Managing Interest Rate and Exchange Rate Volatility - Assignment Example

INTRODUCTION. Considering Kaufman & Connelly Plc's present expansion plan and worries about effects of expected interest rate changes on present borrowings and proposed future borrowings as well as the type of exchange rate exposure the company can expect to face in the coming years, I present in this paper how interest rate fluctuations might affect its present and future borrowings. We also present an overview of the types of exchange rate fluctuations the company can expect to face in coming years. i. EFFECTS OF INTEREST RATE CHANGES ON PRESENT AND PROPOSED FUTURE BORROWINGS. Interest rate risk measures the sensitivity of a firm's cash flows, profit and firm value to interest rate fluctuations. In addition to the interest risk that a company might face as a result of changes in its cash flows, profit and firm value. Buckley (1996) identifies two other types of interest rate risk, which include basis risk and Gap risk. If interest rates are determined on a different basis for assets and liabilities then a firm having loans and debts will face basis risk. A company faces basis risk when the interest rates on its loans and debts are determined using different basis. (Buckley, 1996) Assume for example that Kaufman & Connelly Plc issues a fixed rate bond to fund its financing needs and at the same time gives out a loan to another party at a floating interest rate. Her interest payments will therefore be fixed while interest receipts will be variable and will depend on prevailing rates. She will therefore be facing basis risk since her interest expenses and revenues will be determined on different basis. A company faces gap risk when it has both fixed rate liabilities and assets. When fixed rate liabilities exceed fixed rate assets then there is positive Gap, with a positive gap a rise in short term rates increases margins while declining rates decrease margins. On the contrary if fixed rate liabilities are less than fixed rate assets, then there is negative gap. In this case a rise in short-term rates decreases margins while a decrease increases margins.(Buckley, 1996). Elekdag and Tchakarov (2006). Changes in interest rates have also been the major determinants of business cycles or trade cycles in emerging markets such as Thailand in recent times. (Elekdag and Tchakarov, 2006). The figure above is an indication of how interest rates and business cycles are related in Thailand. High interest rates lead to low output whereas low interest rates lead to high output. Therefore Kaufman & Connelly Plc is likely to face decreases in demand for its products during a period of the high interest rates and increases in demand during lower interest rates. ii. FOREIGN EXCHANGE EXPOSURE Exchange rate exposure can be defined as the degree to which a firm's cash flows, assets, liabilities and value can be affected by exchange rate movements. (Buckley, 1996). According to Buckley (1996), assets, liabilities, profits or expected future cash flows are said to be exposed to foreign exchange risk when a change in exchange rate would result in either a positive or negative change in the home functional currency (home currency) value of the asset, liability, profit, expected cash flow or firm value. The term "exposure" used in the context means that the firm has assets, liabilities, profits or expected future cash flow streams such that the home currency value of assets, liabilities, profits or the present value in home currency terms of expected future cash flows changes as changes in exchange rates occur (Buckley, 1996: pp 133). From the foregoing foreign-currency-denominated assets and liabilities as well as expected foreign-currency-denominated future cash flow streams are clearly exposed to exchange rate risk. (Buckley, 1996; Shapiro, 2003). Buckley (1996) also notes that home-currency-denominated expected future cash flows may also be exposed to foreign exchange risk. For example, a firm based and selling goods in the United States may be competing with European firms and as such its expected future cash flows will be affected by exchange rate movements between the euro and the dollar by strengthening or weakening its competitive position against its European competitors. (Buckley, 1996). Exposure to foreign exchange risk is classified into three types including transaction exposure, translation exposure and economic or operating exposure. (Buckley, 1996; Shapiro, 2003). Transaction Exposure Foreign-currency-denominated receivables and payables (assets and liabilities) lead to transaction exposure (Buckley, 1996). Shapiro (2003). Transaction exposure measures the change in value of foreign-currency-denominated assets and contracts resulting from exchange rate fluctuations (Shapiro, 2003). The degree of loss or gain resulting from transaction exposure depends on the terms of the contracts and this gains and losses are in real terms (Shapiro, 2003). Translation Exposure Foreign-currency-denominated balance sheet items lead to translation exposure during consolidation of subsidiary accounts. (Buckley, 