A Model of International Company that Trades with Lubricants - Term Paper Example

 MULTINATIONAL FINANCIAL MANAGEMENT EXECUTIVE SUMMARY International trade is conducted by multinational corporations. Due to the fluctuations of the currency in different countries, multinational companies are faced by the risk management problems. There are several methods in which a company can manage its risks. In this paper, a model international company is created that trades with lubricants. Using this model, it is possible to investigate the effects of the different financial instruments availed in the exchange markets. The process of evaluation involves conducting a survey about the finacial instrument then applying it to the model multinational corporation. From the results obtained the best financial risk instrument is determined and recommended (Aswath, 2008). TABLE OF CONTENTS Topic page Executive summary 2 Introduction 4 Background study 4 Problem statement 5 Objectives 5 Justification of study 5 Scope and limitations 6 Research methodology 6 Nature of company 6 Process of manufacture 6 LUBRICOM Financial Risk Assessment 7 Crude oil 8 Exchange market 8 Forward contract 11 Future contract 12 Money market hedge 13 Options 13 Conclusions 14 Recommendations 15 References 16 INTRODUCTION Background information A multinational company is a company that conducts its trade between two or more countries. To conduct the business, a set of rules and regulation are laid down by international organizations and the countries where these organization conduct business. One common effect is the fluctuation of different currencies. The volatility affects the profitability of international trade. Also due to the currency volatility, there is a very high probability of the traders incurring loses on future sales. The formation of any multinational company is rigorous and most of the companies are run as joint ventures, mergers between two companies, private limited companies, public limited companies, licensing agreements among others. Corporate finance deals with the making of appropriate financial decision for the company. These decisions are made using analytical tools. These tools help in the maximization of corporate value and in the management of the firm’s financial risks. The decision made may be classified as short term or long term. Long term decisions involve capital investments decisions while short term decisions involve managing the working capital. Financial risk management, aids in evaluations of risks and developing strategies to manage these risks. In risk evaluation, the nature of the risk is determined by evaluating the impact of the exchange fluctuation on the corporation and the nature of the currency one is trading with. Risks can be managed/hedged using financial instruments. These instruments include interest rates, commodity prices, stock prices and foreign exchange rates. The most effective way to manage financial risk is by the use of derivatives that trade on the financial markets. These derivatives are traded using instruments such as futures contract, Forwards contracts, swaps and options. Problem statement Due to the nature of the international trade, companies are exposed to different financial risks. This is because of the ever fluctuating currency values. These risks can be hedged using financial instruments. The finance manager must carefully study these financial instruments and determine the best instrument to use; this again creates a problem in the decision making. The choice of instrument to use is not easy to make as over the counter transactions are not open and the availability of vital information about the behaviour of different commodities and currencies in the short and long run is not readily availed. Objectives of the study The main objective of this report is to study four major financial instruments used in the exchange market with a view of evaluating the best option to use. The specific objectives include; To develop a model multinational company conducting international trade with lubricants To subject the lubricants sold by this company to financial instruments market using futures contracts, forwards contracts and options Recommend the best instrument to use Justification for the study This study is important as most financial managers have difficulties in deciding the financial instruments to use. The managers are also faced with a problem in determining the actual value to hedge. This report therefore gives insight on different financial trading instrument and helps in selecting the best risk management instrument. Scope and limitations The scope of this paper is limited to the evaluation of one product being sold by a multinational company located in the USA and selling its products to the UK and Japan. The manufactured product is a lubricant made from light sweet crude oil. The product is hedged using futures contract, forwards contract and options. The trading period in the future is three months. RESEARCH METHODOLOGY Nature of company The company created was called LUBRICOM standing for lubricant company. The company was incorporated in the United States of America under the rules and laws governing the operation of private limited company. The major company objective was to develop a range of superior lubricants that can trade at low cost. The fundamental trading unit was the US dollar. Process of manufacture The process of manufacture involves the importation of crude oil, the type of crude oil is the light sweet crude oil, distilling this oil to get the fuels and remnant, using the heavy remnant to