Foreign Exchange Rate Risk - Coursework Example

Foreign Exchange Rate Risk Table of contents Table of contents 2 Introduction 3 Importance of effective foreign exchange-rate risk management 3 Methods and techniques available to manage foreign exchange-rate risk 6 Corporate examples of foreign exchange rate risk management 8 Strategy for a fast growing company 10 Reference 12 Peterson Institute for International Economics. 2009. The Liquidity Trap Does Not Make Monetary Policy Ineffective. [Online]. Available at: http://www.petersoninstitute.org/realtime/?p=1020 [Accessed on November 25, 2009]. 14 Bibliography 15 Introduction The term foreign rate risk refers to the risk which arises due to change in the currency. This risk basically affects those companies which are involved in export or import, but an investor who has invested in international market is also exposed to this risk (Levi, 2005, p.204). As the companies are getting diversified, their operation is not limited to a particular country; they have to deal with different currencies. So appreciation or depreciation of a home currency against foreign currency has a direct bearing on a company’s earning. To manage the foreign risk, companies undertake different tools and strategies so take they can minimise the risk. Importance of effective foreign exchange-rate risk management In the present globalised world, foreign exchange rates directly or indirectly affect each and every business. Before understanding the importance of foreign exchange rate risk, one should understand the factors that influence the foreign exchange rates. These factors can be grouped into two segments: The first one is the economical factor which can be again decomposed into different government’s policies like monetary policy and fiscal policy; that controls the liquidity in the market and the domestic interest rate. The other economical factors are inflation rate, economical growth and productivity of the economy. The second factor which influences foreign rate is political factor like the level of political stability and a country’s relation with its neighbour countries. Finally, the market psychology (trading behaviour of the investors) also influences a country’s domestic currency against other foreign currencies (Gray & Irwin, 2003). To retain the profitability, a company has to manage their foreign currency risk effectively. Those companies who have to pay in foreign currency have to worry more regarding fluctuation in foreign currency rate fluctuation (Ledgerwood, 1999, p.258). The main objective of a company’s foreign exchange risk management is to enhance profitability and to minimise the risk associated with change in currency rates. The company also wants to retain liquidity and to take maximum advantage by lowering it after tax cost (BMO, n.d.). In the current market, both economic as well as political conditions are fluctuating at higher rate, so to reduce the risk; companies are trying to hedge the risk. Hedging can be effective if the risk premium is low (Porter, 1986, p. 161). Through efficient risk management policies the management tries to diversify its financial risk and to gain adequate compensation for the risk. So the compensation and financial risk are assessed in parallel. It has been found, at the time of economic boom, companies pay less attention towards foreign exchange rate risk. Again if the tax rates are high, companies try to use different hedging tools to reduce the tax payable. Many a time the risk management policies used by the firm are influenced by its competitor’s policies or the one which are prevailing in market (Frenkel, 2005, p.551). Through a proper foreign exchange rate risk management a company can develop an appropriate risk culture. It helps in management of transactional exposure, translational exposure and economical exposure. As defined by Wihlborg, the uncertain domestic currency value against the foreign currency in open market condition give rise of transactional exposure which directly affects future cash flow. So through an appropriate risk management process, the future loss of cash flow can be minimised. Wihlborg defined risk which arises due to periodic consolidation of the future earning by multinational firm’s results in translational exposure. It has been found, the amount of profit made by a company’s subsidiary depends on the foreign currency’s value against the domestic currency. So if the company does not manage the foreign risk efficiently, they might face downfall in their future earning. The multinational companies are also exposed to economical exposures which affect their future cash flow (Stonehill & Moffett, 1993, p.95-98). Hence an efficient risk management can provide a cover against risk, but care should be taken that the risk premium should not to be too high, as it might reduce the monitory benefits (Hildebrand, 2006). Methods and techniques available to manage foreign exchange-rate risk Different companies undertake different tools and techniques for managing foreign exchange rate risk. Some of the internal methods often used by multinational companies are discussed below: 1. Doing nothing: as per this method the company do not go for any kind of hedging and it simply accept the spot rate at the time of transaction in future. They follow the “efficient market hypothesis” which indicates the current spot rate is the best forecast of the future spot rate. So the companies rely on the future spot rate for conversion of currencies. There exists two main problems in this policy; firstly the market rates might not follow efficient market hypothesis and the current market spot rate might not be the best possible exchange rate. Secondly the company may be risk averse and is more interested to know the future cash flow to plan its pricing policies (Buckle & Thompson, 2004, p.285-287). 