Exposure to Currency Risk: Definition and Measurement - Coursework Example

?Running Heading: Strategic Finance Strategic Finance PAPER FOR CHIEF EXECUTIVE OFFICER INTRODUCTION Starting a new venture or moving to another country is not an easy task because the investor or the company not only has to face usual risk that a business faces but it has to deal with the exchange rate risk or translation risk (Gitman, 2003). Exchange rate risk is the risk that the company or investors have to face because of changes in the exchange rate (Adler, & Dumas, 1984) and when the company will be making investment in Euro Zone then it will have to face risk because of changes in the value of currency of Euro and Pound Sterling. However, if the investment is profitable and the management expects that it would pay dividends for taking the risk then there is no harm in making the investment. CURRENT SCENARIO Currently the board of directors of the company are analysing the feasibility of setting up a subsidiary company in European Union. However in order to start a new subsidiary company it is important for the management to know what important concepts and factors they have to consider while moving from one state to another. This report analyse important concepts that the management should know while setting up a new subsidiary in European Union. This report to the CEO of the company is mainly divided into three parts; the first part explains about the foreign currency translation and related terms, the second part explains about the feasibility of forecasting spot and forward rates of exchange and how management can use it effectively for the company, and the third part explains the internal and external hedging techniques. FOREIGN CURRENCY TRANSLATION The rate at which one currency is exchanged for the other currency is called as the Exchange Rate or foreign exchange rate (O'Keefe, 2010). As in this case, the sterling to euro exchange rate is 0.90 therefore it means that for the value of one unit of pound sterling to euro is 0.90 and one unit of euro can exchanged for 0.90. There are two important concepts to be considered; sport exchange rate and forward exchange rate. Spot Exchange Rate The current exchange rate at which the currency will be changed right away is called the Spot exchange rate (Ehrmann, Fratzscher, &Rigobon, 2011). Forward Exchange Rate Forward exchange rate can be defined as the exchange rate at which the currency will be changed later on at a specified date but the rate is quoted at present time (Fama, 1984). Direct and Indirect Rates of Exchange When the cost of one unit of foreign currency is represented in units of local currency then it is referred to as Direct Quotation whereas when the cost of one unit of local currency is presented in foreign currency units then it is referred to as Indirect Quotation (Khan, 1993). Previously, indirect quotation was not used as widely however now indirect quotation has been accepted widely across the world. Direct exchange rate is presented as: 1 Pound Sterling = 0.90 Euro Indirect exchange rate is presented as follows: 1 Euro = 1.111 Pound Sterling Cross Rates Between Paris of Currencies Currency pair is defined as the quotation of the relative value of a particular currency against the unit of other currency in the foreign exchange market. Counter currency or quote currency are the terms used for the currency which is used as the reference whereas base currency or transaction currency are the terms used for currency which is quoted (Siegel, 1972). When there are two currencies and both currencies are not the official currencies of the country in which the exchange rate quote is provided then it is referred to as Cross Rates. However, at times when US Dollars are not involved despite of which country the quote is provided in then this is also referred as Cross Rates (Instaforex). One way to calculate the cross rates is by taking an average of the bidding and asking rate for both the currencies against dollars and then with the help of formula for current prices, the current value of cross rate quotation can be calculated. FEASIBILITY OF FORECASTING SPOT AND FORWARD RATES OF EXCHANGE It is important for investors or any company which is investing in another country to calculate the exchange rate and consider the exchange rate risk as well. Foreign exchange rate risks can distort the real value that an investment might yield and inclusion of foreign exchange rate risk can change the management decision (O'Sullivan, & Sheffrin, 2003) therefore it is important for the management and CEO of the company to consider the exchange rate risk while setting up a new subsidiary company in European region. For instance, as spot exchange rate is the existing exchange rate at which the currency would be exchanged immediately but if the currency of Euro zone changes then the exchange rate would change and thus it could distort the profitability of the investment as the value of money would change. Spot exchange rate and forward exchange rate can be used by management to their advantage