Risk Analysis in Foreign Exchange Transactions - Example

Risk analysis in foreign exchange transactions Name: Lecturer: Course name: Course code: Date: Introduction Foreign exchange exposures are identified by the company so as to become aware of the impact of exchange rate on all operational aspects. Therefore, the objectives evaluated reflect management’s attitude and forbearance toward foreign exchange risk, which are candidly stated in the policy (Murphy, 2006). Management is obligated in ensuring that action applied in reducing economic exposure that will be justifiable on after-tax implications. Safeguarding objectives essentially state instances of hedging explored in qualitative or quantitative dimensions. Prohibitive cost appearing in dollars may be left open to analysis by appropriate personnel assigned in the policy. On the other hand, protection objectives involve situations where the company is not forced to hedge its position in its currency when the subjective conditions prevail. This happens because of the minimal risk of loss. Again, the cost of wrapping the position is prohibitive. It implies that covering the position is unavailable in the market. Objectives of risk analysis Basically, risk analysis objectives are categorized into two classes: Protection and financial objectives. Financial objectives are further subdivided into primary and secondary objectives: a) To consider all logical procedures to mitigate losses arising from consolidated earnings exposure. b) To ensure worldwide operations funded at the lowest after-tax cost. c) To ensure liquidity for global operations while maintaining access to domestic credit markets. d) To protect assets globally and maximize currency profits from all the operations overseas. e) To avoid hedging decisions made with no consideration to cost and efficiency. f) To rank exposure priorities so that the types of exposures faced as a consequence of fluctuating exchange rates occur with respect to their significance to financial, operating and senior management. g) To give priority to exposure management efforts h) To decide on the protective actions that can be employed by the company. i) To establish risk thresholds where each exposure type determines the level above which a foreign currency exposure demands protective action. This depends on the extent of fluctuation in corporate earnings emanating from severe exchange rate movements. It also influences the quantity in cash, the company intends to use so as to lower and protect from exposures. Techniques used in foreign exchange risk analysis Natural Hedging The purpose of natural hedging is to lower the difference in receipts and payments in a particular foreign currency. For instance, an Australian manufacturer exports to the Ukraine and to collect $5 million in the following year, it may expects to have payments of $500,000 in time, the forecasted company’s exposure becomes $4.5 million, if it does not hold any dollars in a bank account currently (Eaker, 2001). Reducing this exposure requires that the company decides on borrowing about $1 million and raise its procurement from Ukrainian suppliers by about $1.5 million. This lowers the exposure of the company to $2 million. On the other hand, the company may opt to build or purchase a production plant in the Ukraine to remove the greater part transaction exposure. Natural hedging is effective at lowering the company’s risk in foreign exchange; however, it can protract implementation of natural hedges like searching for new suppliers in another state. The solutions often consist of long-term commitments like borrowing in United States dollars. The constraint ought to reflect the company’s tolerance of risk in foreign exchange and other operational risks (Meese, & Rogoff, 2003). Risk thresholds can be expressed in various forms like currency values, currency percentage in earnings based on aggregate, quarterly, monthly, or annually. The company identifies such levels in relation to its business and size. This procedure ensures that the total hedging costs like personnel and treasury systems are consistent with the anticipated benefit from the management process exposure. It will inhibit effort being expended on insignificant exposures. Financial Hedging This method involves the purchase of foreign exchange hedging instruments ordinarily sold by banks and brokers in foreign exchange. The common ones are foreign exchange forward contracts, currency alternatives and swaps. Forward contracts enables an organization to set the exchange rate meant to buy or sell a particular future quantity of foreign currency appearing in a fixed date or period of time. These flexible instruments easily fit future transaction exposures to about one year. For instance, a company anticipating to have, in the following year, a foreign exchange exposure receiving $350,000 more than it can pay each month; can enter a sequence of forward contracts involving selling at a preset exchange rate (Neely, & Paul 2007). By agreeing into these forward contracts, the firm will have removed most of its transaction exposure. Forward contracts carry no purchase price and easy to use, making them immensely popular with all sized Australian companies. However, with a contractual commitment to either deliver or purchase from a foreign exchange broker or a bank a specific quantity of future foreign exchange. If not done, the forward contract can be terminated or protracted so as bear a price tag for the company. This explains action of banks and foreign exchange brokers in setting limits on the maximum amount hedged by a company applying forward contracts. Buying from a commercial bank