1996). Translation exposure can also be referred to as accounting exposure and it refers to changes in income statement and balance sheet items that result from changes in exchange rate changes. (Buckley, 1996; Shapiro, 2003). Accounting rules are used to determine exchange gains and losses which are on paper only and the measurement of translation exposure is by retrospectively restating each foreign-currency-denominated income statement and balance sheet item following the prevailing exchange rate. (Shapiro, 2003). Operating or economic exposure Economic or operating exposure measures how exchange rate fluctuations can affect a firm's expected future operating cash flows, which include its future sales and costs. (Shapiro, 2003). Both domestic and foreign firms face operating or economic exposure irrespective of whether they have foreign-currency-denominated cash flows or not (Buckley, 1996; Shapiro, 2003). There are four methods or measuring translation exposure, which include, current/non-current method, monetary/non-monetary method, temporal method and current rate method. (Buckley, 1996; Shapiro, 2003). Current/Non-Current Method. Under the current/non-current method long-term assets and liabilities are separated from short-term assets and liabilities. Short-term assets and liabilities are translated using the current rate while non-current assets and liabilities are translated at their historical exchange rates. (Buckley, 1996; Shapiro, 2003). The average exchange rate is applied when translating income statement items associated with short-term assets and liabilities. (Shapiro, 2003). One short-coming with this method is that it implies that long-term debt is not exposed to foreign exchange exposure while inventory is exposed. (Buckley, 1996). In fact, long-term debt is exposed to foreign exchange exposure as the home-currency amount of a foreign currency denominated debt will change as exchange rates, and thus the non-current method is not a proper method for measuring translation exposure. (Buckley, 1996). The accounting exposure under this method is given by the net amount of current assets. (Shapiro, 2003). Monetary/Non-Monetary Method Under this method monetary assets are separated from non-monetary assets. (Shapiro, 2003). Monetary items include assets and liabilities that are fixed in money terms and include claims to receive or obligations to pay determined amounts of foreign currency. (Buckley, 1996; Shapiro, 2003). Non-monetary assets and liabilities represent fixed assets, investments and inventory. Monetary items are translated at the current rate while non-monetary assets are translated at the historical rates. (Buckley, 1996; Shapiro, 2003). Revenue and expense items in the income statement are translated using the average exchange rate except those that relate to non-monetary items. These latter items which include depreciation and cost of goods sold are translated at the historical rate. (Shapiro, 2003). The translation exposure is then calculated by calculating the net monetary assets. (Buckley, 1996). Temporal Method The temporal method is like the monetary method with the only difference being that the temporal method translates inventory using the current rate if it is carried in the balance sheet at market value and translated using the historical cost if not carried at market value, whereas under the monetary/non-monetary method, it is always translated at the historical cost irrespective of whether it is carried at market value or not. (Shapiro, 2003). The current rate method The current rate method is relatively easy to understand and apply as it translates all income statement items and liabilities at the current exchange rate. (Shapiro, 2003). From the foregoing, considering Kaufman & Connelly Plc's present expansion plan, it is evident that it will have subsidiaries in Thailand, Malaysia with whose financial statements will be denominated in the Thai Bhatt, Rigget and other East Asian countries. Thus the financial statements for these subsidiaries will be denominated in these foreign currencies. Also its current plan to borrow 200million denominated in foreign currency further increases its translation exposure as regards repayment of principal plus interest in future. It will therefore either suffer currency translation losses or enjoy currency translation gains as a result of its decision to expand to a number of different countries. Measuring Transaction Exposure. As earlier stated transaction exposure results from contracts entered into that will result in future liabilities or assets denominated in foreign currency. (Shapiro, 2003). It refers to the possibility of incurring future foreign exchange losses or having foreign exchange gains as a result of these transactions. (Shapiro, 2003). For instance consider a situation where Kaufman & Connelly Plc in the course of its operation in Thailand sells widgets to the US, it will not expect to receive payment immediately and if these sales are invoiced in the US dollars, then it has a transaction exposure to dollars. Transaction exposure is measured currency by currency and