Hedging, remeasurement, and exchange rate - Essay Example

Hedging, Remeasurement, and Exchange Rates Effects of exchange rates to companies The exchange rate is a critical external factor that has significant effects on the profitability of a company. Exchange rates play a critical role in companies dealing in the importation and exportation business in the international market. For instance, the devaluation of the local currency will lead to cheaper exports, which benefits an exporting firm in such a country. On the other hand, as a currency appreciates in value, imports become more expensive, reducing the profitability and competitiveness of goods in such a market.

For example, in the first quarter of 2014, Coca-Cola Company lost about $247 million in its earning-stream after devaluation of the Venezuelan bolivar, which changed from 6.3 to 10.8 bolivars to one U.S dollar (McGrath, 2014). Similarly, the consumer product maker Procter & Gamble reported having incurred an extra charge of between $230 and $280 million in the third quarter of the year (McGrath, 2014). Therefore, changes in exchange rates impact the operating income of companies negatively, leading to lowered earnings per share, which could make the companies unattractive as profitability dwindles.

Besides the above companies, in 2011, McDonald’s sales in the European market had significantly increased, which could have translated into improved profitability. However, the weakening euro against the U.S dollar meant that the actual yearly profits for McDonald’s were significantly down (Associated Press, 2012). Considering that companies such as McDonalds have almost three-quarters of their revenues from international markets, the strengthening of the U.S dollar against other currencies would be a huge blow to the profitability of the company unless the company utilizes hedging as a risk mitigating measure against the currency volatility risk.

Exchange rate An exchange rate between two currencies is that rate of exchanging one currency for another. In other words, the rate indicates the value of the country’s currency compared to another. Of importance is the spot exchange rate, which refers to the prevailing exchange rate in the market. For instance, currently, 1 US dollar is currently exchanging for 0.92 Euros. On the other hand, 1US dollar is currently exchanging at 0.67 British pounds. Exchange rates have a clear indication of the strong of major currencies in the market and are a good indication of assessing the growth of other economies based on the standard measurement in trade, which is mostly the U.

S dollar or the Pound or Euro. Any gain in these currencies might indicate a good performance of the country’s currency. Reducing the negative effects of exchange rates Companies employ different strategies towards maintain the effects of foreign exchange rates in the global market. The major step in this process involves identifying and ranking the type of exposures and undertaking intense exposure management efforts (Orol, 165). These efforts involve determination of the extent of currency exposure by the time, monitoring the consolidated exposure of the company and studying the exchange rate moves in the market.

The next thing involves the company deciding the types of exposures to manage. The next step involves carefully choosing among a number of hedging techniques to managing the foreign currency risk. These may include the company taking no action, the company hedging everything at all times, trading of positions in an active manner and hedging such risks selectively (Daurat &McCormick, 2015). The Coca-Cola Company has elaborate policy towards mitigating the effects of foreign exchange fluctuations.

The company reduces its price margins in cases the costs incurred in purchasing materials internally failed to be compensated through local procuring. Again, the company decreases its sale value in high inflation and devaluation economies. Mostly, the company changes its income into other currencies other than the euro, the functional currency especially in the European market. On the other hand, companies such as Kellogg, a leading producer of cereals employ methods such as the use of derivative commodity and financial items that may include options, swaps and even futures to manage the exchange rate risks (Kellogg Company, 2009).

This involves taking some derivatives as fair value, cash flow or even net investment hedges in reducing any possible volatility when exchanging any foreign currency earned to the U.S dollars. Hedging and remeasurement Hedging is a strategy used by many companies to reduce risks through offsetting any possibility of loss incurred from fluctuations in the prices of currencies, stocks or commodities. In other words, hedging could be considered as a risk transferring strategy without the requirement to pay for any insurance policy.

Companies dealing in international trade where two different currencies are involved have to hedge to mitigate any possible losses that may occur from the volatility of exchange rates in the market. Coca-Cola Company, the leading beverage producer undertakes extensive hedging policies in mitigating such risks. The company has over the time hedged its packaging and the cost of ingredients to prevent high production costs that would result from increased cost of packaging materials and ingredients.

