Marks & Spencer Foreign Exchange Risk Exposure - Case Study Example

MARKS & SPENCER FOREIGN EXCHANGE RISK EXPOSURE –AN ANALYSIS Executive Summary Marks & Spencer (hereinafter referred as M&S) is one of the leading retailers in UK. M&S was established about one hundred twenty five year ago. It is having a record of twenty –one million satisfied customers in UK alone. Further, it is having foreign operations in more than forty three countries. It is having about 2,000 suppliers and employs about 78,000 employees. M& S controls about 11.2 percent market share in retail clothing and about four percent of UK food market. The major monetary perils encountered by the M&S group are funding, “liquidity”, foreign currency, and “interest rate“and cashflow perils. The strategies and policies for administering both foreign currency and exchange rate exposure risks are being deliberated in this research essay. Aim and Objectives Treasury department was launched in M&S solely with the aim of capitalising the company’s vast exposures in employing financial products to manage and administer interest rate, foreign exchange, cashflow and commodity-price risks. M&S had proven solid expertise in these provinces but visualise further vistas in a more methodical approach to the management of structural, long-run exposures. (Smithson 1998 :519). M&S is imparting continuous training to its treasury department employees for necessary comprehension of various financial products and how it can be used for risk mitigation. Further, M&S is also employing extensive in-house research on its financial risks and also employ external expertise for such research whenever deem it necessary.(Smithson 1998 :519). Introduction Exchanger rate risks originate from the volatility in the comparative values of foreign currencies against each other currencies when they are sold and bought on international financial markets. In fact, each transaction in every international business is impacted by exchange rate risk. For example, if M&S sells goods to a company in USA. In an import / export transaction, one of the parties will be dealing in the currency of the other. The party who deals in the other party’s currency will borne the exchange rate risk. If the contract demands for the payment in £ UK pounds , upon the despatch of goods , which is to happen in sixty days , the US importer bears the risk between the intervening period. If US firm does not have a source of income in UK Pounds (£), it must purchase pounds from a US bank at the current prices at the time when it makes payment to M&S. If the value of UK Sterling declines vis-à-vis US dollars during the same period , the more £ will be required to buy the same numbers of US dollars to pay the UK firm. Likewise, if the UK Sterling appreciates against the US dollar, then the U.S. firm will find the M&S products cheaper than it had anticipated. Thus , currency exchange rates can have a tremendous impact on investment and trade decisions made by companies and thus can impact the flow of money out and in of all nations. (Schaffer et al 2008: 35). Foreign currency exposures arising out of transactional which arise from import of products and materials purchased straight from the foreign vendors and the export of products from the United Kingdom to other nations. M&S group treasury department hedge these vulnerabilities by employing foreign exchange contracts progressively covering up to hundred percent up to eighteen months. Boards approval is obtained where the hedge is needed to be taken for more than eighteen months. M& S group is principally vulnerable to forex with regard to UK pounds against volatility in euro and US $. M&S treasury department uses cash flow hedges as the forward forex deals for the Group’s forecasted exchange need with reasonable value volatility accounted straight into equity. To the magnitude that these hedges envelop real exchange receivable and payables then connected just value volatility earlier acknowledged in equity are reported in the revenue report in tune with the matching liability and asset. The group does not employ derivatives to cover both profit and loss and balance sheet translation vulnerabilities. Nonetheless, the conversion vulnerability originating from foreign net assets are covered with “foreign currency debt”. The group also covers foreign currency inter-corporate loans where these present. The Group’s intercompany foreign currency loans designated through “forward foreign exchange contracts” with regard to hedging of the Groups “foreign currency” inter-corporate credits are marked and kept for merchandising with fair value volatility being acknowledged in the Group’s revenue report. (M&S Annual Report Treasury Policies 2009). Profits and losses in equity on forward forex contracts will be reported to the income report at different times over the succeeding fourteen months (earlier year nineteen months) from the date of financial statement i.e. 28 March 2009. (M & S Annual Report Treasury Policies 2009). Foreign Currency Cash Forecasts Companies like M & S Co which is having large foreign currency cash flows will find that preserving cash forecasts for each currency can help in recognising currency vulnerability and timing gaps where investing or