International Financial Management - Medco Ltd - Case Study Example

INTERNATIONAL FINANCIAL MANAGEMENT Table of Contents Introduction 3 Part a) 3 Part b) 5 References 13 14 Bibliography 15 Introduction Medco Ltd is a UK based pharmaceutical company that has recently begun to importing and exporting medicines throughout Europe. The company’s Board of Directors are considering international exposure to explore new markets. Consequently, the obvious concern of the company’s board is related to the international financial risk involved in movement of cash flows. The objective of this study is to evaluate two methods of hedging exchange rate risk and present a report to the BOD that evaluates and highlights various international risks likely to be faced by the company and also discusses appropriate methods for managing those risks. Part a) It is given that the company is about to invoice a customer in France 500,000 Euros, payable in six months’ time. The Board of Directors are considering two hedging options that can minimise exchange rate risk faced by the company. Given Information: Amount Payable € 500,000 Spot Rate (Euro/Sterling) € 1.2834 to £ 1.0000 6 Month Forward Rate (Euro/Sterling) € 1.2755 to £ 1.0000 It is given that the 6 month forward rate of exchange is 1.2755 Euros to £1 while the spot rate of exchange is 1.2834 Euros to £1. Based on these given assumptions the two hedging strategies can be evaluated as follows: Analysis of Method 1: Method 1 Borrow Euros now, converting the loan into sterling and repaying the euro loan from the receipt in six months’ time. i) Borrow sum @ 2% p. a € 500,000 ii) Interest Liability after 6mths € 10,000 iii) Convert Euro into Sterling (Spot rate) £ 389,590.1512 iv) Invest in UK @ 4% p. a £ 389,590.1512 v) Interest earned after 6 months £ 15,583.6060 vi) Total amount earned £ 405,173.7572 vii) Convert Sterling into Euro (Fwd rate) € 516,799.1273 viii) Total Liability € 510,000 ix) Net Profit € 6,799.1273 From the above analysis it can be said that Medco Ltd will be able to earn €6,799.1273 from this strategy which is due to the differences in forward and spot exchange rates and differences in the lending/borrowing rates in France and UK. Analysis of Method 2: Method 2 Enter into a 6 month forward exchange contract with a bank to sell 500,00 Euros. i) Borrow sum @ 2% p. a € 500,000 ii) Interest Liability after 6mths € 10,000 iii) Spot rate conversion £ 389,590.15 iv) Interest earned @ 4% p. a £ 15,583.6060 v) Total amount earned £ 405,173.7572 vi) Net Gain/(Loss) € 3,950.0000 From the above analysis it can be said that Medco Ltd will be able to earn €3,950.0000 from this strategy which is due to the differences in forward and spot exchange rates. Recommendations As the net liability of invoice to French customer turns out to be less than using Method 1 hedging strategy compared to Method 2, Medco Ltd is recommended to practice Method 1. Part b) An Evaluation of International Risks in relation to Foreign Exchange Rates Medco Ltd is a pharmaceutical company that is located in UK and the company has recently begun importing and exporting medicines throughout Europe. Globalisation has increased the volume of international trades and transactions and needless to say that international transactions involves exchange or conversion of currencies. Dealings in foreign currencies automatically exposes the company to the risks inherent to changes in exchange rates. This is the reason why Euro was adopted and used as the single currency for exchange of goods and services. But for companies that have trade relations to other nations using their own local currencies increases changes of foreign exchange risks and the finance manager should identify such risks at an early stage and formulate appropriate risk management strategies to minimise international risks. There is an increasing tendency among business to expand their operations in other countries that requires set-up of subsidiaries/factories/etc. that is seen as a strategy to explore new markets and develop customised products to suite the requirements of foreign markets. The foreign exchange markets provides a platform where one country’s currency is traded for another. Hence, foreign exchange risk management constitutes an integral part of corporate decision making for companies that choose to expand their operations overseas. (Source: Cambridge Mercantile Group, 2013) Basically, the international risks of businesses that have global business exposures can be primarily classified into: Transaction Risk – A firm that has international exposures and involves contractual cash flows in terms of cash receivables and cash payables due to global transactions are subjected to unexpected changes in exchange rates. These changes might turn out to be either favourable (when foreign currency depreciates relative to home currency of exporting company and vice-versa for importing company) or unfavourable. The uncertainty in determination of direction of currency movements make forecasting of cash flows very unpredictable or volatile. For instance, if the company is about to invoice €500,000 to its international customer in repaying loan and the currency depreciates against sterling, then without appropriate risk management contract the actual cash flows of the company will