International Financial Management in Medco Ltd Pharmaceutical Company - Example

International Financial Management Introduction Medco Ltd pharmaceutical company based in United Kingdom had begun to export and import medicines throughout Europe. In trading outside United Kingdom, the company is exposed to various international risks, one of which is foreign exchange rate exposure. The Board of Directors are concerned regarding the foreign exchange rate exposure since the company will invoice a customer in France an amount of 500,000 euro. The amount is payable after 6 months and thus the Board of Directors wants to figure out the risk that the trade will encounter in future. They also have the desire to figure out the possible measures or methods through which they can hedge the particular risk so that they do not loss any money. The report highlights the advantageous financial method among the two prescribed methods. The foreign exchange rate exposure is elaborated in this report in order to examine the types of risk Medco can encounter in future during the payment to a customer in France after 6 months. Foreign exchange rate risk is elaborated in the report along with the possible methods for hedging it. The trade is taking place between Medco Ltd and a customer in France. The currency of United Kingdom is euro whereas the currency of France is sterling. Thus, to pay an amount of 5, 00,000 euro after 6 months, Medco Ltd has to hedge the amount against different types of risks that it can encounter while paying the amount to the foreign customer of France. The report thus describes the best method through which risk of foreign exchange rate exposure can be mitigated. Foreign exchange rate risk Foreign exchange risk can be defined as the risks that a company can encounter in near future due to the drastic movements in foreign exchange rates. The risk associated with the movement is due to the unfavourable variations in exchange rates which results in loss of the money. It actually originates from two main factors (Bielecki and Rutkowski, 2010; Lam, 2003). Firstly, the mismatch of currency between the trading companies or institutions since both belongs to different countries. The mismatch is in the assets and liabilities of the company. Secondly, the risk continues to occur until the foreign exchange position is covered (Van Deventer, Imai and Mesler, 2004; Hartmann and Issing, 2002). Moreover, the risk can occur from more than one source as the foreign currency keep account of retail cash transactions and investments. It also includes investments that are denominated in foreign currencies. The amount of risk is the function of the degree of variations in the exchange rate, size and duration of foreign currency exposure. The exchange rate risk pertains to the impact of variations in the unexpected exchange rate based on value of any company’s transaction. It explains the direct or the direct loss that a particular company can encounter due to the variations in exchange rates. The cash flows are affected along with the net profit, asset and liabilities (Longin, 2001). The strategies for hedging the exchange rate risk entails at reducing or eliminating the risk that occurs due to foreign exchange rate exposure. The risk requires understanding the ways that pertains to the method that relates to the reduction of risk for the economic agents. The appropriate strategies for hedging the risk are often hard to find out since it involves measurement of risk exposure. It also gives emphasis on the magnitude of the risk exposure that is needed to be covered. Thus, there is a need for currency management that highlights the foreign exchange rate risk mitigation. Types of risk The small as well s the multinational firms are participating in trading in the currency market for the past few decades. It has helped them to earn profit from the trade exchange. The effect of the movements of exchange rate experienced by a company is measured through the value-at-risk (VAR) process (Papaioannou and Gatzonas, 2002; Allayannis and Ofek, 2001). The company is engaged in transactions denominated in foreign currency. Thus, it has to locate the types of risks it is exposed to and also the amount of risk it will encounter if the exchange rate variation takes place. There are mainly three types of risks associated with the foreign exchange rate. These are the possible risk that Medco Ltd is bound to encounter when it will make the payment of 5, 00,000 euro to the customers in France denominated in sterling. The risks are as follows: 1. Translation risk relates to profit or loss which results from conversion of