funding may be essential. Basically, the forecast format permits the user to view the forecast from a consolidated or by currency cash flow view. When there is a consolidation of cashflow across currency, it is essential to use a conversion rate for all currencies to a common currency, especially the main operating currency like euro’s or U.S. dollars. The treasury department of M&S will assess for each currency in which there are cash flows and decide whether there is a cumulative excess or deficit of each currency over time based on reasonable on some cash flows with the help of the forecast model. Over longer periods, the short –term differences between currency outflows and inflows will be offsite so that cumulative totals by month, by quarter or on an annual basis are also helpful. Cash flows that counteract over time symbolise a timing issue and are frequently administered by employing foreign exchange swaps. Thus, the treasurer of M&S may use hedging if there exists a gap between cash inflows and outflows. . (Horcher: 24). A cash flow forecast should be structured for foreign currencies to acknowledge the delays in timings either in requesting for payments or receipt of funds. There is frequently a day or more delay, since foreign currency payments need a bank in the foreign currency jurisdiction to make the payment. Hence, it is significant to plan in the earlier day when cash flow is needed. (Horcher: 25). Currency Flow Forecasting M&S Group treasury employs derivative transactions, mainly forward currency contracts and currency swaps to set off currency flow risks. The main aim of these transactions is to administer currency risks emanating from the Group’s financing and operations. M & S Foreign Currency Exposure: 2009 2008 Currency Fixed rate £m Floating rate £m Total £m Fixed rate £m Floating rate £m Total £m Sterling 2252.4 629.9 2882.3 2665.9 673.0 3338.9 Euro 7.6 286.1 293.7 - 192.5 192.5 Hong Kong Dollar - 16.4 16.4 - 6.9 6.9 Other 0.3 7.9 8.2 - - - Total 2260.3 940.3 3200.6 2665.9 872.4 3538.3 Source :( M&S Annual Report 2009). Foreign Currency Collection and Payments Foreign Currency management involves decisions about overseas banking arrangements and foreign currency bank accounts as well as currency borrowings and cash conversion from one currency into another. Fund management involves obtaining cash and financing activities. Funding decisions footed on cash forecasts and fund needs are minimised by enhanced cash flows. The finance needed, especially for exports, depends upon not only on collection arrangements and time-scales but also on credit periods. A multinational company like M&S has to decide on its cash management arrangements. With its overseas subsidiaries which have it own local banking arrangements , if the M & S treasury department at London wants to centralise its surplus cash holdings in what it thinks to be a hard currency , such as Sterling or US dollar and hence would need arrangements for converting cash into the selected currency and transferring into a central bank account. The transfer could take the guise of inter corporate loans or re-invoicing subsidiaries from head office or dividend payments. If M& S witnesses a cash shortage, treasury department should initiate decision to fund the deficit and for what term the funds might be required. (Graham & Coyle 2000:10). Currency Purchases and Sales M&S foreign currency transaction exposure comes in various shapes as it purchases numerous sales and purchase transactions in foreign currencies especially euro and dollars. Thus, this transaction exposure is the subset of economic exposure. Further any remittance from M&S foreign subsidiaries to the UK parent also mirror the transaction exposure. Moreover, any volatility in exchange rates that impacts the demand for M&S retail products at other competitive products can indirectly impact the demand for M&S retail products. All these happenings when taken together result in economic exposure. M&S gives special significance options as a way of safeguarding against an increase of the dollar and at the same juncture, permitting the firm to derive advantage from depreciation. M&S also engage in currency swaps and also regularly purchase forward contracts as well as trying to enhance purchases in the currency of their sales. Further, M& S endeavours to hedge some of its transaction exposure in advance. However, it cannot eschew transaction exposure since it cannot estimate all future transactions ahead of time. (Madura & Fox 2007:437). Foreign Currency Banking and Bank Services Much number of banks facilitates foreign exchange transactions but only the top twenty handle about fifty percent of the transactions. J.P.Mogan Chase, Citibank (a subsidiary of Citigroup, U.S), and Deutsche Bank (Germany) are the largest forex traders as of today. Majority of the global forex trading is carried out in New York, London and Tokyo, which are the three largest foreign exchange trading centres of the world. Virtually, banks in every major city carry out the foreign exchange transactions between MNCs. Commercial transactions between nations are often carried out electronically and the exchange rate at the time decides the quantum of funds necessary for the transaction. M&S bankers not only