evaluation and adjustments in the riskiness of the MNE's position; and (4) ensuring that risk management systems are valid and appropriate for the task at hand. Research in this area is still in its infancy. In particular, we await the results of comparative analysis of the success rates of different corporate governance structures established to implement an MNE's overall risk management strategy.

20.6 Conclusion

This chapter maintains that the advent of an increasingly integrated global capital market system, characterized by volatility in real and financial asset prices and macroeconomic risks, enhances not only the competitive impact of MNE financial risk management, but augments the potential gains from integrating financial management considerations into key strategic and operating decisions. With the possible exception of routine hedging, financial decisions are not a function which can be isolated from the underlying strategic and operating decisions which effectively determine an MNE's cash flows or earnings in a volatile macroeconomic environment. Several areas have been identified where further work is needed. First, attention should be given to alternative methods of estimating country risk premium that do not rely on the analysis of historical data. The use of implied equity premiums derived from equity market valuation models is one possibility which is identified. Second, more investigation is required of the reasons for regional differences observed in MNEs' stated risk management objectives and revealed risk management practices. Third, attention must be given to the appropriate procedures MNEs should adopt when implementing internal risk management processes such as cash‐flow‐at‐risk or variants of value‐at‐risk. Fourth, the implications of differences in capital costs arising from equity market segmentation (Oxelheim et al. 1998; Cooper and Kaplanis 2000) on the motives for FDI and its impact upon competition in international product markets needs investigating. Fifth, further theoretical refinements to market‐based (p. 580) models of financial risk exposure will enhance our understanding of the important time variations and nonlinearities inherent in measuring MNE exposure to asset price fluctuations, in particular exchange rates. Finally, a case has been made that financial contracting considerations are a relevant, but largely neglected, determinant of the choice of mode of market entry. Further attention should be paid to this issue, particularly in the light of recent findings that certain mechanisms for market entry appear to reduce corporate value.


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                                                                                                                                                                                                                                                                                                                                                                              (1.) To define financial risk, we must first select the financial variable(s) of interest. The value of the MNE's portfolio of assets and liabilities, corporate earnings, equity capital, or a specific cash flow arising from an operating or contractual exposure, are all natural candidates. Focusing on the former variable for illustrative purposes, financial risk can be defined as unexpected changes in the valuation of a multinational corporation's portfolio of assets and/or liabilities arising either: (1) from changes in the value of financial instruments or (2) consequent upon the corporation's activities in financial markets. Unexpected movements in the prices of financial instruments, such as exchange rates, interest rates, commodity and equity prices, collectively termed market risk, are the major sources of financial risk for most MNEs.

                                                                                                                                                                                                                                                                                                                                                                              (2.) The irony of this fact has not escaped the attention of many commentators (see e.g. Lessard 1997), given that many of the building blocks for the modern theory of the MNE were established following Hymer's critique of the ‘international capital flow’ theory of FDI which stimulated much early theoretical work on MNEs.

                                                                                                                                                                                                                                                                                                                                                                              (3.) We note that this trend is not universal. While the global financial environment incorporates an increasingly integrated core, there remains a large periphery including many LDCs ostracized by debt overhang and incomplete contracting regimes which in Lessard's words is ‘dependent upon but only loosely linked to the core international market’. For further discussion of the impact of debt on capital market access, see Bowe and Dean (1997).

                                                                                                                                                                                                                                                                                                                                                                              (4.) For a recent survey of MNE activity in relation to emerging markets, see Errunza 1997.

                                                                                                                                                                                                                                                                                                                                                                              (5.) There are some commentators who argue that country risk is diversifiable (unsystematic) and that there should be no correction for country risk premium in evaluating international investment decisions. Recent asset pricing behaviour in international financial markets provides substantial evidence of cross‐market correlation (systematic risk) suggesting country risk is non‐diversifiable even in a global portfolio. Classic studies in this area include Solnik (1974); Severn (1974); Jacquillat and Solnik (1978). The debate is treated in Buckley (2000).

                                                                                                                                                                                                                                                                                                                                                                              (6.) This analysis makes no attempt to consider the important issues surrounding the appropriate theoretical framework for international capital budgeting decisions in terms of present value versus real option approaches. Appropriate discussion can be found in Dixit and Pindyck (1994, 1995); Sercu and Uppal (1994, 1995); Brennan and Trigeorgis (2000); and Buckley (2000). A thorough analysis of surveys (e.g. Oblak and Helm 1980; Wicks Kelly and Philippatos 1982; Shao and Shao 1993; Buckley et al. 1996), of the actual practice of MNE international investment appraisal, is contained in Buckley (2000).

