Financial Management (Currency Risk Management) - Essay Example

Currency Risk Management The fluctuating exchange rate that can create certain uncertainties in some transaction of manufacturing based company andthe feasible solutions regarding minimising uncertainty are described distinctly in some separate discussion of each attribute. On the other hand the best possible means of hedging which is the potential cash flow of 12 million Euros are systematically described in the following paragraph. An exchange rate specifies the number of units of the given currency that can be purchased with one unit of another currency. Exchange rate appears in the financial section of newspaper each day. The number of US dollar required purchasing one unit of foreign currency, this is call direct quotation. Direct quotation has a dollar sign in their quotation. The number of foreign currency that can be purchase for one dollar, these are called indirect quotation. Indirect quotation often begins with the foreign currency equivalent to the dollar sign. Suppose a U.S tourist flies from New York to London then to Paris then to Munich and finally back to New York. When he arrived at London’s Heathrow Airport, he goes to the bank to check the foreign currency listing. The rate he observed for US dollar is $1; this means that $1 will cost him € 0.6814. Assume that he changed $2000 for €1362.8 and enjoys a week vacation in London, spending €500 while there are saving €862.8. At the end of the week, he travelled to Dover to catch the Hovercraft to Calais on the coast of France and realizes that he needs to exchange his €862.8 remaining Euro for Swiss francs. However what he sees on the board is the direct quotation between Euro and dollar and indirect quotation between franc and dollars. The exchange rate between any two currencies is called the cross rate. Cross rates are actually calculated on the basis of various currencies relative to the USD$. For example the cross rate between Euro and French franc is computed as follows: Therefore for every Euro he would receive 0.009923 Swiss franc and arrives at Czech Koruna, he again needs to determines a cross rate. This time between Swiss franc and Czech Koruna to find the cross rate he must divide the two dollar basis rate. Cross Rate= In this example we made three very strong and generally incorrect assumptions. First, we assume that our traveller had to calculate the entire cross rates. For retail transactions it is customary to display the cross rate directly instead of a series of dollar rate. Second, we assume that exchange rate remain constant over time. Actually exchange rates vary every day, often dramatically. We will have more to say about exchange rate in the next section. Finally we assume that there was no transaction costs involved in the exchanging currencies. In reality small exchange transaction such as those in our example usually involve fixed and/or sliding scale fees that can easily consume five or more percent of transaction amount. However credit card purchases minimize these fees. The tie-in with the dollar ensures that all currencies are related to one another in a constant manner. If the consistency did not exist, currencies traders could profit by under valued and overvalued currencies. This process known arbitrage work to bring about the equilibrium where in the same relationship describes earlier would exist. Currency traders are constantly operating in the market. Selling small inconsistencies in which they can profit. The traders existence enables the rest of us to assume that the currency matter are in equilibrium and that at any point in time cross rates are all indirectly consistent. As a final point you should recognize that the consolidation of European market has had a profound impact on European exchange rates. The exchange rate for the currencies of each of the participating countries is now fixed relative to the euro. Consequently the cross exchange rate between various participating currencies is also fixed. Note, however the value of the euro continues to fluctuate. Therefore if the Euro strengthens relative to the US dollars the value of the Czech Koruna and the French franc (and all the EMU countries currencies) will also relative to dollar. A fundamental difference between international business finance and domestic business finance is that international transaction and investments are conducted in more than one currency. Since different currencies are involved in rate of exchange must be established between them. The conversion relationship of the currencies is expressed in term of their price relationship. If foreign exchange rate did not fluctuate, it would make no difference whether firms dealt in dollars or another currencies. However since rates fluctuation risk if they have a net asset or net liability position in a foreign currency. When net claims exceed liability in a foreign currency, the firm is said to be in a “ long “ position because it will benefit if the value of foreign currency rises. When net liabilities exceed claim in regards to foreign currencies, the firm is said to be in a “short” position because it will gain if the foreign currency declines in value. The forward market is chiefly used as protection against unexpected changes in the foreign exchange value of a currency. Three basic relationships will be treated 1. Consistent foreign exchange rate. 2. The Fishers Effect. 