execute the transactions but also act as the foreign exchange dealer. Each month, M &S bankers receive dollars from various branch operations in other countries, and it may also provide euro or sterling to them on their request. Further, the bank helps other transactions for MNCs in which it receives sterling in exchange for dollars. Moreover, M&S’s bank maintains a statement of dollars, euro, sterling and other currencies to help these forex transactions. Some MNCs rely on an online currency trader that acts as an intermediary between the member banks and the MNC. One of the famous online currency traders is currenex, which conducts more than $ 300 million in forex transactions per day. If an MNC requires to purchase forex, it logs on to website and details its needs. Currenex relays the order to various banks that are members of its system and permitted to bid for the orders. When currenex relays an order, the member banks have to make their quote within 25 seconds to specify a quote online for the currency that MNC desires. Then, Currenex exhibits the quotes on a screen graded from the highest to lowest. The MNC has about five seconds to select one of the quotes offered, and thus how, the deal is completed. (Madura 2009:52). Foreign Exchange Rate Forecasting For business, the movement in forex is more significant for taking decisions. Thus, many businesses are more interested in forecasting the movements of forex rates both for long-run corporate planning and short-run forecasting for making viable business decisions. Forecasting includes both technical analysis and fundamental analysis. Technical analysis employs the use of historical forex data to evaluate future values. Under this, extrapolation of historical exchange -rate trends and ignores both political and economic determinants of forex rate movements. This method involves various charting technical analysis like cycles, currency price and volatility. Observers will make a close watch on new lows and highs, patterns and broken trendiness that are contemplated to predict price movements and targets. Fundamental analysis is just reverse of technical analysis. It uses an economic variable that is anticipated to impact the demand and the supply of a currency and its exchange value. This method employs computer –based econometric models, which are statistical guesstimate of economic theories. Econometrician develops models to generate forecasts for individual countries that try to integrate basic variable that triggers forex movements; balance of trade, inflation rates, productivity and the like. However, econometric model employed to forecasts suffers from some limitations like changes in key economic variables like interest rates and inflation rates. For instance, the economic models are best fitted for estimating long-range trends in the near future. For instance, inflation-rate changes may not mirror full effect on a currency’s values till six months or one year in the future. However, econometric model does not offer the forex exact information regarding when to sell or buy a particular currency. Thus, currency traders will normally prefer technical analysis rather than fundamental analysis when make a trading strategy. (Carbaugh 2008: 422). Foreign Exchange Rate Selection: Exchange rate selection process includes both customary and traditional methods. The evaluation of varied variables impacting the “exchange rate regime” corroborates the position that global atmosphere and features of the specific nation decide the probable choice. The customary method comprises visions that have been seen for a larger phases of time in the “exchange rate regime option” evaluation. This customary method includes “the theory of optimum currency” province and real shocks vs. nominal shocks. The contemporary methods connect the usage of a “fixed parity with economic policy” having no standing and offering not convincing outcomes in the institution of inflationary steadiness, macroeconomic policy and yielding displeasing outcomes with the “exchange rate as nominal anchor”. Forex Calculation A ratio of one unit to another is known as the exchange rate. An exchange rate is instituted between two currencies. The demand / supply relationship of currencies determines the conversion rate. Due to change in the exchange rates, companies are vulnerable to exchange rate fluctuation perils due to a net liability or net asset position in a foreign currency. Exchange rate may be in terms of US dollars per foreign currency unit, which is known as an indirect quote or units of forex per dollar, which is known as an indirect quote. Hence, an indirect quote is the reciprocal of the direct quote and vice versa. If the exchange rate of one currency is calculated on the exchange rates of two other currencies, then it is known as cross rate. (Shim & Siegel 2009:457). Exchange Rate Bench Marking The user should select which exchange rate best mirrors the opportunity cost of forex. This is known as the exchange rate benchmark which is employed to a value a commodity traded in the global market in domestic currency units. Thus, the resultant border price is thus free of any alterations tempted by the nation’s forex rate. The benchmark process of calculation can be channelised by