requires that collateral is used to reduce the amount to be drawn under ones line of credit. If a company fails to manage foreign exchange risk, the exchange rate will remain unstable or trend in the unfavorable direction, though it does not occur regularly over time. Foreign exchange risk management infers forecasting in the future direction of the exchange rates. One can be able to protect a company from foreign exchange risk even with minimal knowledge of payments on the export sales (Dukes, 2008). An effective policy on foreign exchange risk may not essentially reduce all risk, but the center on safeguarding against risks unacceptable to the company. Exposure starts before the point of invoicing foreign customers. Forward contracts and swaps are used in combination with natural hedges so as to meet the objectives of foreign exchange management of most Australian companies. Currency options Managing foreign exchange risk is not time-consuming given that the currency options are other tools that can be used to reduce transactional exposure. Standard options provide an organization with the right, but not the responsibility, to trade in future foreign exchange at a prearranged exchange rate. Since these options are often employed by firms that bid on contracts, it does not force them to trade in foreign currency (Dufey, 2002). Acting will be deemed as contrary to forward contracts. Currency options enable companies to gain from positive movements in exchange rates, hence the reason why many types of currency options bear an upfront cost. For instance, a company has bought an option providing it the right to sell Australian dollars at an exchange rate of 1.4565USD/AUD eight months starting today. If, in the time, the exchange rate will be 1.2170USD/AUD, the company will not exercise its right to sell its United States dollars at 1.4565 USD/AUD. If, nonetheless, the exchange rate is 1.7875 USD/AUD, then the firm will exercise its right to sell United States dollars at a rate of 1.4565 USD/AUD. The sophistication perceived of currency options emanates from the fact that many company’s purchase price has reduced their use by Australian companies, in specific dismal or medium sized companies. Fundamental options are easy to understand since some of them are essentially referred to as participating forwards or Zero-Cost Collars have minimal purchase capacity though some require collateral. The principle is based on return for accepting some unfavorable change in the exchange rate implying a downside risk. The company will benefit out of favorable in exchange rate movement. Swaps Nevertheless, swaps, which constitute the concurrent trading in foreign currency, assists firms match foreign currency receipts and payments (Cornell, 2000). For instance, a company receiving a AUD255,000 payment now and assures it needs to make a payment of AUD$255,000 in 30 days, may enter a swap arrangement where it sells AUD250,000 now in exchange for US dollars. It commits to buying the same amount of Australian dollars in 30days at a pre-determined exchange rate. A company entering into a swap has easy access to the Australian dollar equal to $250,000 US dollars in 30 days to come. During this period, the foreign exchange exposure is considerably reduced. On the contrary, the company today will have a contractual commitment to buy Australian dollars in 30 days and will require making pay for these United States dollars at that time (Aliber, 2009). Conclusion Risk analysis objectives essentially state instances of hedging explored in qualitative or quantitative dimensions. Prohibitive cost appearing in dollars may be left open to analysis by an suitable personnel assigned in the policy. Protection objectives involve situations where the company is not forced to hedge its position in its currency when the subjective conditions prevail. This happens because of the minimal risk of loss. Again, the cost of wrapping the position is prohibitive. It implies that covering the position is unavailable in the market. Foreign exchange risk management influences forecasting in the future direction of exchange rates. One can be able to protect a company from foreign exchange risk even with minimal knowledge of payments on the export sales. An effective policy on foreign exchange risk may not essentially reduce all risk, but center on safeguarding against risks unacceptable to the company. References Aliber, R. Z. (2009). Exchange Risk and Corporate International Finance. New York: John Wiley and Sons.  Cornell, B. (2000). Inflation, Relative Price Changes, and Exchange Risk. Journal of Financial Management. pp. 30-44.  Dufey, G. (2002). Corporate Finance and Exchange Rate Variations, Financial Management. California Management Review. pp. 51-57.  Dukes, R. (2008). An Empirical Investigation of the Effects of Statement of Financial Accounting Standards No. 8 on Security Return Behavior. Stamford, Connecticut: Financial Accounting Standards Board.  Eaker, M. R. (2001). The Numerical Problem and Foreign Exchange Risk. Journal of Finance. pp. 419-427. Meese, R. A., & Rogoff, K. (2003). Empirical Exchange Rate Models of the Seventies: Do They Fit out of Sample? Journal of International Economics. pp. 3-24. Moorthy, V. (2005). Efficiency Aspects of Exchange Rate Response to News: Evidence from U.S. Employment Data. Journal of International Financial Markets, Institutions and Money. pp. 1-18. Murphy, J. J. (2006). Technical Analysis of the Futures Markets. New York: Institute of Finance, Prentice-Hall. Neely, C., & Paul W. (2007). Technical Analysis and Central Bank Intervention. Federal Reserve Bank of St. Louis Working Paper. Missouri. Read More