Hedging an Account Payable - Case Study Example

Quiz Hedging an Account Payable1 Company (US) has to pay a UK supplier two million pounds due in 90 days. The spot exchange rate (S is 50/ while the forward exchange rate (F$/ ) for delivery is $1.48/ . The interest rate in the U.S. for a 90 day period (RUS ) is 4.5 percent while the UK rate of interest (RUK ) for 180 days is also 5.0 percent. Option 1: Not Hedging At All: Payable = Forecast ($/ ) * 2,000,0000 Forecast Probability Payable $1.45 20% $ 2,900,000 $1.47 70% $2,940,000 $1.51 10% $3,020,000 Since the probability for the second case is much higher than the two, take payable amount to be $2,940,000. Option 2: Forward Contract Hedge: The present value of selling the pounds in the forward market is: Equation: F$/ (Amount Payable) = (1/ 1.045) ($1.48/ 1.0) 2,000,000 = $2,832,535.89 The present value from borrowing the present value of the payable (denominated in units of foreign currency) and converting to dollars is: Equation: S$/F (Amount Payable) = ($1.50/ ) (1/ 1.05)(2,000,000 ) = $2,857,142.86. Since the present value in the forward is lower, take this to be the company's recourse for this option. Option 3: Option Hedge Strike Price: $1.485 Premium: $0.25 Payable = (2,000,000 * 1.5) - (Spot Price - Option Premium -Strike Price)* 2,000,000 Spot Price Option Premium Strike Price Probability Payable $1.45 $0.25 $1.485 20% $3,570,000 $1.47 $0.25 $1.485 70% $3,530,000 $1.51 $0.25 $1.485 10% $3,450,000 Since the second case has the highest probability, take it to be the loss for the company. December 10 , 2006 [Name of Director] Director: [Company Name] Dear Sir: This is a report regarding the decision whether to hedge for the 2,000,000 payable to one of our UK supplier within 90 days. Three options were investigated and the results are as follows: 1. Not to hedge at all - $2,940,000. 00 2. Forward Contract Hedge - $2,832,535. 00 3 Option Hedge - $3,530,000. 00 From the list above, it would be advisable to undertake a forward contract hedge since it offers the least cost for the company. The plan calls for a forward exchange rate of $1.48 / agreement with the UK supplier for a 90- day due date. The calculations and analysis are stapled with this report. Apart from these three financial arrangements, there are other alternatives that the company can resort to. They are as follows: A. Currency Swap This financial agreement is a swap that involves the exchange of principal and interest in one currency for the same in another currency after a specific period of time. It is considered to be a foreign exchange transaction but is not required by law to be shown on the balance sheet. In this type, there should not only be a need for our US based company to acquire Pounds but also the UK supplier needing US dollars. If such is the case, both companies could arrange to swap currencies by establishing an interest rate, an agreed upon amountand a common maturity date for the exchange. Currency swap maturitiesare negotiable for at least 10 years, makingthem a very flexible method of foreign exchange. This may be recommendable considering that the UK supplier has a subsidiary in the US which may need US dollars for its transactions. The data available to us however indicates does not contain any information regarding this. (Investopedia, 2006a); (Wikipedia, 2006a). B. Interest Rate Swap Rather a popular form of swap, the interest rate swap is a financial agreement in which one party exchanges a stream of interest for another party's stream. Interest rate swaps are normally 'fixed against floating' but can also be 'fixed against fixed' or 'floating against floating' rate swaps. Interest rate swaps are used to change the company's exposure to interest-rate fluctuations by swapping fixed-rate obligations for floating rate obligations or vice versa. To understand howeach party wouldbenefit from this type of arrangement, consider two parties where each has a comparative advantage to take out a loan at a certain rate and currency. For example, Company A can take out a loanwith a one-year term in theU.S. fora fixed rate of 8%anda floating rate of Libor + 1% which is comparatively cheaper, butthey would prefer a fixed rate.On the other hand, Company B can obtain a loan in the UK on a one-year term for a fixed rate of 6% or a floating rate of Libor +3%, consequently, they'd prefer a floating rate. Through an interest rate swap, each party can swap its interest rate with the other to obtainits preferred interest rate Note that swap transaction are often facilitated by a swap dealer, who will act as the required counterparty for a fee. The problem with this financial arrangement is that the data for the interest rates indicate that both countries are the same. Furthermore, the company gives no indication of whether it would require a loan. (Investopedia, 2006b); (Wikipedia, 2006b). C. Quanto Swap This is a swapinvolving varying combinations ofinterest rate, currency and equity swap features where payments are based onthe movement of two different countries' interest rates. This is also known as a differential swap. It is a combination of the foreign currency swap and interest rate swap. Currency