increase. Accounting or Translation Risk - This type of risk basically arise due to financial reporting standards of the company which are affected by exchange rate movements. As the firms are generally required to report their earnings, expenses, assets, liabilities and capital in the consolidated financial statements, they automatically get exposed to the currency conversion risk from foreign currency of subsidiary firm to domestic currency of parent firm. Economic Risk – The company’s economic risk exposure is determined from the degree to which its market value is subjective to sudden changes in exchange rate fluctuations. The risk lies in the fact that if exchange rate movements turn out to be unfavourable then it can severely affect the current and future market position of the company’s expected cash flows relative to its competitors. Thus, from the above discussion it can be said that the firm’s economic exposures affect its present value of future cash flows. In addition, it is also important to mention that a sudden shift in exchange rate also influences the demand for goods and services for the selling entity. Appropriate Methods for Managing Risks Forward Contracts – It is a non-standardised or customised contract between two parties to sell or buy an asset on a given future date at predetermined price. The contract is widely used by companies as a standard tool for hedging international risk exposures. The settlements in forward contract occur either on cash or delivery of asset. As these contracts are not standardised they are traded as OTC (Over-The-Counter) instruments. While the properties of OTC makes the contract makes forward contract easier to customise, however lack of centralised clearing procedures exposes the firm to counterparty credit risks of defaulting (Kwok, 2008, p.21). Due to this reason the forward contracts are only available to large companies and not retail clients because the former has much better economical and financial resources to manage counterparty risk. For instance, Medco Ltd can invoice its French customer by entering into a six month forward exchange contract where the spot rate of contract (€1.2834 to £1) is higher than 6 month forward rate (€1.2755 to £1) thereby bringing certainty in transaction. One drawback of forward contract is that the parties cannot exit agreement before delivery or expiry date of the contract. (Source: Wordpress.com, 2011) Currency Futures – Currency futures is a foreign exchange risk management futures contract that agrees on specific exchange rate in one currency for another which is determined on the date of purchase. Thus, these type of futures contract are transferable and they also specify the price at which a particular currency may be bought or sold irrespective of current market positions. This type of contract are primarily manages risk by marking-to-market (MTM) on daily basis. Another advantage of this type of strategy is that the buyer or seller may exit their obligations before actual expiry of the contract by closing position. The price of currency futures is determined at the time of entering the contract and only the currency pair is exchanged at delivery date (Coyle, 2001, p.13). (Source: Kaplan.co.uk, 2012) Currency Options – This type of contract provides the option holder the right to sell or buy specific currency at specific exchange rate without an obligation to do so. In order to obtain this right, the holder will have to pay the option premium to the broker or exchange who will provide the contract. The premium varies depending on the number of contracts purchased. It is considered as one of the most safest and widely used hedging tool in foreign exchange markets to protect against adverse currency movements (Shamah, 2004, p.7). For instance, Medco Ltd may hedge against foreign currency risk by purchasing a currency call or put option. In this case it is assumed that the forward rates could decrease from €1.2834 to €1.2755 against £1 in six months implying that it will be a less expensive transaction for the client. Medco Ltd can buy put option on €/£ so that it can protect itself from depreciation of Euro(€) against sterling (£). Currency Swaps – It is a foreign exchange agreement between entities to exchange interest or principal sum of loan in one currency for equivalent net present value of loan in another currency. These contracts are generally treated as O-T-C derivatives and are closely related to interest rate swaps with only difference that these contracts could also involve of principal loan in addition to interest liability (Clark and Ghosh, 2004, p.41). (Source: Kawaller & Company, 2012) The most simple currency swap contract could involve only the exchange of principal with the counterparty at predetermined rate agreed upon at the time of entering the contract. Such agreement performs similar to any standard future or forward contract. In another form of currency swap option the interest rate cash flows are not netted unless they are paid to counterparty as they are denominated in diverse currencies. This strategy is also known as plain vanilla interest rate swap (Flavell, 2012, pp.159-169). Interest Rate Risk Management – When the company opts to borrow money from abroad it faces interest rate risk due to the fluctuations of currencies