3. The interest rate parity theorem. The following chart is given for the purpose of evaluating the currency rate, so that the fluctuating can be determined easily with the assigned proble. Table 1: Benchmark Currency Rates USD EUR JPY GBP CHF CAD AUD HKD HKD 7.7958 11.4325 0.0703 15.8188 6.9311 7.6961 6.8003   AUD 1.1464 1.6812 0.0103 2.3262 1.0192 1.1317   0.1471 CAD 1.013 1.4855 0.0091 2.0554 0.9006   0.8836 0.1299 CHF 1.1248 1.6494 0.0101 2.2823   1.1104 0.9811 0.1443 GBP 0.4928 0.7227 0.0044   0.4382 0.4865 0.4299 0.0632 JPY 110.947 162.7038   225.1281 98.6415 109.5286 96.7791 14.2316 EUR 0.6819   0.0061 1.3837 0.6063 0.6732 0.5948 0.0875 USD   1.4665 0.009 2.0292 0.8891 0.9872 0.8723 0.1283 Above is a chart designed to display the cross rates of eight major world currencies. Scan across the chart to find the rate of exchange between any two of these currencies. Source: http://www.bloomberg.com/markets/currencies/fxc.html Fluctuation in exchange rate occurs because of exchanges in supply of and demand for dollars pounds and other currencies. These supply and demand changes have two primary sources. First change in the demand for currencies depends on changes in import and export of goods and services. For example the US importer must buy British pounds to pay for US goods. Where as the British importer must buy US dollars to pay for US goods. If US exporter from Great Britain exceeded US exporter to Great Britain there would be greater demand for pound than for dollar and this would drive up the price of the pound relative to that of the dollar. The US dollar would say to be depreciating because a dollar would now be worth fewer pounds whereas the pound would be appreciating. In this example, the root cause of the change would have the deficit with Great Britain. Of course if US export to Great Britain were greater than US import from Great Britain would have a trade deficit with the United States. Changes in the demand for a currency and the resulting exchange rate fluctuations, also depend on capital movement. For example interest rate in Great Britain was higher than those in the United States. To make advantage of the high British interest rates, US banks, Corporation and sophisticated individuals would buy pound with dollars and then use those pound to purchase high yielding British securities. Before august 1971, exchange rate fluctuations were kept within a narrow 1 percent limit by regular intervention of the British government in the market. When the value of the pound was falling, the bank of England would step in and buy pounds to push up their price, offering gold or foreign currencies in exchange. Conversely, when the pound rate was too high, the bank of England would sell pounds the central banks of other countries operated similarly. The United States and other major trading nations currently operate under a system of floating exchange rate whereby currency prices are allowed to seek their own levels without much governmental intervention. However the central bank of each country does intervene to some extent buying and selling ifs currency to smooth out exchange rate fluctuations. Under the current floating rate system such intervention (central banking policy) can affect the situation only temporality because market forces will prevail in the long run. In the case of the euro, each of the EMU currencies is fixed relation to the euro still fluctuates. The II EMU countries have turned control of their monetary policy to the new European central bank. Beginning in 2002, the national currencies of the countries in the ENU will be phased out and only the Euro will exist. The inherent volatility of exchange rate under a floating system increased the uncertainty of the cash flows for Multinational Corporation. Because its cash flows are generated in many parts of the world. They are dominated in a many different currencies. Since exchange rate can be change the dollar equivalent value of the companies consolidated cash flow can be also fluctuate. For example, Toyota estimates that cash on Yen drop in the dollar reduces the company’s annual net income by about 10 billion Yen. This is exchanged rate risk and it is a major factor differentiating a global company from a purely domestic one. Concern about exchange rate risk has led to attempts to stabilize currency movements. Indeed, this concern was one of the motivating factors behinds the European consolidation. As we indicated above each participating relative to the Euro Countries with pegged exchange rates establish fixed exchange rates will some major currency and then the value of pegged currencies move tighter over time. Cash flow is inseparable parts of the business operation of the firms. The firm need cash to invest inventories, receivable and fixed assets and to make payment for operating expenses in order to maintain growth in sales and earnings (Pandey, 1996:767). It is possible that a firm may be making adequate profits, but may suffer from the shortage of cash as it growing needs may be consuming cash very fast. The “cash poor” condition of the firm can be corrected if its cash needs are planned in advance (Ivancevice & Skinner, 2003: 640). Cash flow management is the management of collection and disbursement procedures with following objectives. (i) collection from customers as quickly as possibly so that the funds will be available to firm as soon as possible (e.g., to earn interest). (ii) payment to vendors and other parties as slowly as possible so that the funds will remain available to the fund as long as possible (e.g., earning interest). There are other three procedures for managing cash flow (Pandey, p. 774). (a) Aaccelerating cash collection; (b) Decentralised collection; (c) Lock box system. The other alternative approaches available to the UK manufacturing company which wishes to minimise the uncertainty caused by fluctuating exchange rate on cash flow both payable and receivable in Euro are briefly described underneath: How can the exchange risk of a delayed payment be eliminated? One way is to cover the transaction in the forward exchange markets. If the goods are invoiced in the importers currency i.e., dollar, the exporter bears the risk. The exporter can eliminate this risk by selling a forward contract to deliver the importers currency at the time the sell is made. For example, Doug Plc. Manufacturing Company which operates within the UK and Mainland in Europe provides 90 days of credit and invoiced the goods at a price of €12 Million. It will be receiving €12 Million in 90 days (which