foreign currency balances for purpose of preparing accounts. It is the exchange rate risk that is observed in the balance sheet and pertains to the movements in the exchange rate for the evaluation of foreign subsidiary (Papaioannou, 2001; Hagelin and Pramborg, 2004). Translation risk for any company is evaluated by measuring its exposure of net assets (assets minus liabilities) for identifying movements in potential exchange rate. During the consolidation of the financial statements, translation can be observed “at the end of the period exchange rate or at the average exchange rate of the period” (Chance and Brooks, 2010). The translation also depends on the accounting policies that are affecting the companies who are involved in the trade. IT is noticed that the translation of the balance sheet and income statements are different. The income statements are translated by considering the average exchange rate whereas the balance sheet is translated at the current exchange rate prevailing during the time of consolidation (Marrison, 2002). 2. Transaction risk is the risk that relates to the foreign currency transactions at an exchange rate when settled with that of another. This risk is managed by the financial managers with the aim of reducing the risk to a great extent so that the trade encounter considerable amount of profit and eliminate the scope of loss (Economy Watch, 2014; Thomsett, 2010). It is basically the risk that is associated with the cash flow. It aims at addressing the impact of variations in exchange rate on transactional account pertaining to the payables and receivables. Variations in the exchange rate in form of currency denomination are subject to the direct transaction of the exchange rate risk of a company (Times Interest Limited, 2014). 3. Economic risk refers to the modifications of the present value of future cash flow which occurs due to the unexpected movement in the foreign exchange rates. It actually reflects the risk associated with the present value of a future operating cash flow of a company which is encountered due to the change in the foreign exchange rates. Economic risk is concerned with the effect of the variations in the exchange rate that is associated with the revenues and the operating coast of the company (Siddiqi, 2002). Method for managing foreign exchange rate exposure There exist a number of options which can hedge the exposure to the different types of risk associated with the transaction. Medco Ltd will encounter transactional risk since the transaction of 5, 00,000 euro is subject to variation in foreign exchange rate. Medco Ltd will pay the amount to the French customer in sterling after six months from the day of contract. Thus, the company has to encounter variation in exchange rate since the amount in euro is to be converted into sterling. It is possible that the conversion of euro to sterling will cost more after six months to the company (Haushalter, 2000; Mihailov, 2005). Thus, the company has the following option for hedging the risk of variation in exchange rate: Forward contract The most important and easy method for hedging the risk associated with foreign exchange rate is known as forward contract. The currency forward is associated with the purchase or sell of the currency contract for the future delivery of a specified amount at a price that is set on time of the contract (Brown, 2001; Brown and Toft, 2002). There are two types of contracts that are used for the purpose of hedging the exposure of foreign exchange rate risk: the outright forwards that involve with the delivery of currencies and also the non-deliverable forwards that are settled on the basis of net cash basis. These types of contract are traded in the over the counter (OTC) market. By employing forward contract a company can completely hedge the risk of losing any amount due to the changes in the prevailing exchange rate. The high cost of forward contract and the variation in the exchange rate are the main disadvantages of this type of contract (Berk, Green and Naik, 2004; Billington, Johnson and Triantis, 2003; Muller and Verschoor, 2006). It enables the exporter to sell an amount of foreign currency at rate that is set at a pre-agreed rate with a specified delivery date (Ernst & Young Global Limited, 2014). Here, in this case, the French customer who exports goods to Medco Ltd for 5,00,000 euro can demand a forward contract which expires after 6 months when the actual payment is made. The forward rate after 6 months is set at 1 British pound sterling = 1.22 euro. Thus, the French exporter has eliminated the foreign exchange risk by making a forward contract