International Capital Budgeting: Approaches & Exchange Rate Risk

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  • 0:02 Background on…
  • 0:49 The Home Currency Approach
  • 3:23 Lesson Summary
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Lesson Transcript
Instructor: Natalie Boyd

Natalie is a teacher and holds an MA in English Education and is in progress on her PhD in psychology.

International businesses face risks that domestic companies don't. In particular, the exchange rate can pose a risk for multinational corporations. In this lesson, we'll examine the home currency approach and how it can help mitigate this risk.

Background on International Business

Mario owns a company that does business internationally. That means that the business spends and earns money in different currencies, and then has to change the money into US dollars, since that's where the company is based. There are many risks to international business, including political upheaval, local restrictions, and the fluctuations in the exchange rate, or the value of one currency against another. For example, one US dollar might be worth 100 Japanese yen today, but tomorrow, it could be worth 90 yen or 200 yen.

How can Mario manage the exchange rate to help mitigate the risk associated with its fluctuations? One way is to use the home currency approach. Let's help Mario by looking at what that means and how it is a long-run approach to managing exchange rate risk.

The Home Currency Approach

Mario wants to help his company manage the exchange rate. But he doesn't want to focus on short-term fluctuations; he's more concerned with long-term ways of managing money in the international market. A long-run approach to international capital management is about mitigating long-term risk and ignoring or discounting short-term fluctuations.

One example of a long-run approach is the home currency approach to capital management, wherein all international business is done based on the currency of the company's home country. For example, Mario's business is based in the US, so his home currency is the US dollar. According to the home currency approach, Mario's business should be run as though they were using US dollars, even when they are doing business in Japan.

In practice, this means following four steps:

1. Estimate cash flow in foreign currency.

The first thing that Mario will have to do is to figure out what the cash flow (that is, how much they are spending and earning) is in the currency of the country where they are doing business. For example, they'll want to know how many yen it costs to operate their Japanese factory.

2. Estimate future exchange rate.

The next thing Mario will want to do is to forecast what he thinks the future exchange rate will be. There are many experts who calculate this, and Mario can choose the expert or experts that he believes is closest to the truth.

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