Foreign Exchange Exposure - Case Study Example

School: FOREIGN EXCHANGE EXPOSURE Lecturer: FOREIGN EXCHANGE EXPOSURE Executive Summary Once the company wishes to grow and expand, there are several options that may be used. Each available has its own merits and demerits. The selection of a particular growth and expansion module should therefore be based on a weighted consideration between advantages and disadvantages. International franchise is one of the options as currently agreed upon by the management of Bellingham. In such a situation, the major area of risk that has to be considered is the issue of foreign exchange exposure. Such foreign exchange exposure is necessary in the current situation because the targeted country, which is U.S., uses currency that is different from what is used in the parent country, which is U.K. Where are differences in currencies and exchange rate of currencies, movement of money from one point of sale to the other causes either depreciation or appreciation of cash. In such a situation where there are depreciation tendencies, it is said that foreign exchange exposure exist. Because the currency f U.K. is stronger than that of the U.S and because the funding of American Creations will be done with funds from U.K., it can be expected that such foreign exchange exposure will take place. The presence of the risk should however not mark the end of the dream to go international. There are various exchange risk management interventions that can be used, including option and forward contract. When well applied, these management interventions will help the company overcome its foreign exchange exposure. Business Purpose The competitiveness of the current global economic client could be either a threat or an opportunity to any company, depending on how the company positions itself in today’s fast-pace economic climate. For most companies that will look around them to see the opportunities in expanding and taking advantage of the globalised business environment, they would identify with the changing business climate as a merit (Stokey and Zeckhauser, 2008). At the same time, companies that will withdraw from the race of being competitive, chances are that they will see the changing business climate as a threat because they will find it difficult to cope (Carmeli, 2003). For Bellingham plc, the need to take charge of the new globalised business has been realised as an important stake in surviving in business. This has partly informed the company’s current business purpose, which is to undertake massive international diversification and expansion. This business purpose has been trumpeted by the present directors of the company, who see future international diversification and expansion as the answer to the company’s long-term success. Even though the idea of international diversification and expansion has been identified by Sohl et al (2009) as an important determinant of business growth and development, Wang, Dennis and Tu (2007) warned that the approach to such diversification and expansion is very important. This is because the approach must be backed by extension research and investigation that can justify any targeted diversification and expansion agenda. This report therefore looks into the foreign exchange exposure associated with the directors’ ambition of acquiring a subsidiary in the USA and more particularly the American Creations investment project. Types of Foreign Exchange Exposure from American Creations Investment Project Reading through the case of Bellingham plc and American Creations, there are four major types of foreign exchange risks that Bellingham plc will be exposed to, once the company admits to pursuing the American Creations investment project. The first of these risks is transactional exposure. As the company undertakes the American Creations investment project through any means such as diversification, acquisition or merger, it is expected that there will be independent financial activities taking place in the USA as part of programmes to give American Creations some level of financial autonomy grow according to the U.S. financial climate. Meanwhile, Wassily (2006) noted that such financial autonomy risks in a situation whereby the parent company, which is Bellingham will be having most contractual agreements taken from a fixed cash flow foreign currency, which in this case is the dollar. Once this happens, Bellingham will be exposed to transactional exposure due to differences in the strength of currency in the U.K. as against the U.S. Specific instances of transactional exposure may arise from account receivable denominate in dollar, any maturing financial asset such as bonds that American Creations will purchase as part of its autonomy, and all maturing financial liabilities such as loans that will be incurred by American Creations on behalf of Bellingham. There is also an expectation of economic exposure to Bellingham, once the American Creations investment project goes through. Moe specifically, the economic exposure will come as Bellingham makes physical entry into the U.S market. This is because the physical entry into the U.S. is expected to come with various foreign direct investment decisions that will border on the promotion and marketing of the company to its new segment. In terms of spending cost make with the dollar as against the pound, it is not expected that there will be any demerits to Bellingham plc, given that the company will require less pounds to get enough dollars for specific payoffs. However, the risk does not end with the transfer of cost from U.K to U.S along. Rather, there are going to be part of the physical entry, different forms of revenues made in areas such as sales and commission. It is in these areas that Bellingham will feel the risk as there is conversion from dollar to pound for any supposed onward investment into the U.K company. Indeed, the economic exposure remains only future risks that are not known today but it is important that the necessary interventions are put in place to controlling them. What may be particularly worrying in terms of economic exposure is the difference in currency exchange depreciation and appreciation rate between the U.S and the U.K; as forecasted against future incomes. Bryson (2004) noted that between dollar and the pound, there is a loose depreciation against the dollar such that, when forecasts are made in the dollar and subsequently converted to pounds, the value of forecasted sums may be less. In the graph below, the projected turnover of American Creations in the next five years is given. From the graph above, it would be noted that for the next five years, there is a projected growth rate in the turnover of American Creations, which has been corresponded to a percentage growth, which are all progressive. Meanwhile, because