                                                                                                                                                                                                                                                                                                                                                                              (7.) Other studies of the foreign exchange risk management behaviour of US and UK corporates include those by Collier and Davies (1985); Mathur (1985); Belk and Glaum (1990); Davies et al. (1991); Berg and Moore (1991); and Joseph and Hewins (1991).

                                                                                                                                                                                                                                                                                                                                                                              (8.) Collier et al. 1990 indicate that financial managers in certain UK and US‐based MNEs are concerned about the adverse impact of translation risk on leverage, distributable reserves, and overall balance sheet value. See also Schooley and White (1995).

                                                                                                                                                                                                                                                                                                                                                                              (9.) For further discussion of the financial management implications for MNEs of the asymmetric incidence of accounting standards, regulations, and taxes see Gray, Meek, and Roberts (1995); Meek, Roberts, and Gray (1995); and Roberts, Weetman, and Gordon (1998).

                                                                                                                                                                                                                                                                                                                                                                              (10.) Moreover, as fluctuations in exchange rates impact on operating cash flows in both domestic and foreign currency the total resulting impact could imply an elasticity greater or less than one. Capturing operating exposures through accurate elasticity estimates is critical to cash flow sensitivity analysis. How corporations obtain elasticity estimates, for example using economic models or simulations, will vary. Indeed, this translation of financial price risk into changes in the corporation's operating performance is perhaps the most challenging aspect of accurately ascertaining cash flow exposure. It also compels multinational treasurers to be explicit about their operating parameters, and these parameters can then be re‐evaluated in the context of the model(s) used.

                                                                                                                                                                                                                                                                                                                                                                              (11.) The nature of the company's operations is a critical determinant of its ability to model successfully the dependency of cash flows upon market risk. Multinational corporations with global production operations are obviously at the complex end of the modelling spectrum relative to single product or commodity driven firms.

                                                                                                                                                                                                                                                                                                                                                                              (12.) Gao (2000), Griffin and Stulz (2001), and R. G. Williamson (2001) among many others, selectively discuss these issues.

                                                                                                                                                                                                                                                                                                                                                                              (13.) For a critique see Lewent and Kearney (1990); and Glaum (1990).

                                                                                                                                                                                                                                                                                                                                                                              (14.) Giovannini (1989) discusses several mechanisms for tax shifting. A particularly interesting one, cited in Lessard (1997), is when an MNE structures foreign operations as a branch of a domestic subsidiary that can be consolidated or unconsolidated at the parent's discretion. This facilitates a continuous movement from deferred to nondeferred treatment, thereby creating an international mechanism for shifting tax losses, which cannot be obtained using portfolio management techniques.

                                                                                                                                                                                                                                                                                                                                                                              (15.) The market anomalies (or inefficiencies) which may give rise to such opportunities are extensively discussed in Bowe (1988), and most leading international finance texts, e.g. Buckley (2000).

                                                                                                                                                                                                                                                                                                                                                                              (16.) For further discussion see Radebaugh and Gray (1997). This procedure, while reducing funding costs, provides a foreign exchange exposure in at least one currency, the risk of which can be appropriately managed.

                                                                                                                                                                                                                                                                                                                                                                              (18.) An insightful discussion of the cost of capital as a competitive variable is presented in Lessard (1997). See also Oxelheim et al. (1998).

                                                                                                                                                                                                                                                                                                                                                                              (19.) These types of approaches are critiqued in Kester and Luehrman (1992); and Lessard (1997).

                                                                                                                                                                                                                                                                                                                                                                              (20.) The model thereby explains the ‘home‐bias’ results of Cooper and Kaplanis (1986, 1994); and French and Poterba (1991).

                                                                                                                                                                                                                                                                                                                                                                              (21.) The references are selective as these motives are considered at length elsewhere in this volume.

                                                                                                                                                                                                                                                                                                                                                                              (23.) Moreover, some studies, such as Nance, Smith, and Smithson (1993); and Dolde (1995), focus only upon external methods for managing risk.

                                                                                                                                                                                                                                                                                                                                                                              (25.) A closely related reference is Ware and Winter (1988).

                                                                                                                                                                                                                                                                                                                                                                              (26.) It is the responsibility of the MNE's Board of Directors to: (1) understand how risk management affects the corporation's overall business plan; (2) ensure that the team of managers entrusted with implementing the corporation's risk management policies have the required expertise; (3) evaluate the performance of the risk management activity, and ensure it is reviewed periodically.