with Medco Ltd. for delivering an amount of 411141.50 sterling to its bank account after 6 months at the specified forward rate. This forward contract will assure the French exporter that the conversion of the 5000000 euro has been risk free and it will not loss any amount after 6 months. Future contract The future contracts are traded in exchanges that are specified in accordance with the standard volume. The currency needs to be exchanged on a particular settlement date. The operation of the future contract is similar to that of the forward contract. The only difference is that the price of the contract is fixed at a future date. It is advantageous for undertaking a future contract but it is also recognizable that if the future price is less than that of the current price at the time of the preparation of the contract then the parties will lose money (Mt. Rushmore Securities LLC, 2014; Hagelin, 2003). Advantageous method for Medco Limited Two methods are suggested for Medco Ltd which will lead to a successful import plan from customer in France. Here, successful import signifies to the advantage that Medco Ltd will have from the deal. The two methods are evaluated in order to chose the best and the advantageous one for Medco Ltd. Method 1: Currently borrow 5000000 euro and convert the amount into loan which is denominated in sterling and then repay the euro loan after six months of time. Company borrowing 5,000,000 euro Conversion into sterling Calculation for conversion at the spot exchange rate: 1.2834 euro = 1 pound sterling Or, 1 euro = 1/ 1.2834 = 0.779 pound sterling Or, 5,00, 000 euro = 389590 pound sterling. If Medco Ltd borrows 5,00,000 euro and pay the France customer after 6 months then it has to pay an amount of 3,89,590 pound sterling. Method 2: Enter into a forward contract with the bank for selling 5, 00, 00 euro. Forward contract with the bank at a forward exchange rate of 1.2755 euro = 1 pound sterling Therefore, the calculation: 1.2755 euro = 1 pound sterling 1 euro = 0.784 pound sterling 5, 00, 000 euro = 392003 pound sterling If Medco employs a forward contract with the bank he has to pay 392003 pound sterling to get an amount of 5, 00, 000 euro. After evaluating both the methods it can be concluded that Method 1 is advantageous for Medco Ltd since it can pay a lesser amount than Method 2. Leading and lagging Leading is an indicator that signals the events in the future. In finance, the leading indicators the same signal is provided for the bonds or shares in which the investor is expecting to invest. The yields of the bonds are regarded as good leading indicator in stock market since the bond traders have the ability to predict and speculate the economic trends. Lagging indicator is the one which follows an event. The main significance of the lagging indicator has the ability to confirm the trend that is approaching or is about to approach. Unemployment can be referred as one of the lagging indicator. Invoicing in home currency Invoicing in home currency is the currency of a country that is used by a business to charge its customers. A purchaser agrees to pay the currency when he/she places an order or signs a purchase agreement. In both the cases the currency represents the method of pricing the order. The currency of the invoice and amount of purchase are determined at the time of the business. Any domestic transactions have currencies for invoicing, however a seller or a buyer employ the currency as the invoice currency is sometimes assumed. Netting When there is a consolidation of two or more transactions positions or payments are created in a single value, netting is applied. OT offshoots the value of multiple positions and it can be employed in order to examine the remuneration owned by the party in the multi party agreement. Currency futures A futures contract specifies price of a contract that is to be bought or sold at a future date by freezing the current price. This type of contract gives the benefit of hedging the foreign exchange rate risk for the investors. This type of contracts is traded in the exchange and it involves a lot of process that governs the contract from the beginning till the expiry date. Currency options Currency option is the contract that allows the holder to exercise the right but not the obligation. The right or the obligation is on the purchasing or selling of the currency at a specific exchange rate which is due at a specific period later. Currency options are regarded as the best way of mitigating the foreign exchange rate risk. The options can be further classified into call and put option. The call option is exercised for