equals the difference between contractually fixed future cash inflows and outflows in each currency. (Shapiro, 2003). To illustrate suppose Kaufman & Connelly Plc enters a contract to deliver Widgets costing 20,000 US dollars and receives goods from the US worth 14,000 US dollars, then we can calculate its exposure to the dollar by netting out its expected inflows from expected out flows. Lets assume a current exchange rate between the US dollar to be 0.5dollars/Thai Bhat, then its net dollar exposure will be given by: 20,000-14,000 = 6,000 USD. Assume that the dollar depreciates in value say to 0.4USD/Thai Bhat then its translation loss will be given by 6,000x0.1/0.5 = 1,500 dollars. Measuring Economic Exposure. Economic or operating exposure is a measure of the impact of exchange rate movements on expected future cash flows, which result from foreign investments. (Kim and Kim, 1996). Economic exposure may arise as a result of economic shocks such as the disappearance of price stability, availability of funds, favourable balance of payments and low tax rates due to a deterioration of the economic situation of the country. (Kim and Kim, 1996). These events will lead to depreciation in the value of the home currency and the subsidiary will face economic exposure or operational problems if it has to pay its imports in a hard currency or if it has foreign currency denominated loans. Inflationary forces, price controls, availability of labour and loanable funds may also be affected by exchange rate fluctuations. (Kim and Kim, 1996). Economic exposure is a more serious and more attentive form of exposure as it affects almost every aspect of the firm's operations. (Kim and Kim, 1996). It is also very difficult to estimate and better still hedge because it affects the firm's long-term performance and profitability and to a greater extend firm value. (Kim and Kim, 1996). Managing Foreign Exchange Exposure. Kaufman & Connelly Plc can mange its currency exposures through hedging. By so doing Kaufman & Connelly Plc will take a position such as acquiring a cash flow or an asset or a contract that will rise or fall in value and offset the fall or rise in value of an existing position. (Moffet et al, 1995). Shapiro (2003, pp 329) states that hedging a particular currency refers to establishing an offsetting position so that whatever is lost or gained on the original currency exposure is exactly offset by a corresponding foreign exchange gain or loss on the currency hedge. Kaufman & Connelly Plc can use currency futures, currency swaps, currency forwards and currency options to hedge its expected future exposure to exchange rates. Forward market Hedge If Kaufman & Connelly Plc has to receive a future stream of cash flows in a foreign-currency, she can sell the stream of cash flows in a forward market. On the other hand if Kaufman & Connelly Plc has liabilities to pay in foreign currency, then it can buy a forward contract to hedge against an appreciation of the foreign currency. That is a company that is long in a foreign currency will sell the foreign currency forward while a company that is short in a foreign currency will buy the currency forward. (Shapiro, 2003). For example, assume that Kaufman & Connelly Plc has to receive 10million Thai Bhat in 3 months. The current spot exchange rate between the Thai Bhat and the pound is 100 Thai Bhat/pound. Also assume that the three-month forward rate is going to be 110Thai Bhat/pound and Kaufman & Connelly Plc wants to hedge itself against further depreciation of the Thai Bhat. She can do this by selling forward its receivables and therefore lock in a minimum value of 110Thai/pound. Therefore she will be sure of receiving 10,000,000/110 = 90,909.09 in three months. If Kaufman & Connelly Plc fails to establish this hedging strategy, then she will have a 10 million Thai Bhat asset whose value will fluctuate with the exchange rate. The forward contract creates an equal Thai Bhat liability, offset by an asset worth 90,909.09. The Thai Bhat asset and liability will cancel each other out and Kaufman & Connelly Plc will be left with an asset equal to 90,909.09. This is illustrated in the T-account below: Kaufman & Connelly Pl T-Account Account receivable 10million Thai Bhat Forward contract payment 10million Thai Bhat Forward contract receipt 90,909.09. However, by establishing this hedging strategy, Kaufman & Connelly Pl also foregoes any benefits that may accrue if on the other hand the Thai Bhat appreciates relative to the pound. Therefore downside risk is protected at the expense of upside potential. (Shapiro, 2003). Options Market Hedge Instead of establishing the hedge with a forward contract Kaufman & Connelly Plc could hedge its 10million Thai Bhat receivable by buying a put option. By using this technique she will be able to speculate on the appreciation of the Thai Bhat as well, while limiting downside potential. A currency put option gives the holder the right but not the obligation to deliver a currency at a specified price known as the exercise price at the expiry date. (Moffett et al, 1995; Shapiro, 2003). Thus if we