Treasury and Risk Management - Assignment Example

TREASURY AND RISK MANAGEMENT Question Strategies to Deal with the Exchange Rate Risk a) Introduction Exchange risk management is an important aspect in every firm’s decision on foreign currency exposure. According to Allayannis, Ihrig and Weston (2001), currency risk hedging strategies are concerned with eliminating or reducing risks associated with exchange rate fluctuations. It requires the company to understand how the risks can affect their present and future business undertakings economically. i) Unhedged strategy To deal with the exchange rate risk, ABC Company can employ the use of unhedged risk strategy if it expects the exchange rates to remain stable or move in its favor. On using this strategy, the firm’s amount is exposed to the movement of exchange rates. The unhedged strategy is exposed fully to currency risk caused by fluctuation in the exchange rates, as stated by Froot and Thaler (1990). Increase in the value of dollar will lead to decrease in the value of portfolio overseas when it is converted to dollars; hence leading to the funds delivering high returns even if the market is performing quite poorly. However, unhedged strategy can benefit the company when the value of the dollar decreases relative to that of euro. This is because the company can receive more upon the conversion of foreign currency into dollars. As an alternative, the company can use either an equity-linked debt structure or swap structure. When ABC Company use unhedged strategy, especially when the spot rate will remain constant up to one year, then the company will receive 60 million Euros. In this context, the ABC Company will be paid 60 million Euros. If dollar depreciates against the euro, ABC Company will receive more dollars and hence more returns on investment. On the contrary, if the dollar appreciates against euro the company will receive fewer dollars than on depreciation. Therefore, the company will incur extra costs to gather for the losses. If exchange rate after one year will be €1= $1.0, the company will receive 60 million dollars which is less by $. 6 million; hence the company will incur extra costs of $.6 million. If the exchange rate changes €1=$1.2, then the company will get $72 million. In this case, the company will get additional income of $.6 million. Unhedged strategy acknowledges that if the exchange rate remains stable for one year, upon conversion the company can receive $.66 million. The advantage of spot rate is its simplicity, and disadvantage is the losses incurred if the foreign exchange moves against the expectation of the company. ii) Forward hedge strategy This kind of hedging involves taking a forward contract to exchange two currencies; the euro and the US dollars after one year for ABC Company, and at a predetermined exchange rate. The method of determining the future forward rates of exchange will depend on the exchange quotation. Direct quotation is where one euro is quoted to a specified number of US dollars. In order to get the forward rates, discounts are added to the spot rate and the premiums are subtracted from the forward rates. If indirect quotation is used, one euro is quoted as equal to the given number of units of the US dollars. To get forward rate of exchange, discounts are subtracted from the spot rate and the premiums are added to spot rates. Based on the forward hedged strategy, €1=$1.13. In this context, the company in subject will receive $67.8 million after one year. iii) Money Market Hedge Hedging with the help of money market is used to eliminate currency risk by trading the currency today using the spot rate. To do this, the ABC Company, which is going to receive 60 Euros million after one year, will borrow 60 million Euros from a bank in America and convert it to dollars using the spot rate. After borrowing, the company will deposit the money on the fixed account for one year to earn interest. Using the spot rate, the company will have $.66 million. The interest earned by depositing $.66 million in the fixed account will be calculated at the rate of 5.5% per annum, making the total amount to $.69.63 million after one year. The rate charged by the bank for borrowing 60 million Euros is 2% at euro zone. This means that after one year, ABC Company will pay the bank plus interest a total amount of 61.2 million Euros. After one year, the 60 million that the company will receive will be used to offset the loan. The interest accrued for depositing $. 66 million in a fixed account will be used by the company to pay the interest charged by the bank from the loan borrowed. iv) Option Hedge ABC Company can use option hedge to minimize losses that could arise in case the exchange rates becomes unfavorable on the payment it will receive after one year. According to Allayannis et al. (2001), option hedge does not provide full protection against unfavorable exchange rates. This strategy uses current level of exchange rate to explain several concepts. It helps to protect against losing more than a given sum of money by selling an option prior to expiry date. There are two types of options; call options and put options. Call options is always used when the company thinks the price of the underlying exchange rates changes will be favorable, while put option is adopted when the company thinks that the exchange rate changes will be unfavorable. ABC Company can opt for put option if it forecast that the exchange rate will change unfavorably. At an exercise price of $.1.15 per euro expiring after one year, when rate of premium of $.0.08 per unit is subtracted, the company will remain with $.1.07 exchange rate per euro. After one year, ABC company will receive a total of $.64.2 million. Even if the price falls, the seller of the put option is obligated to buy the Euros at the price of $.1.15 per euro. Therefore, this strategy will therefore save the company from incurring significant losses. The table below shows the summary of the final amount in dollars the company will receive when different hedging strategies are used and also, when unhedge is used. Euros received after one year (in millions) Euros to dollars after one year: unhedged (in millions) Forward hedge strategy (in millions) Money market hedge (in millions) Option hedge (put option). (in millions) Savings loan 60 $. 66 $.67.8 $.69.63 -€.61.2 $.64.2 50 $. 55 $.56.5 $.52.5 -€.51 $.53.5 40 $. 