buying a foreign currency and put option is excersied for selling the same when the price falls to a great extent. Currency swaps Swap is referred as the exchange of financial instruments between two parties who are involved in a trade. The exchange of the financial instruments takes place at a specified time in the future date that is specified in the contract. The swaps are not traded over the counter and are delat in the banks. The swaps are used to hedge various types of risk that are related to the foreign currency exchange. The most important swaps are the currency swap and interest rate swaps that are frequently traded in the market. Conclusion As a financial manager of Medco Ltd, both the methods are examined by calculating the individual pound sterling and then it is compared. It is observed that the amount of pound sterling is higher in case of second method than the first one. Thus, after taking consideration the spot exchange rate and forward exchange rate, it can be concluded that the first method is advantageous for Medco Ltd. Reference List Allayannis, G. and Ofek, E., 2001. Exchange Rate Exposure, Hedging, and the Use of Foreign Currency Derivatives. Journal of International Money and Finance, 20, pp. 273-296. Berk, J., Green, R. And Naik, V., 2004. Valuation and Return Dynamics of New Ventures. Review of Financial Studies, 17, pp. 1-35. Bielecki, T. and Rutkowski, M., 2010. Credit risk: Modelling, valuation and hedging. New York: Springer. Billington, C., Johnson, B. And Triantis, A., 2003. A Real Options Perspective on Supply Chain Management in High Technology. Journal of Applied Corporate Finance, 15, pp. 32-43. Brown, G. and Toft, K., 2002. How Firms Should Hedge. Review of Financial Studies, 15, pp. 1283- 1324. Brown, G., 2001. Managing Foreign Exchange Risk with Derivatives. Journal of Financial Economics, 60, pp. 401-448. Chance, D. and Brooks, R., 2010. Introduction to derivatives and risk management. Connecticut: Cengage Learning. Economy Watch, 2014. Money Market Instruments: Treasury Bills and Certificate of Deposit. [online] Available at: < http://www.economywatch.com/market/money-market/money-market-instruments.html > [Accessed 21 April 2014]. Ernst & Young Global Limited, 2014. Market Risks. [online] Available at: < http://www.ey.com/GL/en/Services/Advisory/The-top-10-risks-and-opportunities-for-global-organizations---The-top-10-risks---6--Market-risks > [Accessed 21 April 2014]. Hagelin, N. and Pramborg, B., 2004. Hedging Foreign Exchange Exposure: Risk reduction from Transaction and Translation Hedging. Journal of International Financial Management and Accounting, 15(1). Hagelin, N., 2003. Why firms hedge with currency derivatives: an examination of transaction and translation exposure. Applied Financial Economics, 13, pp. 55- 69. Hartmann, P. and Issing, O., 2002. The international role of the euro. Journal of Policy Modeling, 24, pp. 315-345. Haushalter, G. D., 2000. Financing Policy, Basis Risk, and Corporate Hedging: Evidence from Oil and Gas Producers. Journal of Finance, 55, pp.107-152 . Lam, J., 2003. enterprise risk management: From Incentives to Controls. New Jersey: Wiley. Longin, F.M., 2001. Beyond the VaR. The Journal of Derivatives, pp. 36-48. Marrison, C., 2002. The fundamentals of risk measurement. New York: McGraw Hill. Mihailov, A., 2005. Exchange Rate Pass-Through on Prices in Macrodata: A Comparative Sensitivity Analysis, University of Essex Department of Economics Working Paper, pp. 568. Mt. Rushmore Securities LLC, 2014. Market Risk. [online] Available at: < http://www.hedgefund-index.com/d_marketrisk.asp > [Accessed 21 April 2014]. Muller, A. and Verschoor, W., 2006. European Foreign Exchange Risk Exposure. European Financial Management, 12(2), pp. 195-220. Papaioannou, M., 2001. Volatility and Misalignments of EMS and Other Currencies During 1974–1998 in European Monetary Union and Capital Markets. International Finance Review, 2, pp. 51–96. Papaioannou, M., and Gatzonas, E.K., 2002. Assessing Market and Credit Risk of Country Funds: A Value-at-Risk Analysis. International Finance Reviewed, 3, pp. 61–79. Siddiqi, N., 2002. Credit risk scorecards. New Jersey: John Wiley & Sons. Thomsett, M., 2010. Put option strategies for smarter trading. New Jersey: Pearson Education. Times Interest Limited, 2014. Definition of money market. [online] Available at: < http://economictimes.indiatimes.com/definition/money-market > [Accessed 21 April 2014]. Van Deventer, D.R., Imai, K. and Mesler, M., 2004. Advanced financial risk management:Tools and techniques for integrated credit risk and interest rate risk management. New Jersey: Wiley. Read More