irrespective of whether the interest rate was borrowed at floating interest rate or fixed interest rate. Floating interest rates are subjected to changes in fluctuations of interest rate futures while the fixed interest rates arise due to changes in relative currencies of the parties to contract (Fabozzi, 1998, p.21). The various methods for managing the interest rate risk are discussed as follows: Forward Rate Agreements – The forward rate agreement or popularly FRAs are tools to manage interest rate risk that fix the interest that is applicable to loan starting at fixed rate in future. It is an instrument that is used in the O-T-C market and generally involves asking the bank to quote interest rate applicable to borrowed amount for specific period of time starting at a future date. Once the interest rate is agreed between the parties then even if the actual rate at the start of loan is changed due to market movements, the bank and the company will settle the difference (Eales and Choudhury, 2003, p.41). (Source: Wang, 2010) Interest Rate Futures - These hedging instruments operates similar to currency futures discussed earlier where the rate of interest changes from the date of entering contract with the date when the contract is executed. At the end of the deal any losses or profits are settled and calculated between the dealer and the investor. The company that intends to borrow money on future date exposes itself to interest rate risk. Using a interest rate futures contract it can minimise risk by creating opposite position that will net-off against the inherent risk of underlying transaction (Arditti, 1996, pp.119-138). Interest Rate Options – The various interest rate options available to Medco Ltd includes fixing ‘caps’, ‘floors’ and ‘collars’. The company can fix a cap when it expects that interest rates cost will increase in future and thereby capping the net borrowing cost. The reverse strategy can be employed when the company expects that interest rate cost would decline in future receivables. In such case the company can set a minimum ‘floor’ price which it can expect no matter how much the rates decline. A collar is a combination of the above two complementary strategy and is generally used when the firm is unsure about the direction of movement of interest rate. All these options are available only when the company shell out a premium for respective strategy that further depends on volume of transaction (Jarrow, 2002, p.231). References Arditti, F. D., 1996. Derivatives: A Comprehensive Resource for Options, Futures, Interest Rate Swaps, and Mortgage Securities. USA: Island Press. Cambridge Mercantile Group, 2013. FX Hedging and Risk Management Strategies. [Online]. Available at: http://www.cambridgefx.com/69/fx-hedging-and-risk-management-strategies-.aspx. [Accessed on April 16, 2013]. Choudhury, M. and Eales, B. A., 2003. Derivative Instruments: A Guide to Theory and Practice. United Kingdom: Butterworth-Heinemann. Clark, E. and Ghosh, D. K., 2004. Arbitrage, Hedging, and Speculation: The Foreign Exchange Market. United States: Greenwood Publishing Group. Coyle, B., 2001. Currency Futures. Chicago: Taylor & Francis. Fabozzi, F., 1998. Perspectives on Interest Rate Risk Management for Money Managers and Traders. United States: John Wiley & Sons. Flavell, R., 2012. Swaps and Other Derivatives. United Kingdom: John Wiley & Sons. Jarrow, R. A., 2002. Modeling Fixed-income Securities and Interest Rate Options. United Kingdom: Stanford University Press. Kaplan.co.uk, 2012. Money Market Hedges. [Online]. Available at: http://kfknowledgebank.kaplan.co.uk/KFKB/Wiki%20Pages/Money%20market%20hedges.aspx?mode=none. [Accessed on April 16, 2013]. Kawaller & Company, 2012. Alternative Hedge Accounting Treatments For Foreign Exchange Forwards. [Online]. Available at: http://kawaller.com/author/ira/page/3/. [Accessed on April 16, 2013]. Kwok, Y., 2008. Mathematical Models of Financial Derivatives. Singapore: Springer.   Shamah, S., 2004. A Currency Options Primer. United States: John Wiley & Sons. Wang, L., 2010. Forward Rate Agreements. [Online]. Available at: http://letianwang.net/Fixed_Income/06_LIBOR_Rates.htm. [Accessed on April 16, 2013]. Wordpress.com, 2011. Derivatives for CFP – 1. [Online]. Available at: http://prashantvshah.wordpress.com/2011/12/07/derivatives-for-cfp-1/. [Accessed on April 16, 2013]. Bibliography Brooks, R. and Chance, D., 2012. Introduction to Derivatives and Risk Management. USA: Cengage Learning. Buckle, M. J. and Thompson, J., 2004. The UK Financial System: Fourth Edition. USA: Manchester University Press. Cofnas, A., 2008. The Forex Options Course: A Self-Study Guide to Trading Currency Options. New Jersey: John Wiley & Sons. DeRosa, D. F., 2011. Options on Foreign Exchange. New Jersey: John Wiley & Sons. Garner, C., 2012. Currency Trading in the Forex and Futures Markets. New Jersey: FT Press. Helliar, C., 2005. Interest Rate Risk Management. United Kingdom: Elsevier. Kobold, K., 1986. Interest Rate Futures Markets and Capital Market Theory: Theoretical Concepts and Empirical Evidence. Germany: Walter de Gruyter. Mark, R., Galai, D., and Crouhy, M., 2005. The Essentials of Risk Management, Chapter 6 - Interest-Rate Risk and Hedging with Derivative Instruments. United Kingdom: McGraw Hill Professional. Read More