swap usually involves the exchange of principal and interest payments of a local firm for that of a foreign entity. An interest rate swap, both of the firms are local and only the interest payments are exchanged. The quanto swap involves the exchange of interest payments of a local firm for that of a foreign entity. The local firm will pay interest at the foreign interest rate, but its notional will be held in the local currency. Fixed-for-floatingquanto swapsallow an investor tominimize foreign exchange risk. This isachievedby fixing both the exchange rate and interest rate at the same time. Floating-for-floating swaps have slightly higher risk, since each party is exposed to the spread between each country's currency interest rate. Although this is possible since both parties, our company and the supplier, has subsidiaries in their country's counterpart which means that they both have UK and US currency reserves. The problem with this arrangement is that the interest rates for both countries are the same and offers no comparative advantage. Furthermore, there is no indication of whether the UK supplier would agree to such an agreement. (Investopedia, 2006c); (Wikipedia, 2006b). These alternatives are worth looking at and may even provide fewer risks for the company. However, because of the requirements of these alternatives, this report would still recommend forward contracting as the better choice for the company. [Name of Author] Financial Consultant [Firm Name] References: Chance, Don M.(1995). An Introduction to Derivatives. Harcourt Brace College Publishers: Orlando, 1995. Kenyon, Alfred.(1981) Currency Risk Management. John Wiley & Sones, Inc.: New York, 1981. Schroeder, Richard and Clark, Myrtle. (1998). Accounting Theory, 6th edition. John Wiley & Sons, Inc.: New York, 1998. Investopedia Online (2006a). Currency Swapping. Retrieved December 9,2006 from www.investopedia.com Investopedia Online (2006b). Interest Rate Swapping. Retrieved December 9,2006 from www.investopedia.com Investopedia Online (2006c). Quanto Swapping. Retrieved December 9,2006 from www.investopedia.com Wikipedia Online (2006a). Currency Swapping. Retrieved December 9,2006 from www.investopedia.com Wikipedia Online (2006b). Interest Rate Swapping. Retrieved December 9,2006 from www.investopedia.com Wikipedia Online (2006c). Quanto Swapping. Retrieved December 9,2006 from www.investopedia.com QUIZ 2. THE EUROPEAN SINGLE MONETARY UNION A. OBJECTIVES AND CRITERIA The Euro had its roots from the market integration of the European Union. The Single Market Programme (1987-1992) involved the market integration of European Union member countries primarily to create an upsurge in foreign direct investment. The integration was based on the following premises: 1) the increase in the size of the market due to regional integration results to larger scale investment that would not have been profitable in member states' national markets and 2) regional integration can lead to an increased economic growth rate and foreign direct investment (FDI). Emphasis is usually given to FDI. Policy instruments which Member States had previously employed to manage their economies were no longer available to the EU members as per agreement. These policies were previously designed to protect the local market and include import controls, export subsidies, devaluation of national currencies to regional and sectoral subsidies and the strategic use of public procurement and the employment buffers of public-service industries(European Parliament, 1996). The free movement of goods, services, capital and labour which resulted from the Single Market Programme meant that the member state would be constrained from imposing increases in taxes and regulation which would surely reduce benefits due to increase domestic production costs. To facilitate further trade, the European Union embarked on a venture of establishing a single currency for its members. The result of the EU monetary union was the euro. This currency is currently used by Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal, and Spain. Monaco, San Marino while the Vatican City are licensed to issue and use the euro (UK DTI). Besides from belonging to the European realm, countries who wish to participate or is already participating in the "Euro land" has to pass the following economic tests referred to as 'convergence criteria': Annual government budget deficit cannot exceed 3 percent of gross domestic product (GDP, the total output of the economy). Total outstanding government debt (the cumulative total of each year's budget deficit) cannot exceed 60 percent of GDP. Rate of inflation must be within 1.5 percent of the three best performing EU countries. Average nominal long-term interest rate is within 2 percent of the average rate in the three countries with the lowest inflation rates. Exchange rates stay within "normal" fluctuation margins of the European Exchange Rate Mechanism (ERM) for at least two years. The criteria are not that strict however. It was agreed upon that interested and participating countries must at least show that they are on track of achieving these criteria. However, to ensure that the country is indeed