as well. For instance, if management is able to predict that the exchange rate of Sterling to Euro would decrease and thus it would impact the profitability and net value of the investment then in such a situation, the management could use this to their advantage by using forward exchange rate and agree to exchange the currency at a later period but quoted at that time. If the management expects the exchange rate to decrease from 0.90 to 0.70 within next 60 days and the market rate of forward exchange rate after 60 days is 0.80 then the management can go for forward exchange rate and with forward contract it will be able to improve the value of its investment. Similarly, if the management is not sure whether the currency value would appreciate or depreciate then it is better to not go for any forward contract and in such situations, it would be better to use spot exchange rate. INTERNAL AND EXTERNAL HEDGING TECHNIQUES Hedging refers to an investment position taken by an investor or company to offset from potential losses (Ederington, 1979). An investor can hedge its position from different types of financial instruments like stocks, forward contracts, options, swaps, exchange traded funds etc. Hedging can be useful in minimising the risks that an investor faces because of changes in exchange rate and because of changes in interest rate (Allayannis, & Weston, 2001). There are two main types of hedging techniques used and these techniques are: Internal Hedging Techniques When hedging techniques are created within an organization then it is referred to as internal hedging techniques. Examples of such hedging techniques are invoicing in the home currency, matching and netting. External Hedging Techniques Hedging techniques that are created outside the organisation are referred to as external hedging techniques and examples of such techniques are Forward rate contracts, Options, Swaps, Futures, Swaptions etc (Joseph, 2000). Considering the situation, the management needs to make use of external hedging techniques particularly forward exchange rate to minimise the losses from changes in exchange rate. Because of using forward contract rate, the company will be able to limit their losses and thus minimise the impact of changes in fluctuations in exchange rates. PAPER FOR BOARD OFFICER BACKGROUND As the company is planning to set up a new subsidiary in one of the countries of European Union therefore it is important to know the returns from the new subsidiary should be higher than its net present value. However as the investment is made in another country therefore company has to consider the exchange rate risk as well as the risk of inflation. To assist in making better decision for the company whether they should set up a new subsidiary or not, this report helps as it calculates and analyses Net Present Value of the investment that the company would make and assists the management in making decision. VALUE OF EXPECTED CASH FLOWS IN POUND STERLING As the company would be making its investment in another country therefore the first and foremost thing it has to consider is the value of future cash flows in Pound Sterling. The value of expected cash flows in Pounds are as follows considering the exchange rate of Pound sterling to Euro is 0.90 Cash Flows in Euro Cash Flows in Pounds Initial Investment € 4,000,000 ?3,600,000 Year 1 € 1,000,000 ?900,000 Year 2 € 2,000,000 ?1,800,000 Year 3 € 4,000,000 ?3,600,000 Year 4 € 4,000,000 ?3,600,000 Net Value of Cash Flows € 7,000,000 ?6,300,000 Changes in exchange rate could change the net value of the investment and therefore the management can hedge their position by entering into forward exchange rate to minimise the losses from fluctuations in the exchange rate. Also because of this, the company will be able to limit their losses. NET PRESENT VALUE OF THE INVESTMENT The management has already estimated the expected cash flows that the subsidiary would be able to generate in four years after the investment has been made. The cost of capital for the company is 10%. The present values of the expected cash flows using cost of capital of the company are as follows: Net Cash Flows in Euro Net Present Value Initial Investment € 4,000,000 € 4,000,000 Year 1 € 1,000,000 € 909,091 Year 2 € 2,000,000 € 1,652,893 Year 3 € 4,000,000 € 3,005,259 Year 4 € 4,000,000 € 2,732,054 Net Cash Flow € 7,000,000 € 4,299,296 The present value of the expected cash flows of the investment is € 4,299,296. Similarly, the present value of the cash flows are also calculated in Pound sterling and the present value of these cash flows are: Net Cash Flows in Euro Net Cash Flows in Pounds PV in Pounds Initial Investment € 4,000,000 ?3,600,000 ?3,600,000 Year 1 € 1,000,000 ?900,000 ?818,182 Year 2 € 2,000,000 ?1,800,000 ?1,487,603 Year 3 € 4,000,000 ?3,600,000 ?2,704,733 Year 4 € 4,000,000 ?3,600,000 ?2,458,848 Net Cash Flow € 7,000,000 ?6,300,000 ?3,869,367 The present value of future cash flows in Pound Sterling is ?3,869,367. However this present value reflects the nominal present value of the expected cash flows of