Multinational firms can always reduce the foreign exchange risk faced by their foreign affiliates by borrowing in the local currency. True or false? Why?
ANSWER. False.
Currency risk is reduced when swings in operating profits due to currency changes are offset, in whole or in part, by opposite movements in the cost of servicing its debts. In this way, currency changes have less effect on dollar cash flows. Consider an MNC with a foreign subsidiary that manufactures for export. The subsidiary’s dollar operating cash flows will rise with LC appreciation and fall with LC depreciation. If the subsidiary borrowed in the local currency, then the dollar cost of servicing its liabilities would also rise with LC appreciation and fall with LC depreciation. This would reinforce, not dampen, the swings in its operating profits caused by the currency changes.