working to achieve these criteria, he Stability and Growth Pact 1996 stipulates that fines would be charged to countries who have excessive deficits. Member states which have a budget deficit that is greater than 3.0 percent of the GDP will be charged 0.2 percent of their GDP plus 0.1 percent of the GDP for every percentage point of deficit above 3.0 percent. Countries that are in recession which is defined as a fall by at least 2.0 percent for four fiscal quarters are exempted from the fines. A fall by any amount from 0.75 to 2.0 percent requires a vote by the EU to impose the fine. B. Developments Although the Monetary Union seemed, at the start, to be effective in increasing intraEU-trade and foreign direct investments, recent reports suggests otherwise. According to the Kok Report for the Commission (2004) and UNCTAD (2004), intra-EU trade has shrunk since the launch of the Single Market (SM) and the Monetary Union. Kok states that the "intra-EU trade in manufactured goods has been shrinking since 2000: it's the same story in serviceslevels of intra-EU trade in services are lower than a decade ago." (Cited in New Frontiers Foundation, 2006) Besides from the low intra-EU trade turnout, foreign direct investments pouring into member countries are lower than that of non-member UK countries such as the UK. Source: UNCTAD, January 2005 Furthermore, even though the European Union is poised to increase its sphere of influence, it is projected that the EU's share of global GDP will nearly half by 2050 -falling from 18 percent now to just 10 percent by the middle of century (see Fig. 2): Fig 1. Share of Glbal GDP projections ( European Commission in New Frontiers 2006, p.8) The graph shows that still developing countries are poised to dominate the global and no enlargement can ever hinder this from happening ( the EU portion also includes the GDP of the United Kingdom). Even if the European Union enlarges itself and dissolve trade barriers between European countries (reducing manufacturing costs and tariffs), the changes would be insufficient to match the cheap manufacturing and labor costs in countries such as China and India. Companies are keener to place a major portion of their supply chain to these developing countries as the costs is far more lower as compared to the costs of services in the European domain. C. UK and the EURO There has been much fanfare on the UK's non adoption of the Euro. In this section, we will discuss thru examples and recent developments how UK benefits or loses from not joining the UK. Through this discussion, we are actually discussing the arguments for and against joining the Moneta Business Aversion: The Case for Toyota and Nissan In the year 2000, the United Kingdom was threatened with pullouts from major industry players. Industrialists, one after the other, have warned that unless the UK joins Euroland, they will be forced to move their operations out of the country. One of the most prominent of this pro-Euro group is the Nissan Motor Company (UK) which manufactures automobiles from its plant in Sunderland. In April 2000, John Cushnaghan, managing director of Nissan (UK) announced that the high value of the pound was imposing an "unsupportable burden" brought about by exchange rates fluctuations. By May of the same year, the company claimed the strength of the Sterling against the Euro necessitated the need to cut costs by 30 percent. This loss, according to them, could force the company to transfer the production of the next generation of the Micra to be built in French and Spanish Factories transferring a 150 million investment (North, 2005). Another case would be that of the Toyota Motor Manufacturing (UK) LTD which required its British suppliers to use euro for its financial transactions with the company. The move was brought about by the 1999 operating loss in British operations (BBC, 2000). The requirement, Toyota claims, would reduce the risk to the company that it could lose money when converting euros to sterling in order to pay British suppliers (CNN, 2000). Toyota (UK) has a passenger car plant in Derbyshire producing Avensis and Corolla with an initial investment of 1.1billion. It also has an Engine Plant in North Wales with an initial investment of 400m. (Toyota Online, 2006) Toyota has also expressed its propensity to shop around in euro-friendly countries for cheaper goods if the pound remained high. Yoshio Ishizaka, a senior managing director for Toyota, said his company would strive to reduce costs by buying more from suppliers in pro-euro countries. (BBC, 2000) The two companies are only two of the growing list of industrial players who have expressed their resentment over UK's vacillation of whether to join Euro or not. Some industrial analysts argue that Nissan is only using the Euro issue as an excuse to transfer its operations in France or Spain because Renault, a French Motor Group and Nissan Europe's owner, can benefit from the tax cuts offered by the French and Spanish governments. However, even if such is the case, if UK only joined EuroLand then Nissan and other companies could not have used this argument. Looking at the bigger context, we find that the main issue