2. Forecasting foreign rate exchange rate movement: many a time the company try to use its own experience and forecast the future spot rate. On the basis of the assumption it finalises where to use an internal policy or to go for other external hedging strategies. If the firm finds that domestic currency is going to depreciate in the near future, it will speed up payments and will delay the receipts where as if the assumption indicates domestic currency will appreciate, it will do the reverse. But when the company lacks the expertise, such assumption may not go accurate and it sufferers with great losses (Buckle & Thompson, 2004, p.285-287). 3. Invoicing and accepting invoices in domestic currency: only this method overcomes the foreign exchange rate risk completely, as no transactions have to be made in foreign currency. But it might happen that the foreign purchaser denies to accept an invoice in the supplier’s domestic currency. This leads to a state of competition and the company might loss orders (Buckle & Thompson, 2004, p.285-287). 4. Operating a foreign bank account in foreign currency: as long as the receipt balances the payments, this method will success in counter balancing the loss on payment and receipt in one currency by other specific foreign currency. Even the overdraft facility is also available to assist the company in minimising the risk. But such risk management policy has a drawback as it can counterbalance the risk for a single foreign currency only (Buckle & Thompson, 2004, p.285-287). So it can be concluded that internal methods of foreign risk management have limited applications, and for any multinational company these alone are not so affective, so the company have to follow both internal as well external methods. There are many external methods available for mitigating foreign exchange rate risk. These are as follows: 1. The forward exchange market: A company can go for forward contracts by negotiating with a commercial bank regarding the unit of currency, time and rate at which the currency will be purchased or sold foreign currency (Madura, 2006, p.330). 2. The future contracts: these are standardised contracts of purchase or sell of currency in future date at a fixed rate and at certain time. These contracts get traded in the future exchanges (Smart & Megginson, 2008, p.540). 3. Option: an option can be purchased after payment of premium amount as it contains a contract of buying or selling currency in future at a particular rate and at a definite time. It gives a right to buy (call option) or sell (put option) the contract, but it does not result into an obligation. There is no obligation for the contract holder to exercise the contract at the date of maturity (Stapleton, n.d.). 4. Back to back loan: in the back to back loan two companies can take parallel loan. His is also known as swapping of the interest rates. This is more commonly used by the multinational companies to raise loan for their subsidiaries while raising finance. The interest rate swap can be fixed rate or floating rate contract (Smithson, 1998, p.173). Corporate examples of foreign exchange rate risk management For a company which is growing and diversifying at a fast rate, its foreign exchange risk management plays a vital role. To understand the fact that how the fast growing companies in UK manages their foreign exchange risk two companies were selected. And their currency risk management policy was analysed. Melrose Resource plc is a UK based company engaged in oil and gas exploration and production. It’s headquarter is in Edinburgh and it was established in 1999. At present the company is working in Egypt, Bulgaria, France, USA, Romania and Turkey. The company mainly act as asset operates to provide full control on strategy and expanders. In the financial year 2008-09 the company’s profitability increased many folds along with expansion in the company’s production. The company maintains a high reserve so that it has to depend less on external source of capital and can keep the cost of financing as low as possible. The company often go for short term borrowing at variable interest rates which gives it more flexibility. It keeps the borrowing at floating rates, fixed just for a month. It goes on reviewing the interest rates to adjust their hedging policies. Taking all these facts into consideration, director enters in derivatives either for long term or for short tem. They also go for capital market investment to earn interest from their floating rate deposit. It maintains a policy to borrow in dollar and it considers the cash flow for the project in dollar only. This strategy minimises the currency risk (Miranda, 2008). Another company is British Polythene Industries PLC. It is among the largest polythene file, bags and stock manufacture. It has pioneered in recycling products. They supply their bags to different food processing companies throughout the world. As per company’s interim report 2009, their profit before tax increased by 26 percent and operating cost rose to almost 50 percent. The company’s sale in UK for 2008 was not satisfactory due to fall in demand and hike in raw material prices. As the company is operating in many parts of the world, so there exists a high foreign exchange risk and the movement of Euro and US Dollar affects company’s profitability. So the company go for hedging in the known currencies. It transfers production among different groups sites located in UK, Europe, US and China (where it is possible). The company believes movement in Euro and USD is favourable for their exports and this will improve its profitability. As large part of the company’s borrowing is denominated in Euro, so fall in LIBOR will reduce down the cost of finance (British Polythene Industries