first defining the particular period of analysis and the decisions of the analysis which will assist to clarify. Analyst can employ many alternatives to evaluate the exchange rate to employ in guessing the border price, the first-best shadow exchange rate (SER), the auction rate or black market rate and the effective exchange rate (EER). The first-best shadow exchange rate is the equilibrium rate in a scenario of no distortion in international capital markets and in trade policy. The second –best shadow exchange rate can also limelight policy reform and is the most commonly employed. Under this method, distortions are present unlike the first-best rate. The EER (Effective Exchange Rate) is analogues to the second –best shadow price rate since it recognises the distortions of the present trade and exchange system. (Tsakok 1990:35). Exchange Rate Hedging The forex market offers resources for hedging risks connected with movements of exchange rate. The main aim of hedging is that an investor who is expecting a receipt in the foreign currency takes a short position to counter it. Further, a long position can be taken to hedge perils linked with future payment commitments. One can eliminate a risk by acquiring forex and holding it for a month to meet the commitment within a month. One another substitute is that to purchase the currency forward for delivery in one month. If the foreign currency appreciates, the value of the foreign currency held is offsetted by the increase in domestic currency value or of the forward contract. If the currency depreciates, the fall in the value of the liability is counterbalanced by a fall in the value of the foreign currency asset. This eschews the probability of both unexpected losses and unexpected gains. Bank’s hedging strategies are obscured by the fact that many of the products they sell like floors ,caps , swaps and collars do not have been noticeable exchange-traded collimates to be employed in a hedge portfolio as many of these products are tailor –made to meet the requirements of a specific client. (Goldstein 1993:34). Forex Forward Contract: A UK Exporter is expecting an inflow of US $ 1 million in 1 months time. \ Spot --------------------Current Spot Rate £1 = $1.4199 1 Month Forward Rate 0.005 cents Premium on Forward $ Therefore, 1-month forward $ 1.4278 The exporter is expected to receive $ 1 million in one month. Thus, the thirty-day forward contract to purchase $1 million at the exchange rate of $ 1.4278. By employing the forward contract, the company has taken away all the foreign exchange risk from this transaction. Hence S = 1.4199 X = 1.427 t =0 T=30/365 Pos =1; Size= 1000000 and Assume that r= 0.10 : rf = 0.15 Suppose that the spot exchange rate in 30 days’ time is 14,270,000 to buy $ 1 million, the company would cost the company $ 14,160,000, Thus , by using forward contract ,the company has saved $ 110,000. Conclusion and Recommendations Forex management is an important business activity for M &S as it would minimise the risk of loss that may be encountered by a multinational company like M&S because of transformation in exchange rates and the methods and means available to the multinational company (MNC) to eliminate or reduce such perils and finally, to comprehend how the management of a MNC should introduce best policies with regard to such perils. Thus, the main aim of the study is to safeguard the international investment from exchange rate volatility based losses rather than safeguarding the profitability of international trade. Forex risk management policy is considered to be a significant policy for developing optimal MNC policies to handle exchange risks. M & S exchange rate risk policy is drafted in such a way that if any risks that is to be covered to be more than eighteen months, then Boards approval is necessary. Thus, an efficient forex risk management policy should have the following features: To reduce exchange rate losses and exchange rate risks. To reduce inflation –caused losses on an international basis. To reduce the damaging effect on international operations of individual nation exchange and remittance checks, tariffs and other blockades to the free flow of goods and money. (Aggarwal 1980:2) List of References Aggarwal, Raj. ( ). The Management of Foreign Exchange. New York: Ayer Publishers. Carbaugh, Robert J. (2008). International Economics. New York: Cengage Learning. Goldstein, Morris. (1993). International Capital Markets. New York: International Monetary Fund. Graham Alastair & Coyle Brain. (2000) Cash Flow Forecasting and Liquidity. New York: Lessons Professional Publishing. Horcher, Karen A. Essentials of Managing Treasury. New York: John Wiley & Sons. M & S Annual Report. (2009). Treasury Policies. [online] available from < (http://corporate.marksandspencer.com/investors/debt_investor/treasury_policies)> [accessed 4 May 2010]. Madura Jeff & Fox Rolland. (2007).International Financial Management. New York: Cengage Learning. Madura Jeff. (2009). International Financial Management. New York: Cengage Learning. Shim, Jae K & Siegel, Joel G. (2009) Schaum’s Outline of Financial Management. New York: McGraw Professional Publishing. Tsakok, Isabelle. (1990).Agricultural Price Policy. Cornell: Cornell University Press. Read More