revolves around "currency adjustment risks". The dominance of the Sterling over the Euro makes the United Kingdom unsuitable as an operations base because of the uncertainty in exchange rates. For example, the appreciation of the Sterling and depreciation of the Euro translates to increase in costs because it will take more euros to pay British suppliers. If Euro was used, then the fluctuations would have been eliminated and costs remains fixed. But is exchange rates the major determining factor in the volume of Foreign Direct Investments Remaining Steadfast: Britain Holds its Grounds Despite the aversion of Toyota and other businesses to continue/establish operations in the UK, the country has attracted more investments from around the world than Germany, France, and Italy combined as Figure 1 suggest: Fig. 1 Country Market Share (Ernst and Young, 2004) According to Ernst & Young's European Investment Monitor, the number of foreign direct investments in the UK in 2003 was 453 investments (up from 370 in 2002) with Euro countries such as Germany and Italy continuing to see a fall in the number of investments. Non EU Countries such as the Nordic countries like Denmark and Sweden also performed well, exhibiting an aggregate growth of 15% over 2002. Aggregate investment into the euro-zone was stable, whereas the three non-euro-zone members of the EU (Denmark, Sweden and the UK) saw an increase in their project numbers (Ernst and Young, 2005). The main reason why the UK still remains as the forerunner in FDIs is that most of the trade was in dollars and not in Euros. A review of imports and exports statistics shows that 2/3 of the imports are invoiced using either pounds or dollars with euro constituting only about a quarter in euros. Three-quarters of exports invoices also use either pounds or dollars with only about a fifth invoiced in euros. Also, the pound has been more stable as compared to the euro. Replacing the pound with euro would only place the UK, with large commitments in America, in a losing position since the Euro is much more volatile against the dollar (New Frontiers Foundation, 2005). Furthermore, Japanese investments accounts for less than five percent of investment in the UK. Most of the FDIs entering the UK come from US investment which is double the amount that Germany, France, and Italy combined invest in Britain. The US also accounts for far more new investment projects than the main EU countries and tends to be in those areas that will expand in the medium-term such as software rather than decline-such as car manufacturing (New Frontiers Foundation, 2005). This market characteristic only goes to show that the argument that the UK should adapt the euro because it would benefit from the elimination of exchange rate risks is unfounded and illusory. Since foreign direct investments come mostly from the United States, it would be unwise to use a currency (euro) which is more prone to exchange rates fluctuations. In the foregoing discussion, we can rightly surmise that keeping the pound is not the main determinant of the volume of foreign direct investments. The main key threats lies in a combination of increased domestic regulation and taxes, increased EU regulation and collapsing education standards while Asian countries improve standards and universities (Asian countries are currently the focus of FDI's especially China). Even Fujio Cho, the President of Toyota declared in 2004 acknowledged that it was "of little relevance whether the UK joins the euro". According to him, what is more important is that they have already established major engine and assembly plants in the UK and that domestic policies and regulations were very accommodating. Nissan also decided to produce the new generation of Micra in its Sunterland plant after the government gave them billions in government grant (BBC, 2004). References: BBC News online (2000) . UK Toyota sparks new euro row. Retrieved Dec. 1, 2006 from www.bbc.com BBC Online (2004). Toyota President Supports the Pound. Retrieved Dec. 1, 2006 from www.bbc.com CNN online (2000) . Toyota fuels UK Euro debate. Retrieved Nov. 30, 2006 from www.cnn.com Ernst & Young European Investment Monitor (2004). FDI Europe. Retrieved Dec. 1, 2006 from www.ey.com Ernst & Young European Investment Monitor (2005)UK and France lead recovery in European foreign direct investment. Retrieved Dec. 1, 2006 from ww.ey.com European Parliament and Council (1996) Summary: THE IMPACT AND EFFECTIVENESS OF THE SINGLE MARKET . Communication from the Commission to the European Parliament and Council. Retrieved Nov. 20,2006 from www.dti.gov.uk New Frontiers Foundation (2005). UK-EU TRADE AND INVESTMENT: INTRA-EU TRADE HAS SHRUNK SINCE THE LAUNCH OF THE SINGLE MARKET, AND UK-EU EXPORTS ARE 49% OF TOTAL. Retrieved Dec.1, 2006 from www.new-frontiers.org North, Richard (2005). Nissan and the Euro. Retrieved Nov. 30,2006 from www.official-document.co.uk Toyota Online (2006). Toyota European Manufacturing. Retrieved Dec. 1, 2006 from www.toyota.com UK Department of Trade and Industry(2006). WORKING WITH THE EUROPEAN UNION. A practical guide to the EU. London: DTI. Retrieved Nov. 20,2006 from ww.dti.gov.uk Read More