develop a lubricant called LUBRIOIL. This oil will be sold in the local market and exported to UK and Japan. To enhance the product, some natural plant oils will be used to replace 60% of the crude oil. Due to this, the product will have a competitive edge in terms of price and environmental friendliness to the current available lubricants. The product will also not contain lead. Some additives will be added to improve its lubricity and working life. This will make it more attractive importers. Formation and operation of company The company will be a joint venture. LUBRICOM will manufacture the lubricant while GASCOM will sell the petroleum obtained from the distillation process. The company will sell these products to companies located in United Kingdom and Japan. LUBRICOM sells its products to foreign distribution agents who sell these products to consumers in those countries. Due to the existing instability in the Foreign exchange and the competition from other companies, the distributors may prefer to buy the lubricants from LUBRICOM competitors. This decision is based on price and foreign exchange stability. LUBRICOM Financial Risk Assessment Based on the raw materials and the products manufactured. The company has two main risks that it can incur. These are; Effects in buying the raw materials This type of risk occur if the company purchases the raw materials, that is the crude oil at a high value, and this crude oil is to be used at a future date. If the prices of crude oil fall, The company will suffer losses as it cannot be able to cover production costs. If the crude oil used to manufacture one million packets is say 5 barrels and the cost of one barrel is $ 1000 , if these oil was bought at this price and the price falls at a future date say to 900 per barrel, the company will produce very expensive product as they bought the commodity at a higher price. Due to the prevailing market condition, they will be forced to reduce the price of their product hence incur loses up to the extent of not be able to cover production costs. Effects in selling finished products when the company buys inputs If the products, in this case the lubricants are produced for sell at a future date and due to price fluctuation the price of the product falls. The company might not be able to cover the cost of production. Exchange currency risks Because the company is engaged in international trade, there is the exchange of different currency, in this case the dollar against the British pound or the Japanese Yen. Fluctuations in these currency may lead to the firm incurring loses. In order for the company to maximize on profits, It is necessary evaluate these risks and manage them well. To do this, it is necessary to study the different instruments. It is also necessary to conduct a market survey about the product being sold and the raw materials used to manufacture the lubricant. It is also necessary to determine the exchange market, the actual monetary flows and expectations of changes in monetary flows. Crude oil Crude oil is one of the products that affect the global trade. The price of most commodities is directly affected by crude oil prices. Lubricants are made from crude oil. Crude oil in the exchange market falls into two main categories, there is the light sweet and the heavy sour crude oil. The classification is based on the sulphur content of the oil and the density. Those with low density and less sulfur are referred to as light sweet crude oil, while those with high density and high sulphur are heavy sour crude. Light is fast moving and its demand is higher. The exchange market The exchange market to be used by the firm is the New York Exchange Market (NYMEX). This exchange market deals with the trading crude oil futures, forwards and options. In this exchange the daily price index is computed by comparing the Dubai and the Omani oil. The oil type is the light sweet crude oil. The index is given by Daily index = (average for Oman + average for Dubai)/2 This index is used as the reference point for the other world exchange market. Hence it is the best market to trade in. The crude oil commodity charts obtained from this exchange market are as shown below. Commodity chart for crude oil; adopted from TSC commodity charts. 2009. Crude Oil Weekly Price Chart. [Online]. Available at: http://futures.tradingcharts.com/chart/CO/89 Accessed 30 June 2009. From the chart the fast moving average is represented by plot 1, while plot 2 is the slow moving average. In the long run the plot 2 is the fast moving average while plot 3 is the slow moving average. In the short run the market for crude oil is bullish. This is because the fast moving average is above the slow moving average. The market in the long run is extremely bullish and all indicators show that the prices are going to rise. This is due to the fact that the fast moving average is above the slow moving average. The volatility of the market for the crude oil is declining meaning that the prices will not fluctuate much. This volatility is based on 9 bar moving average. The market for the crude oil is overbought as shown by Momentum (18.83) which is above zero and the rate of change is 37.41. The data collected by Bloomberg is as shown in the diagram below Price Change % change Time NYMEX Crude future 69.16 -1.07 -1.52 06/30/2009 Adopted from: Bloomberg.L.P 2009. Energy Prices. NYMEX crude future. [Online].Available at http://www.bloomberg.com/markets/commodities/energyprices.html Accessed 30 June 2009. From the commodity charts and the data, it can be seen that by investing in the crude oil market and