44 $.45.2 $.42.2 -€.40.8 $.42.8 Spot rate amount in dollars using unhedge strategy. rates (spot) 1.03 1.04 1.05 1.06 1.07 1.08 1.09 1.1 1.11 1.12 1.13 Euros 60 61.8 62.4 63 63.6 64.2 64.8 65.4 66 66.6 67.2 67.8 Euros 50 51.5 52 52.5 53 53.5 54 54.5 55 55.5 56 56.5 Euros 40 41.2 41.6 42 42.4 42.8 43.2 43.6 44 44.4 44.8 45.2 Graph showing amount of dollars the company will get on using spot rate of exchange after one year. b) Optimal Strategy for ABC Company The optimal option for the company to adopt is the forward contract strategy. According to Allayannis et al (2001), this type of hedging protects the company from incurring huge losses, especially when the company opts for other options of hedging. The approach of using unhedged approach strategy is not much reliable because it is very hard to determine future trends with certainty, even for the currency experts, as the forecast can be wrong which might lead to huge losses for the company. The use of money market hedge strategy by the company will lead to losses. Losses will occur if the interest accrued by the company in saving the borrowed amount from the bank is less than the interest the bank will charge on loan borrowed after one year. ABC Company cannot adopt option hedging because this strategy is meant to reduce the losses the company can incur due to unfavorable fluctuation in exchange rate. Question 2 a. Approaches to Forecast Exchange Rates Exchange rate forecast are very essential in evaluating the foreign dominated cash flow which is involved in international transactions. This approaches entails foreign current forecast; forecasting the possibility of the foreign current to appreciate or depreciate in future. It is very important in the process of evaluating benefits and risks that is encountered within international business environment. i. Purchasing Power Parity This is one of the economic theories and techniques, which is used to evaluate the relative value of currencies between two countries. According to Cheung and Yin-Wong (2009), the purchasing power parity allows one to estimate exchange rate between different currencies from two countries so that they can be able to make exchange be at par with the purchasing power of each country’s currency. This approach of exchange rate forecasts helps to prevent misleading comparisons that can arise with the use of market exchange rates. Purchasing power parity exchange rates can be useful when comparing between the two countries because they stay fairly stable and change at a small margin. Also, exchange rate tends to move over a period of years in a general direction of purchasing power parity exchange rate. Therefore, it will be of some value to understand the likely direction that exchange rate can move over a significant period. PPP deals with comparing the inflation or deflation rates between two countries. ii. Relative Economic Strength Approach and Investment Flow This exchange rate approach focuses on the economic growth of two countries so that it can make forecast on the directions of exchange rates. This approach is based upon the idea of strong economic growth of a country that is likely to attract foreign investors. Investors make assessment using the rate of flow of capital into and out of the two countries to determine where to invest. Apart from the economic growth, the investors will also look at investment flows and interest rates. Hakala and Wystup (2002) say that high interest rates will attract investors who desire high yields on their investment. Current accounts between two countries are also used by investors to determine the level activities taking place. Low interest rates will make investors to avoid investing within a given country. iii. Econometric Models It is the mathematical approach used to forecast exchange rates by collecting factors that are considered to affect the flow of a certain currency, and then create a model that will try to relate such factors to the exchange rate. Pedace and Roberto (2013) say this method can be used to objectively forecast exchange rates of a country, by use of models to calculate future expectations. iv. Technical Analysis It is a technical approach that relies on the small sets of available data. Generally, this approach relies on history of price information. According to Aronson and David (2006), the analysis is technical because it does not depend on fundamental evaluation of economic determinants related to exchange rates or price of assets. Rather, it explores on the past price trends. Technical analysis is much of an art than science as it looks for random repetition of price patterns from the past history to the present price b. Myanmar Kyat against US Dollar in the next Two Years Methods that would be relevant to predict the trend of Myanmar Kyat against the US dollar for the next 2 years is the Relative Economic Strength Approach and Investment Flow. It is the best method for forecast as it clearly shows the trend in flow of capital into and out of the countries. This approach also shows the level of economic activities taking place in a country as recorded in the current account. Conclusion Exchange rates approach mechanisms are not convenient enough to give facts on the fluctuations of currency values. According to Asteriou et al (2011), companies are still using hedging strategies to avoid currency risks that result from the fluctuations of exchange rates. At this juncture, it is undeniable that each hedging strategy has its benefits and setbacks. In order to reap maximum economic returns, companies like ABC must select one of the strategies which best suites their investment portfolio. References Allayannis G., Ihrig J. & Weston J. (2001). Exchange-Rate Hedging: Financial vs. Strategies. London: Risk Publications. Aronson, T & David R. (2006). Evidence-Based Technical Analysis. Hoboken, New Jersey: John Wiley and Sons. Asteriou, L., Dimitros, M., Hall, K. & Stephen G. (2011). The Classical Linear Regression Model. Journal of Applied Econometrics. 2(3). 34-72. Cheung & Yin-Wong (2009). Purchasing Power Parity. New York: Cengage Learning Publishing. Froot, K. & Thaler R. (2009) “Anomalies: Foreign Exchange,” Journal of Economic Perspectives, Vol 4. 23-41 Hakala, J. & Wystup, (2002). Foreign Exchange Risk: Models, Instruments, and Operational Strategies” American Economic Review Papers. Pedace. Y & Roberto, C. W. (2013). Building the Classical Linear Regression Model: Econometrics for Dummies. Hoboken, NJ: Wiley. Read More