International Finance: the case of Lorient Enterprises - Essay Example

?International Finance Contents Contents 2 Introduction 3 Brief Introduction of the Case 4 Application of Forward Contracts & Currency Futures 4 Forward Contract Hedge 5 Future Contract Hedge 6 Critical Analysis of Currency Forward & Currency Futures Contracts 6 Analysis of the Hedge using future Spot Rates 8 Effect of Inflation on Hedging 8 Conclusion 9 References 11 Bibliography 11 Appendices 12 Introduction This project includes the analysis of the Lorient Enterprise’ foreign currency payables by hedging using the currency forward and currency futures. The foreign currency payable is due within three months. The forward market and futures market have played a significant role in the financial affairs of multinational firms such as hedging the transactions. There are many fundamental differences in forward market and futures market. For example a company that wishes to go long in forward contract agrees to buy the asset or good at a specific future date i.e. maturity date for a forward price determined at the initiation of the contract. At the maturity the forward price should equal the spot price of the underlying asset because the equilibrium forward price continually changes during the contract period in such a manner that the forward contract will always have zero value in the beginning of the contract because no initial payment is required. A futures contract is similar to forward contract in the manner that there is a specified maturity date, price, and the futures price should equal to the spot price at maturity. The value of futures contract is also zero initially. However the difference lies in the treatment of changes in prices during the contract period. The contract is marked to market and the party in whose favour the price is moved must be paid the amount of change by the losing party. This mechanism ensures that there is no counter party risk. This is known as margin call. Furthermore a futures contract is a standardized contract and cannot be tailor-made to suit the transacting parties’ requirements. The first section of the project involves a brief introduction of the case of Lorient Enterprises. The second section describes how Lorient can hedge its foreign currency transaction exposure. The third section includes the hedges using forward contract and futures contract. The following section describes the merits and demerits of using both types of derivatives instruments. The evaluation of the constructed hedges has been provided in the fifth section. The last section provides the effect of inflation rates in France relative to U.S. on the hedging decision of the company. Brief Introduction of the Case The case is from the subject of international financial management about a French company Lorient Enterprises. The company has got into a transaction with an American company and need to make payments of $400,000 within three months to Washington Technical Inc for the purchase of machinery. Hence it is worried about the exchange rate fluctuations due to surrounding European Sovereign debt crisis. It is concerned that this will impose downward pressure on Euro affecting its cross currency transactions. Application of Forward Contracts & Currency Futures A forward contract is an agreement between two parties usually a foreign exchange dealer and the MNC for exchange of currencies at specified exchange rate and time. The forward rate is a pre-determined exchange rate which is specified in the forward contract. MNCs usually request for forward contracts to hedge their future receipts and payments that they expect to receive or make in foreign currency. They lock in the exchange rate based on their expectations of movements in the currency and therefore do not have to worry about the fluctuations in currency. Forward market is an over-the-counter (OTC) market where forward contracts are traded. The main participants of this market are MNCs and foreign exchange dealers. The forward market liquidity varies among currencies. Euro’s forward market is highly liquid because a lot of firms take forward positions for hedging purpose (Madura, 2009, p.64). Lorient Enterprises is worried about the payments in USD within three months. Therefore it can get into a forward contract to sell EUR after three months. The three month forward rate for EUR is $1.3129 (from Appendix 1-1). If the spot rate after three months declines depreciating EUR further, the company will be in profit due to lock exchange rate. If however, the expectations of the company is proved wrong after three months and EUR appreciates then the company will be in loss. The futures contract is similar to forward contract except it is traded on an exchange instead of over the counter. Currency futures contract is a standardized contract with specified standard volume of currency on a specific settlement date. MNCs use currency futures market to hedge their transactions in foreign currencies. The futures rate, like forward rate is an exchange rate at which a specific currency can be purchased or sold on the settlement date according to the futures contract. Thus the currency futures contract is similar to currency forward contract. If Lorient gets into a currency futures contract to hedge its payables in USD it will short the EUR March futures contract at $1.3088. The standard contract size on Euro is €125,000. Forward Contract Hedge EUR/USD Spot Rate = €/$1.3134 (Appendix 1-1) EUR/USD Forward Rate = €/$1.3129 (Appendix 1-1) If Lorient wants hedge payables exposure using forward contract, it needs to buy $400,000 forward in exchange for the following Euro amount: $400,000 / €/$1.3129 = €304,669 approximately. On the maturity of the forward contract i.e. after three months, Lorient will receive $400,000 from the counter-party in exchange for €304,669. Lorient can then use $400,000 to make payments to Washington Technical Inc. Since Lorient will have $400,000 for sure in exchange for given euro amount i.e. €304,669, regardless of the prevailing spot exchange rate in three months, Lorient’s foreign currency payables is fully hedged. Future Contract Hedge EUR/USD March Future Rate = €/$1.3088 (From Appendix 1-2) The contract size for EUR/USD is €125,000. So Lorient will have to sell approximately 3 contracts to hedge its payables of $400,000. The contract will expire on March 1, 2011 which is nearest expiry date prior to the payment. This contract always expires on March 1. The next contract has expiration on June 1. If Lorient enters into March contract it will still retain the risk of exchange rate fluctuations between its currency sale date of March 1 and payables date of March 21. As the standardized futures contract does not exactly fit Lorient’s transactions, the company should not choose currency futures to hedge its exchange rate risk. Critical Analysis of Currency Forward & Currency Futures Contracts Forward contracts are used for those currencies whose values fluctuate