the dollar generally depreciates against the pound (Bolman and Deal, 2008), when the same projections are made in pound with the current dollar to pound exchange rate, the differences in percentage of growth will not be the same when the given times come. Most certainly, there will be reduction in percentage growth. This means that in terms of economic exposure, there is likelihood of retarded growth for Bellingham if the earnings from American Creations are to be carried back to the U.K for business usage. The last type of foreign exchange exposure that Bellingham faces is translational exposure. This particular exposure will arise if after engaging in the American Creations investment project, Bellingham would want to include financial figures from American Creation into its consolidated financial statement. In principal, such translational exposure does not always result in a loss or risk but may also result in gains or profit, depending on differences in currency strength between two countries involved (Mikesell, 2007). In the present instance, because the parent company is in the U.K. where the strength of the currency is higher, it will be expected that when the consolidated financial statement is being prepared, it will be prepared in the British Pound. In this situation, there will be losses for Bellingham rather than gains due to the fact that the pound is stronger and higher in value than the dollar. The difference with this form of risk as against the economic risk however has to do with the fact that because there will not be the physical transfer of money in this case but only through financial reporting, its cash flow will not be impacted. The area of impact would rather be on the company’s reported earnings and stock price (Petersen, 2007). Management of Foreign Exchange Exposure One the foreign exchange exposures have been identified, what is left of the company is to have the right management strategies to curbing the risk. According to Wooton and Horne (2010), the need to manage risk must be carefully tackled from the perspective of whether the company is with a long term position or a short term position. Generally, a company with a long term position in its foreign exchange exposure will be expecting to receive foreign exchange in the future (Rubin, 2002). This can be said to be the exact situation that the directors of Bellingham are seeking from the American Creations investment project. In such a situation where the company is with a long position, the best management procedure is to offset position with a short position. Technically, what happens in such a situation is that the short position that is offset will can the long position and thereby create a neutralised foreign exchange position. By offsetting the long position with a short position will mean that Bellingham plc will have to undertake payment in the future in the same currency. To do this effectively, there are two major avenues for Bellingham plc, which are through option and forward contract. Singleton and Straits (2010) have explained that an option is a contract, which when used in the context of Bellingham plc will give the company the right, but not the obligation to sell its underlying asset at specific strike price ahead of a specific date. This means that the company will be using this particular option to guarantee that it can make sufficient earnings on financial assets that move from U.K to the U.S. Examples of this could be operating incomes that are sold as call in the form of equity option or bond option. The advantage that this management strategy will have on the company against perceived foreign risk exposure is that the company will have higher values on its financial assets in the U.S dollar when the call option is used to forward-date the value of the asset. This way, the possible difference in foreign exchange rate between the pound and dollar from the time of selling the option to the maturity period will be consumed. In simple terms, the company will be having a future price quotation for today’s financial asset (Minge, 2007). The forward contract has been explained by Mikesell (2011) to be a situation where the company will be agreeing with its trade partners to sell an asset at a specified future time at a price that is agreed by both parties today. This strategy is recommended in cases where Bellingham plc will be transferring physical earnings from American Creations in the U.S to the U.K. Because there will be foreign exchange depletion on the dollar by the time it gets to U.K, a forward contract will serve as a hedge which will ensure that the exchange rate quotation to be given for the cash from U.S will be done using today’s rate. This way, the difference in rate from the time of selling to the time of actual transfer or buying will be covered in the shock of time. There are a number of ways that the company may be engaged in the proposed use of forward contract to cover its future earnings. The most common of these will be to trade off the amounts in buying tangible assets such as real estate. Once such investments are sold at a specified future time at a price quoted in the present time, all forms of exchange shocks will be covered (Pammer, 2010). Conclusion and Recommendation From the discussion above, it will be noted that there is enormous foreign exchange exposure or risk awaiting Bellingham ahead of the company’s decision to go for the American Creations investment project. But it remains a fact that the project will expand the size and market scope of the company. Because of this, there will be a general recommendation for the company to go for the project. However, all management measures must be taken to ensure that the foreign exchange exposure do not generate into an overall lost for the company instead of a gain. From the discussions, it will be noted that it is only when cash is to move from U.S to U.K that the foreign exchange exposure occurs. Because of this, it will be recommended that there should be a one way cash flow where the company only takes money to U.S from the U.K without the reverse. Where the company would need earnings from U.S for other forms of investment, the idea should be to use the U.S market to nurture other markets in places where the dollar has higher value than their currencies. This way, there will be much savings on the U.S revenue, should will also be used to be translated into future revenues from the proposed markets. To make this possible, the U.K base of Bellingham plc must be strengthened to independent without excessive dependence on the U.S market. Where there will be the need for transfer of cash from U.S, the forward contract should be used to absorb shocks. References Bolman, L.G., & Deal T.E. (2008). 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