The company has managed to remain afloat despite the economic uncertainty that persists in the Euro market (Mcgrath, 2014) the Coca-Cola Company has also implemented extensive currency hedging policies. MacDonald’s is another company that critically employs hedging to mitigate the risks of foreign exchange volatility. The company has about 65% of its revenues from the international market (Orol, 164), making it susceptible to any volatility in exchange rates. As such, hedge funds are critical in protecting the company against these shocks considering the company has most of its revenues away from the U.S market. An example of hedging applied in MacDonald is conversion of outlets in some markets, franchising and increasing the company’s stock buyback plans (Orol, 164).

On the other hand, P &G has a strategy that does not include hedging, while still making about two-thirds of its annual sales from the international market. As such, the company faces a challenge where the currency effects retard the company’s revenue. P &G was particularly hurt by a slump in the Russian and Venezuela market caused by falling oil prices that left the company exposed to exchange rate volatility (McGrath, 2014). Kellog, on the other hand, applies financial and commodity instruments that include swaps, options or futures where possible to manage such risks (Kellogg Company, 2009).

Remeasurement is a process through which a subsidiary of a company prepares its financial statements similar to the ones that could be prepared when the subsidiary uses the functional currency for all its transactions. In other words, a subsidiary based in U.S could be forced to re-measure its accounts from Euros to U.S dollars, the functional currency in the jurisdiction of operation. In this case, the net plug has to be entered in the income statement considering the currency of transacting is the U.S dollars. Hedging instruments The two main hedging instruments are currency forwards and the cross currency swaps.

In forward contracts, the price in which the buying party can buy or sell the currency in question at a future date is fixed. This hedging approach does not require an upfront payment particularly when applied by banks and large corporations. However, the risk is that there is little flexibility in the contract signed and the binding obligations rewire that the buyer or the seller cannot default in case the agreed rate proves to be against them (Gimenez, Elices & Villani, 2014). On the other hand in case of currency swaps, a stream of revenues in one currency is exchanged for a stream of cash flows in another currency.

In this case, cross-currency swap has to include both the principal and any recurring interest to cover any currency risk in the loan transactions (Gimenez, Elices & Villani, 2014). For instance, Coca-Cola Company heavily relies on currency swaps to manage the risk related to volatility in foreign exchange. In this case, the company swaps its debts from dollars into peso debt, with the contracts treated as cash flow hedges. Therefore, the final amount, in this case, is calculated using the existing market prices on exchange rates and interest rates that would be used in terminating this contract at the end of the agreed period.

Work Cited Associated Press. Foreign Exchange Rates Squeeze McDonalds Profits. CBS News, July 23, 2012. http://www.cbsnews.com/news/foreign-exchange-rates-squeeze-mcdonalds-profits/ Daurat Cecile and McCormick Liz. Hedging Pays Off at Honeywell as Dollar Surge Punishes P&G. Bloomberg Business. Jan 27, 2015. http://www.bloomberg.com/news/articles/2015-01-27/hedging-pays-off-at-honeywell-as-dollar-surge-punishes-p-g-sales Accessed March 28, 2015 Gimenez, Eduard, Elices Alberto and Villani Giovanna.

A generalized pricing and hedging framework for multi-currency fixed income desks. June 2014. http://arxiv.org/pdf/1406.1811.pdf. Accessed March 28, 2015 Kellogg. Note 12: Derivative Instruments and Hedging Activities. 2009 http://www.annualreport2009.kelloggcompany.com/note12-10K.html Accessed March 28, 2015 Mcgrath, Maggie. Coca-Cola Takes $247 Million Hit From Venezuelan Currency Devaluation As Q1 Profit, Revenue Fall. Forbes. April 15, 2014. http://www.forbes.com/sites/maggiemcgrath/2014/04/15/coca-cola-takes-247-million-hit-from-venezuelan-currency-devaluation-as-q1-profit-revenue-fall/ Accessed March 28, 2015 McGrath, Maggie.

Procter & Gamble Removes The Batteries, Plans An Exit From Duracell. Forbes. Oct 14, 2014. http://www.forbes.com/sites/maggiemcgrath/2014/10/24/procter-gamble-removes-the-batteries-plans-an-exit-from-duracell/ Accessed March 28, 2015 Orol, Ronald D. Extreme Value Hedging: How Activist Hedge Fund Managers Are Taking on the World. Hoboken, NJ: Wiley & Sons, 2008.