considerably in the market. The terms of the exchange are decided by mutual agreement to suit the convenience of the counter parties. The major benefit of currency forward is that the terms of the contract are modified to suit the requirements of the counterparties. Another benefit of the forward contract is that its expires two working days prior to the maturity and on this date the reversing deal can be initiated as a spot deal if delivery of the asset is not contemplated. The other benefits include low or zero transaction costs. The delivery process has a very small transaction cost however the convention is to deliver the currency without any charges. Furthermore the market for currency forwards is highly liquid and well developed (Record, 2003, p.26-28). Lorient wants to hedge its foreign exchange rate exposure for payables within three months. The hedged amount as well as the forward delivery date of the contract has suited to its requirements. However there are certain disadvantages of the forward hedge. Firstly, currency forwards include the counter-party risk or default risk. There is always a probability that the counter-party may not fulfil its obligation. Secondly, currency forwards are a straight line hedge which means that if the forward rate equals the spot rate, the exchange rate risk is fully eliminated. Even though the forward rate is an estimate of expected spot rate, unexpected changes in future exchange movements in the currency may occur. As a result the actual spot rate may differ from the forward rate agreed initially (Kevin, 2009, p.239). This risk will be faced by Lorient. The currency future hedging also has various advantages and disadvantages. Currency futures’ major advantage is the transaction is conducted over an exchange. This improves the liquidity and regulation of the transactions. The exchange clearinghouse eliminates the risk of default by counter party. The information regarding price and transaction is readily available. The major disadvantage of futures hedging is the standardization of the contract. This means that the options to hedge are limited. In case of Lorient Enterprises the futures hedging was not perfect because of its standard expiry date. The company was still exposed to exchange rate fluctuations despite entering the contracts. Moreover the futures contracts are marked to market which means that the margins can be higher in case of high fluctuations. The brokerage and commission fees can be high (Lien, 2008, p.15). Analysis of the Hedge using future Spot Rates Forward Market: On March 21, 2011, the following rate is available: EUR/USD future Spot Rate = €/$1.4185 (from Appendix 2-1) EUR/USD Forward Rate = €/$1.3129 (from Appendix 1-1) Lorient Enterprises entered into the currency forward contract to hedge its payables in three months expecting the euro will depreciate. However, contrary to the expectations, euro has appreciated. This has lead Lorient into loss. Using the forward rate the company will have to sell €304,669 for $400,000. The amount of EUR to be sold when company does not enter into forward contract is $400,000 / €/$1.4185 = €281,988 approximately Therefore the company would have sold €281,988 to buy $400,000 instead of €304,669. Thus the loss amounts to, €281,988 - €304,669 = - €22,680 Futures Market: The currency futures contract does not provide a perfect hedge and therefore Lorient could not enter into the futures contract. Effect of Inflation on Hedging Factor which affects a country’s exchange rate movement with another country is the relative inflation. As the relative inflation changes, the foreign exchange rates which are not constrained by the regulations of government should adjust for the relative differences in the price levels of the countries. This is explained in Purchasing Power Parity theory. According to this theory as the inflation rises in a country, the consumers shift their demand for goods from relatively low inflation countries i.e. they import goods from those countries having relatively low inflation. The change in exchange rates of the two countries is directly proportional to the inflation differential (Saunders & Cornett, 2008, p.246-247). If the forecasted inflation in France relative to U.S. is expected to rise then EUR is likely to depreciate against USD. Based on this expectation the hedging strategy employed by Lorient will be beneficial to the company as the company has locked in the exchange rate and any downward movement in EUR will not affect its payables in future. Conclusion This project has tried to analyze the hedging requirement of Lorient Enterprise, based in France that is engaged in transactions with U.S. based company Washington Technical Inc. The company has payables to be made within three months and expects that EUR would depreciate against USD. The currency forward contract compared to currency futures has been identified to be a suitable hedge for the company because its payment date is not aligned with the maturity of the futures contract and the forward contract can be tailor-made according to the company’s requirements. However it has been found that the forward hedge has not been a successful hedge because in the three months period EUR moved against the expectations of the company. Therefore the company has incurred losses in hedging. Various merits and demerits of the currency forward contracts and currency futures contract have been discussed. The forward contracts are suitable to those firms that have specific requirements in terms of maturity and contract size. The futures contracts are standardized contracts with standard contract size such as 125,000 euro in one futures contract. If the expected inflation in France is high relative to U.S. then according to the Purchasing Power Parity theory EUR is likely to depreciate against USD in future. Overall these factors determine the foreign currency movements and the hedging decision should be based on such factors. References Kevin, S. (2009). Security Analysis and Portfolio Management. PHI Learning Private Limited. Lien, K. (2008). Day Trading and Swing Trading the Currency Market: Technical and Fundamental Strategies to Profit from Market Moves 2nd ed. John Wiley & Sons. Madura, J. (2009). International Financial Management 10th ed. Cengage Learning. Record, N. (2003). Currency overlay Illustrated Edition. John Wiley & Sons. Saunders, A. & Cornett, M.M. (2008). Financial Markets And Institutions. Tata McGraw-Hill Education. Bibliography Bragg, S.M. (2010). Accounting Best Practices 6th ed. John Wiley and Sons. Clark, P.B. (1994). Exchange rates and economic fundamentals: a framework for analysis. International Monetary Fund. Eun, C.S. & Resnick, B.G. (2008). International Financial Mgmt 4th ed. Tata McGraw-Hill Education. Appendices Appendix 1-1: Euro Spot Forward on 21/12/2010 Appendix 1-2: Euro Futures Rate on 21/12/2010 Appendix 2-1: Euro Spot Forward on 21/03/2011 Appendix 2-2: Euro Futures Rate on 21/03/2011 Read More