purchasing the futures. There is a probability of obtaining returns from them. This is because all pointers indicate that the prices will continue to rise. The company can take the ‘short’ position. Forwards contract Forward contracts are agreement for the delivery of a given quantity of goods at a specified future date. The price agreed is paid when the product is delivered. During the formation of the forward contract, the price is given for a specific time in the future. The buyer of the goods holds “the long position”, while the seller of the goods holds “short position”. On receiving the goods the buyer pays the agreed forward price. This method can be adapted by the LUBRICOM to prevent the risk of crude oil price falls in the future. The company takes the long position while the holder of the commodity takes the short position. Should the price increase, the company will not suffer adverse effects of the price increase. However, if the price falls, which is unlikely, the company loses. The company can take a short position when selling its products. The overseas company which purchases the lubricants agrees that a given quantity of goods be supplied by LUBRICOM at a given forward price. The purchasing company takes the short position. If the product price happens to fall, the company is not affected as the future price is calculated to ensure the company does not suffer any loss. Futures contracts This is an agreement by the buyer and seller to deliver a given quantity of goods at a specified amount of money payable in the future. Futures are similar to forwards except that futures are marked to the market. This means that their evaluation is done on daily basis. The evaluation of futures thus takes into account the daily fluctuations in prices of the commodity. The average length of time for maturity of a future contract is about 3 months. Foreign currency can also be traded by the company. This involves exchange traded as future transactions which are of standard contract sizes. An example is trading $ 2000 for next 3 months at an agreed rate. Due to the evaluation of futures on day to day basis, they are more suitable than forwards contracts and are more preferred. LUBRICOM can take two positions. They can take the long position when dealing with the crude oil raw materials and take the short position when dealing with lubricant products. Money market hedge Money market hedge is the leading and borrowing in multiple currencies. This helps in the elimination of currency risk. It involves the use of foreign currencies to lock in the home currency value of the foreign currency being transacted. Options In the foreign exchange option, the owner has right to exchange money from one currency to another currency at an agreed exchange rate at a given date. The foreign options market is the largest and the most liquid market for trading options. Factors that affect the currency value in the country where the product will be traded. For the international traded to be carried out in the foreign currencies. The foreign exchange value plays a major role. The factors that mostly influence the currency value are; The difference between the imports and exports For countries that conduct international trade, the difference between the exports and imports greatly influence the currency value against the major world currencies. An extensive study must be conducted to determine the fluctuation rate of the currency against the dollar. Political systems Countries with poor political systems are faced with possibility of sanctions, when sanctions are imposed, the value of the currency drops and this affects the international trade in that country. Technological changes Technological changes leads to improvement in exchange and transactions; this enhances trade and strengthens the currency. Changes in international and national economic policy policies promoting international trade boost the country currency value while polices barring international trade diminish the value of currency and affects international trade. Changes in the country economic policy may hider international trade thereby affecting the currency value in that country. Conclusion Of all the evaluated instruments, the use of future contracts gives the best results. This is because the values are evaluated on day to day basis for contracts labeled ‘marked to market’. The daily fluctuations in price results to a price that is slightly higher or lowers than the forward market price. Furthermore, most traders prefer the use of futures. The uses of futures apply to both the traded commodities and to the foreign exchange hedging. This means that if the company uses this type of financial instrument, most of its potential risks are covered. Based on the nature of the product being traded, futures yield the best results. Recommendations Based on the study, future contract are recommended for use by multinational companies to hedge financial risks due to fluctuation of prices. The company should take both the short and long positions because the company deals with imported raw materials whose prices fluctuate, and also sell products whose prices also fluctuate. References Bloomberg.L.P 2009. Energy Prices. NYMEX crude future. [Online].Available at http://www.bloomberg.com/markets/commodities/energyprices.html Accessed 30 June 2009. TSC commodity charts. 2009. Crude Oil Weekly Price Chart. [Online]. Available at: http://futures.tradingcharts.com/chart/CO/89 Accessed 30 June 2009. Aswath D. 2008.Corporate Finance: First Principles. New York: New York University's Stern School of Business. Read More