the investment and does not consider the impact of inflation which reduces the actual value of the investment (Abel, & Bernanke, 2005). Thus the above calculated present value cannot be said as the real present value and for that the present value factor should also include the inflation rate. When interest rate is included in the interest rate then the real interest rate can be calculated and for investment purposes it is better to use real interest rate rather than nominal interest rate (Blejer, and Diaz, 1986). To calculate the present value of cash flows it is important to consider the aspect of inflation rate as well as inflation would devalue the present value of the expected future cash flows (Fabozzi, Mann, & Choudhry, 2002). So the real present values of the future cash flows in Euro are: Amounts in Euro Real value Initial Investment € 4,000,000 € 3,555,556 Year 1 € 1,000,000 € 886,918 Year 2 € 2,000,000 € 1,573,247 Year 3 € 4,000,000 € 2,790,682 Year 4 € 4,000,000 € 2,475,106 Net Cash Flow € 7,000,000 € 4,170,397 The real present value of the cash flows is still positive even after inclusion of interest rate of euro zone. As the inflation rate of Euro zone and inflation rate of UK is different and the investment or profits from the subsidiary would be transferred to UK therefore it is important for the management to calculate the present value considering inflation of UK as well. So, the present values of cash flows considering the inflation of UK: Amounts in Euro in Pounds PV in Pounds Real Value in Pounds Initial Investment € 4,000,000 ?3,600,000 ?3,600,000 ?3,600,000 Year 1 € 1,000,000 ?900,000 ?818,182 ?782,949 Year 2 € 2,000,000 ?1,800,000 ?1,487,603 ?1,362,243 Year 3 € 4,000,000 ?3,600,000 ?2,704,733 ?2,370,149 Year 4 € 4,000,000 ?3,600,000 ?2,458,848 ?2,061,895 Net Cash Flow € 7,000,000 ?6,300,000 ?3,869,367 ?3,702,743 The real value of the investment in pounds after inclusion of inflation is ?3,702,743 therefore the investment looks positive and the management should go ahead with the project as the net present value of the investment is positive. CONCLUSION Net present value is one the most widely project appraisal techniques used by investors and financial analysts across the world. The net present value of this investment even when calculated using the real interest rate which also included inflation as well, then the value of the investment is positive and the management should proceed with the investment and start the project immediately because it would be helpful in improving the profitability of the company. Whenever evaluating the project in another country, consideration of exchange rate risk is critical for the assessing the real value and real profitability of the investment, however when the net present value after considering the impact of exchange rate risk of the project has been calculated and the net value of the investment is found to be positive and therefore this investment should be profitable for the company and management should proceed with the investment. References Abel, A, & Bernanke, B, 2005, Macroeconomics, Pearson Prentice Hall: New Jersey. Adler, M, & Dumas, B 1984, ‘Exposure to Currency Risk: Definition and Measurement’, Financial Management, Vol. 13, No. 2, pp. 41-50. Allayannis, G, & Weston, J 2001, ‘The use of foreign currency derivatives and firm market value’, Review of Financial Studies, vol. 14, no. 1, pp. 243-276. Blejer, M, and Diaz, J 1986, ‘Domestic and External Factors in the Determination of the Real Interest Rate: The Case of Uruguay’, Economic Development and Cultural Change, Vol. 34, No. 3, pp. 589-606 Eaker, M, & Grant, D 1987, ‘Cross-hedging foreign currency risk’, Journal of International Money and Finance, vol. 6, no. 1, pp. 85-105 Ederington, L 1979, ‘The Hedging Performance of the New Futures Markets’, The Journal of Finance, Vol. 34, No. 1, pp. 157-170. Ehrmann, M, Fratzscher, M, &Rigobon, R 2011, ‘Stocks, bonds, money markets and exchange rates: measuring international financial transmission’, Journal of Applied Econometrics, vol. 26, no. 6, pp. 948–974. Fabozzi, F, Mann, S, & Choudhry, M 2002, The Global Money Markets, Wiley & Sons: New Jersey. Fama, E 1984, ‘Forward and spot exchange rates’, Journal of Monetary Economics, Vol. 14, no. 3, pp. 319-338. Gitman, L 2003, Principles of Managerial Finance, Addison-Wesley Publishing: Boston. Instaforex. Cross Rates. Available at [Accessed 2 December, 2011] Joseph, L 2000, ‘The choice of hedging techniques and the characteristics of UK industrial firms’, Journal of Multinational Financial Management, Available at [Accessed 2 December, 2011] Khan, M 1993, ‘Theory & Problems in Financial Management, McGraw Hill Higher Education: Boston. O'Keefe, R 2010, Making Money in Forex: Trade Like a Pro Without Giving Up Your Day Job, Willey: New Jersey. O'Sullivan, A, & Sheffrin, S 2003, Economics: Principles in action. Pearson Prentice Hall: Upper Saddle River, New Jersey. Siegel, J 1972, ‘Risk, Interest Rates and the Forward Exchange’, The Quarterly Journal of Economics, Vol. 86, No. 2, pp. 303-309. Read More