PLC, 2008). Strategy for a fast growing company After the economical downfall, all the major economies have shown a stagnant growth, both capital market and share market suffered a huge loss and investors were left to morn on their bad luck. To handle the financial crisis, governments lowered the bank rates and modified their monitory policies. The tax rates were lowered and many sectors got the opportunity to enjoy tax holiday. The main aim was to bring more liquidity and to enhance the purchasing power of consumers. During this phase many currencies depreciated against US dollar, which made the companies to revise their financial exchange risk policies. Due to the financial crisis and instability in capital market, USD dollar appreciated against pound (Bized, 2009). Appreciation of USD was a good sign for the UK companies who use to export in US because it will enhance their receivables and hence the operating profit will go high. But on the other side, the companies who have suppliers in US, they have to be paid more and this extra burden will elevate the cost of production, thus profitability of the firm will go down. Again a UK based fast growing company have to make different transitions with other nations in Europe and payments have to be made in Euro. From past many months movement of Pound against Euro is highly fluctuating (Exchange rate, 2009). So the UK based company should try to make invoice in pound as far as possible. When the company have to raise finance for its subsidiaries located in other nations, it is better to use the loan in the local currency. In many countries like Australia and India interest rates are comparatively higher then the interest rates in US (0 to 0.25 percent) (Peterson Institute for International Economics, 2009). So taking short term loans may be more costly from these countries, hence the company can go for swap where it can exchange the interest rates. The other tools of hedging like bilateral or multinational netting can be a good way for the company in managing foreign exchange rate risk. As the exchange rates are fluctuating too much, so going for a forward contract will further enhance the risk and the company can end with huge lose. On the other hand the company should take up option hedging where it will have the option to either execute the contract or not. But again the cost of coverage (option premium cost) should be considered. Capital market hedging is also a good option to take advantage of difference in interest rates between different nations. The company can invest the excess cash for short term in a country like India or Australia where interest rates are high and the financial market conditions are under control. Before making any decision care should be taken that cost of coverage should not go too high, as it will further enhance the financial burden of the company. The market conditions are highly volatile, so it is better to go for a short term policies and when the conditions come to a more stable platform, long-term strategies should be finalised. Reference Bized. 2009. International Trade: The Falling Dollar or Rising Pound? – Activity. [Online]. Available at: http://www.bized.co.uk/educators/16-19/economics/international/activity/trade.htm [Accessed on November 25, 2009]. BMO. No date. Foreign Exchange: Management Policy Objectives And Controls. [Online]. Available at: http://www.bis.org/review/r061215c.pdf [Accessed on November 24, 2009]. Buckle, M. & Thompson, L. J. 2004. The UK financial system: theory and practice. 4th edition. Manchester University Press. British Polythene Industries PLC. 2008. Report And Accounts 2008. Exchange rate. November 2009. Euros (EUR) to 1 British Pound (GBP). [Online]. Available at: http://www.exchange-rates.org/history/EUR/GBP/G [Accessed on November 25, 2009]. Frenkel, M., Hommel, U., Dufey, G. & Rudolf, M. 2005. Risk management: challenge and opportunity. Springer. Gray, P. & Gray, T. 2003. Exchange Rate Risk. Public Policy For The Private Sector. [Online]. Available at: http://rru.worldbank.org/Documents/PublicPolicyJournal/266Gray-121203.pdf [Accessed on November 24, 2009]. Hildebrand, P. December 2006. Risk management. [Online]. Available at: http://www.bis.org/review/r061215c.pdf [Accessed on November 24, 2009]. Ledgerwood, J. 1999. Microfinance handbook: an institutional and financial perspective. World Bank Publications. Levi, D. M. 2005. International finance. 5th ed. Routledge. Madura, J. 2006. International financial management. 8th ed. Cengage Learning. Melrose. 2009. Annual Report and Accounts 2008. Porter, E. M. 1986. Competition in global industries. 8th ed. Harvard Business Press. Smart, B. S. & Megginson, L. W. 2008. Corporate Finance. Cengage Learning EMEA. Smithson, W. C. 1998. Managing financial risk: a guide to derivative products, financial engineering, and value maximization. 3rd ed. McGraw-Hill Professional. Stapleton, C. R. No date. Interest Rate and Foreign Exchange Risk: An Overview of Hedging Instruments and Strategies. [Online]. Available at: http://pages.stern.nyu.edu/~msubrahm/papers/choi.doc [Accessed on November 24, 2009]. Stonehill, I & Moffett, H. M. 1993. International financial management. Taylor & Francis. Peterson Institute for International Economics. 2009. The Liquidity Trap Does Not Make Monetary Policy Ineffective. [Online]. Available at: http://www.petersoninstitute.org/realtime/?p=1020 [Accessed on November 25, 2009]. Bibliography Chorafas, N. D. 2007. Risk accounting and risk management for accountants. Elsevier. Download It. No date. Foreign Exchange Risk Management. [On line]. Available at: http://www.download-it.org/free_files/filePages%20from%2014%20Foreign%20Exchange%20Risk%20Management.pdf Shim, K. J. & Siegel, G. J. 2008. Financial Management. 3rd ed. Barrons Educational Series. . Read More