Why might firms with exposure to foreign markets use foreign currency derivatives - Coursework Example

? Forex Derivatives- A Tool to Minimise Corporate Risks Introduction As per Rawls and Smithson (1990), risk management is now employed by many multinational corporations to a large extent that outcomes of surveys showed that financial executives graded risk management as one of their foremost objectives. A derivative is defined as ‘an instrument whose price is derived from, or depends on, the price of another asset’ (Hull 2009:779). When a company receives foreign currency against supply of services or goods to a foreign based importer, it acknowledges some kind of foreign exchange risk, since there is a possibility of fluctuation between currencies of both exporter and importer from the time of entering into the contract and receipt of funds from the foreign importer. Thus, in case of companies with substantial export earnings, it should assess the quantum of its forex exposure, create a road map for how to minimise that risk, to employ hedging strategies to minimise any substantial loss that may be encountered due to future forex fluctuations in the currencies where it is likely to receive from its foreign importers. (Bragg 2010: 207). For instance, if a company has quoted its export values in US$ and during the interval period where a foreign importer is under obligation to pay the exporter, if the dollar appreciates against the exporter’s currency, then the importer might be paying with a decreased –value currency, which creates the company to account for a foreign exchange loss at the time of receipt of funds. (Bragg 2010: 208). As per Froot, Scharstein and Stein (1993), if the level of capital investment of a company is high, the chance for employing forex derivatives in its risk management policy is always on the increase. (Froot, Scharstein and Stein 1993:1631). According to Demarzo and Duffie (1995), financial hedging enhances the quality of the financial information of earnings by the corporate as an indicator of management capability. (Demarzo and Duffie1995:746) Forex Derivatives A derivative is a financial instrument which derives its value from the underlying assets like currency or stock. Derivatives are extensively used in global business both in hedging against risks and in speculating the risks. The financial managers of the international companies opt these derivatives so as to take the positions in the anticipation of revenues (speculation) or employment of these instruments to minimise the risk inherent with day to day management of their company’s cashflow hedging).( Aswathappa 2010 :543). The probable advantages from employing forex derivatives are reliant on the anticipated exchange rate movements. Thus, it is essential to comprehend why the exchange rate moves over time before employing the forex derivatives for risk coverage. Different Kinds of Forex Derivatives Forex Forwards: Forward is comprised of spot transactions that have been retained for less than 180 days but held over 48 hours when they due for payment and paid at the current prevailing spot price. If you minus the bid price with that of ask price, then you can arrive at the transaction cost. Forex swaps are financial transactions associated with the swapping of two currency amounts on a particular date and a reverse exchange of the analogues' amount at an afterward date. The main objective is to administer currency risks and liquidity by executing forex transactions at the most apt time. In fact, the underlying currency is borrowed and lent concurrently in both currencies, for instance, by selling Euro for US$ for spot value and consenting to reverse the deal at an afterdate. (Brickford& Brickford 2007:7) Forex Futures: A future can be illustrated as a standardised contract to sell or buy a particular asset at a price previously consented to and at a fixed future date. Forex futures are standardised financial instruments that are negotiated in organised markets. Forex futures have many probable benefits but also have many probable risks. Forex futures markets are not only heavily regulated but also centralised. (Archer 2010:21). Forex Option: An option can be defined as a conditional contract and many option contracts are traded publicly. A forex option contract simply explains the conditions and terms that the seller and the buyer have consented upon, and it is about purchasing something or delivers something or selling the obligation to execute something at a pre-accepted price on or before a particular date. Thus, a forex option is a contract on what is identified as an underlying entity, i.e. foreign currency. (Mccafferty 2005:1). Currency call option offers the privilege to purchase a particular currency at a particular price within a particular period of time which is also known as exercise price or strike price. A currency put option offers the privilege to dispose a particular currency at a particular price within a particular period of time. For instance, Coca-Cola Co has substituted about 40% of its forward contract with currency options. FMC, a U.S based manufacturer of machinery and chemicals now hedges its exports with currency options in lieu of forward contracts. It is to be noted that majority of the MNC (Multinational Companies) employ forward contracts. (Madura 2008:59). Many multinational companies employ forex derivatives to minimise their exposures and losses due to currency fluctuations. IBM, Dow Chemicals, Nike and some other companies have about more than fifty percent of their assets in foreign nations. Further, companies like Fortune brands, ExxonMobil and Colgate Palmolive earns more than half of their revenues in foreign nations. Further, Coca-Cola Co is having business operation in more than 160 nations and employs forty different currencies. About more than sixty percent of its aggregate annual operating income is being earned outside the United States. (Madura 2008:2). Being a true MNC, Coca-Cola is exposed to translation risk since its operations are in the local currency and have to be converted into US$. When there is a fluctuation in the currency, it would definitely affect its expenses, gross revenues, diluted earnings and operating income each year. Coca –Cola management estimated that just ten percent of unidirectional movement in currency exchange rates would have impacted their operational revenue by about $100 million as of 31 December 2010. (Coca-Cola 10K 2011:47). Coca-Cola employs the cash flow hedges to lessen its vulnerability to volatility in cash flow due to forex fluctuations. Coca-Cola’s Cash flow Hedging Instrument (Both Cost of sales and other non-operating income) Amount of gain / loss witnessed in AOCI and Derivative instruments US$ in Millions 2010 2009 2008 Cash flow hedging instruments $18 $5 $5 Thus, considering to Coca-Cola’s net income USD 624 million, its use of financial derivative has not only minimised its forex risk but also contributed about $18 million to its net income, which is about 3.5% of its net income for the year 2010. (Fraser & Simkins 2010:324). Conclusion Bartram et al. (2009) analysed about 7,292 companies in the US and 47 companies in other countries about the impact of the usage of foreign currency and interest rate derivatives and their research revealed that the employment of derivatives resulted in higher value for these companies. According to Cyree & Huang (2004), the employment of foreign currency and interest rate derivatives of publicly traded banks or holding companies from 1993 to 1996 and their research study revealed that banks which used derivative instruments have higher values than those that do not. If one observe the Coca-Cola risk management activity, definitely forex derivatives not only minimise the risk or financial loss but also enhances the company’ overall value. List of References Archer, Michael D.(2010). Getting Started in Currency Trading: Winning in Today’s Forex Market. New York: John Wiley and Sons. Aswathappa. (2010). International Business, 4th edition. New Delhi: Tata-McGraw Hill Education. Bragg, Steven M. (2010).Treasury Management: The Practitioner’s Guide. New York: John Wiley and Sons. Brickford James L & Brickford Jim L. (2007). Forex Theory: A Technical Analysis for Spot and Futures Currency Traders. New York: McGraw –Hill Professional. DeMarzo, P., M., Duffie, D., (1995). ‘Corporate Incentives for Hedging and Hedge Accounting. Review of Financial Studies.’ 8, 743-771 Fraser John and Simkins Betty. (2010). Enterprise Risk Management. New York: John Wiley and Sons. Froot, K., A., Scharstein, D., S., Stein, J., C., (1993). ‘Risk Management: Coordinating Corporate Investment and Financing Policies.’ Journal of Finance, 48, 1629-1658 Madura, Jeff. (2008). International Financial Management. New York: Cengage Learning. Mccafferty. (2005). Options Demystified. New Delhi: Tata-McGraw Hill Education. New York: Cengage Learning. Sec.gov. (2011).Annual Report of Coca-Cola -2010 .[online]available from < http://www.sec.gov/Archives/edgar/data/1491675/000119312511033197/d10k.htm> [25 March 2011] Read More