it will then convert to Euro) suppose the Manufacturing Company sells a contract for delivery of €12 Million in 90 days, time in exchange for Euro. If the forward rate in 90 days futures contract is the same as the current spot rate (£0.7227). Under the forward contract, the exporter will be able to deliver the €12 Million and receive £8,670,217.0368 in 90 days time, regardless of what happened to the exchange rate in the mean time. If the forward rate is at a discount or premium, the amount of Euro to be received will be different from £8,670,217.0368. But in any case, the amount will be known at the time the forward contract 9is made. Indeed the price of the good is likely to depend in part on the length of time for which credit will be extended and the cost of covering the transaction in the forward exchange market. If the goods are invoiced the exporter currency (pound for example) then the exporters bears the exchange rate. The contract would be for the amount of Euro needed to obtain £8,670,217.0368 at the 90 days forward rate. An alternative method of eliminating exchange rate is through money market transactions. The delayed payment is an asset for the exporter (amount receivable) and a liability for the importer (account payable). The party exposed to the exchange rate can eliminate by creating an offsetting liability or asset in the foreign currency. Suppose that the goods in our example is involved at a price of €12000000 to be paid in three months. The UK exporter has a dollar receivable and is exposed to the exchange risk by obtaining a dollar loan (the present value of €12000000 discounted at the interest rate on the loan can be exchanged into pound immediately. At the end of the three months the exporter uses the €12000000 payment on the receivable to pay off the loan. On the other hand goods is invoiced at a price of £8,670,217.0368, the United States department store has a pound payable and is exposed to the exchange risk. The store can eliminate dollar into pound and investing in a UK securities which will pay £8,670,217.0368 pound in three months time. The proceeds from the security can be used to pay the silk mill when the £8,670,217.0368 payment is due in three months. An analysis of the cost of protection against exchange rate risk is complex and beyond the scope of the accounts. In many instances firms do not choose to protect against the risk because the cost are too great. The best means of hedging the potential future cash flow of €12 million are analysed as follows: Unlike futures and forward contracts, options offer the key benefit of hegding, which involves off setting or protecting against the risk of advice price movement. The key drawback to using options to hedge foreign currency exposures is its high cost relative to using more traditional futures or forward contracts. Assume that U.K. exporters just booked a sale dominating in Euro with payment due upon delivery in 3 months. The company could hedge the risk of depreciation in the pound by purchasing a Euro at a fixed price (say €16,604,729.1756). This option would become valuable if the Euro were to depreciate from today’s €16,604,729.1756 to, say €14,604,729.1756 before the exporter receives payment in Euro. On the other hand, if the Euro were to appreciate from €16,604,729.1756 to say €19,604,729.1756, the UK exporter would allow the put option to expire unexercised and words instead convert the Euro received in payment into pound at the new, higher pound price risk but would still be able to profit from favorable price movement. Eight members’ of the European community formed the European monetary system in 1979 and fixed their currency values In relation to each other, although they float “en bloc” against the rest of the world. This left as of 1981, the US dollars , Japanese yen, British pound, Swiss France and Canadian dollar as the principle united currencies. But none of the floating rates are freely determined by supply and demand condition and demand condition in foreign exchange markets. Central bank frequently intervenes unilaterally to prevent their currency from moving up or down to a degree that is considered excessive or undesirable. They also intervenes cooperation with foreign exchange markets. At times the interventions can be massive, but there is no longer an official commitment to keep the fluctuation within fixed limits. The compromise managed float differs from a free float system in two significant respects. First, under a free float exchange rate of a specific currency is presumed to settle at or arrange its equitable value, which is a value that reflects underlying economic factors and that would bring about a balance in that country external accounts. Second, under a free float a nation does not accumulate nor need international reserves because the exchange rate will always clear the market. By contrast, a country that is managing its currency needs reserves to sell for its own currency when moderating decline in the exchange rate and it accumulates reserves when selling its own currency to moderate an increase in the currency. The currencies of the centrally planned or socialist countries remain in convertible and outside the managed float system. International business transactions with these countries generally require better arrangement so that money payments are not needed or triangular deeds. Under a triangular agreement the party scheduled to receive payment in a not convertible currency sells these assets, usually at a discount to another party that needs the currency to buy goods of services from the particular country. In fact a substantial banking business has developed in Vienna, Austria for working out such triangular or multilateral deals. Bibliography Pandey, I. M. Financial Management, (7th ed., Vikas Publishing House:1996). Ivancevice, M. John. & Skinner, J. Steven. (2003). Business for the 21st Century. (Irwin: Boston: 2003). http://www.bloomberg.com/markets/currencies/fxc.html Read More