assume that instead of the forward contract, there is a put option on the Thai Bhat with exercise price 110Thai Bhat/pound, then Kaufman & Connelly Plc purchase this contract and lock in a minimum value of 90,909.09. In this case she protects herself against downside risk but upside potential is unlimited. Should the value of the Thai Bhat fall below 110Thai/pound at the expiry date, she will exercise her option to sell the Thai Bhat at 110Thai Bhat /Pound. On the other hand if the value of the Thai Bhat is above the exercise price of 110Thai Bhat /Pound at the expiration day, she will not exercise her option to sell the Thai Bhat at 110 Thai Bhat/Pound since she has the right but not the obligation. Instead, she will convert her 10million receivable at the current exchange rate. Thus downside risk is limited but upside potential is unlimited. If we assume the put option premium is 5Thai Bhat per Pound, then we can graph the profit and payoff to the hedged position as shown in the figure below: As can be seen downside risk is limited while upside potential is unlimited. The minimum loss that can be made will be the premium paid for the put option to establish the hedge. This type of hedge is analogous to establishing a protective put position in the case of hedging against stock price decreases. (Bodie et al, 2002). Swap Hedging. A currency swap contract is a contract between two counter-parties (Parties to the contract) where one counter-party exchanges a stream of cash flows (debt-service obligations) in one currency for a stream of cash flows in another currency. By so doing both counter-parties can achieve their desired currencies. (Shapiro, 2003). By entering a currency swap contract, Kaufman & Connelly Plc can also manage its currency exposure. In this way Kaufman & Connelly Plc which has borrowed, Thai Bhat at a fixed interest rate can transform its Thai Baht debt into a fully hedge pound liability by exchanging cash flows with another counter-party who desires to have a fully hedged Thai baht liability. The two loans comprising the currency swap have parallel interest and principal repayment schedules. At each payment date, Kaufman & Connelly Plc will pay a fixed interest rate in pounds and receive a fixed rate in Thai Baht. The counter parties also exchange principal amounts the start and end of the swap arrangement. (Shapiro, 2003). In a nutshell, Kaufman & Connelly Plc can engage in a currency swap by borrowing a foreign currency and converting its proceeds to pounds, while simultaneously arranging for the other counter-party to make requisite foreign currency payments at each period. In return for this foreign currency payment, Kaufman & Connelly Plc pays an agreed-upon amount of pounds to the counter-party. Given the fixed nature of the periodic exchanges of currencies, the currency swap is equivalent to a package of forward contracts of currencies. (Shapiro, 2003). From the foregoing, Kaufman & Connelly Plc can hedge its 200million expected pound liability, which will be borrowed in bath by swapping it with another counter-party who desires to hold liabilities in pounds which have been borrowed in the bath. Futures Hedging Currency futures contracts are contracts for specified quantities of a given currency, in which the exchange rate is fixed at the date of the contract. (Shapiro, 2003). For contracts traded on the International Monetary Market (IMM), the delivery date of the contract is determined by the board of directors of the IMM. Futures contracts can be used to eliminate currency risk. (Shapiro, 2003). Currency futures contracts are currently available for the Australian dollar, Brazilian real, British pound, Canadian dollar, euro, Japanese yen, Mexican Peso, New Zealand dollar, Russian ruble, South African rand, and Swiss Franc. (Shapiro, 2003; pp 267). Therefore no futures contracts presently exist for the Thai baht as can be seen from the list in the above paragraph. Thus Kaufman & Connelly Plc will have problems hedging its thai baht by using futures contracts because they are not readily available. In addition, these contracts have limited delivery dates and are traded only in small quantities. Thus designing a hedging strategy using futures contracts can be very difficult. (Shapiro, 2003). REFERENCES Bodie Z., Kane A., Markus A. J. (1999). Investments. Fifth International Edition. McGraw-Hill Irwin. Buckley A. (1996). Multinational Finance. Third Edition. Prentice Hall. Eiteman D.K., Stonehill A. I., Moffett M. H. (1995). Multinational Business Finance. Seventh Edition. Addison Wesley Publishing Company. World Student Series. Kim S.H., Kim Suh. H. (1996). Global Corporate Finance. Text and Cases. Third Edition. Blackwell Publishers Inc. Shapiro A.C. (2003). Multinational Financial Management. Seventh Edition. Wiley and Sons Inc. Tchakarov, Ivan and Elekdag, Selim Ali. (2006), "The Role of Interest Rates in Business Cycle Fluctuations in Emerging Market Countries: The Case of Thailand" (May). IMF Working Paper No. 06/110 Available at SSRN: http://ssrn.com/abstract=910675 Top of Form Bottom of Form Top of Form Bottom of Form Read More