Financial Management - Case Study Example

I. Introduction In this age of globalisation, many companies conduct businesses in countries other than their own. With opportunities in new marketscome various types of risks—business risks, macro environmental risks, as well as foreign exchange risks (Pattichis et al. 2004). When a company conducts a business outside the country where it is based, the company is said to be exposed to some foreign exchange risks, where the fluctuations in the differences between the home countrys currency and the host countrys currency may result in adverse impacts in the companys income from international operations, as well as its balance sheet. This paper aims to explore the importance of managing foreign exchange risks as well as the methods of managing it that most multinational companies employ. Also, by analysing the practices of two companies when it comes to managing foreign exchange risks in line with good academic practices, certain recommendations with regard to risk management practices for a fast-growing listed company in the UK can be proposed in the process. II. Body A. Importance of currency risk management i. Accurate evaluation of performance of international subsidiaries In this age of globalisation, many companies conduct businesses in countries other than their own. With opportunities in new markets come various types of risks—business risks, macro environmental risks, as well as foreign exchange risks (Pattichis et al. 2004). When a company conducts a business outside the country where it is based, the company is said to be exposed to some foreign exchange risks, where the fluctuations in the differences between the home countrys currency and the host countrys currency may result in adverse impacts in the companys income from international operations, as well as its balance sheet. Companies need to protect themselves from these risks; a drastic change in the exchange rate between the home countrys currency and that of the host country can result in significant gains or losses (Nazarboland 2003). Aside from this, those which are otherwise very profitable international ventures of the company, due to fluctuations in the foreign exchange rate, may seem to be a losing business. For companies that have significant foreign direct investments across the globe, in order to assess more accurately the performance of their international subsidiaries, managing the foreign exchange risk is very important (Collier et al. 1990). Also, these differences will have a significant effect on the parent companys reported earnings as well. ii. Translation exposure When companies have investments outside their home countries, these investments are usually exposed to foreign exchange risk. There are three types of exposure to foreign exchange risk—translation exposure, transaction exposure and economic exposure. Translation exposure occurs because of the differences in the currency that the parent company uses, and the currency that the subsidiary in the other country uses (Nazarboland 2003). When reporting the earnings of subsidiaries, these figures have to be translated to the parent companys currency. Translation exposure occurs because of this. When drastic fluctuations in the foreign exchange rates occur, it can result in huge losses or gains (Nazarboland 2003). In order to avoid these extreme scenarios, it is therefore important to manage foreign exchange risk. iii. Transaction exposure When translation exposure to foreign exchange risk occurs because of the differences in the currency used in accounting for the operations, transaction exposure occurs when the firm engages in different transactions that require the use of another currency, and where the time frame before the transaction is completed may result in drastic changes in foreign exchange rates which could affect the respective budgets of the company (Collier & Davis 1985). Some of these transactions include receivables, payables, and fixed-prices sales and purchase contracts. When firms engage in these transactions, such as a purchase of material from another country with a different currency, these transactions normally complete after a certain period. By the time the period completes, the fluctuation in foreign exchange rates can have an impact on the contract price of the transaction (Collier & Davis 1985). If a firm budgets for a certain purchase order from another country under a certain currency, if the foreign exchange rates become unfavourable to its currency, it will pay more than it has budgeted for that certain transaction. These fluctuations can have huge effects on the firms profitability (Collier & Davis 1985). In order to avoid these instances, managing foreign exchange risk is crucial. iv. Economic exposure Economic exposure is a firms overall exposure to foreign exchange risk (Collier et al. 1990). Because the fluctuation in foreign exchange can impact the companys future cash flows, the companys economic value is affected. This type of exposure tends to reflect the economic effect of both transaction and translation exposures. Although economic exposure is hard to describe on operating terms, managing it is important because of its direct effect on the companys economic value (Collier et al. 1990). B. Common practices in the UK: range of methods to manage currency risk i. Managing translation exposure: cash management policies One of the ways of managing translation exposure is by employing some cash management policies that will minimise these risk that fluctuation in foreign exchange rates bring (Furlong 1966). Because cash is an asset that is most susceptible to fluctuations in foreign exchange rates, if the host countrys currency is more prone to devaluation, it is important to keep the subsidiarys cash at the very minimum level—just enough to support its working capital requirements (Teck 1974). All the excess cash can be transferred and wired to the parent company in order to avoid drastic fluctuations in the currency. This is more commonly done when the opportunity cost of holding idle cash is less than the expected gain from revaluation of the host countrys currency. If there is an anticipation of devaluation, apart from this, the excess cash can be used by lending it to other subsidiaries of the parent company (Teck 1974). Also, paying foreign-denominated debts will provide the company some benefits than holding the cash while expecting its value to be eroded. ii. Managing translation exposure: local borrowing Another way of managing translation exposure is by employing local borrowing for the subsidiaries of the parent company. Foreign exchange risks that arise from translation exposure is measured by the devaluation of the difference in the subsidiarys assets and its liabilities, hence, the subsidiarys net current assets (Furlong 1966). In order to protect the companys current assets, the subsidiary can match its local currency current assets with local currency borrowing (Belk & Glaum 1990). This way, if the subsidiarys local currency current assets decline in value, it will be matched by the decline in the value of the local currency debts (Furlong 1966). iii. Managing transaction exposure: foreign currency derivatives Transaction exposure is more commonly managed than translation exposure because of its more direct effect on profitability. Transactions such as receivables, payables, and fixed-price sales and purchase contracts, because of the time lag before these transactions are completed are exposed to the volatility of foreign exchange rates (Makar & Huffman 2008). Firms manage transaction exposure by using foreign currency derivatives (Williams 2004). In the United Kingdom, there are five types of derivative instruments that are used—the over the counter forwards, futures, over the counter options, exchange options, and swaps (Mallin et al. 2001). In a study by Mallin et al., OTC forwards is the most commonly used for hedging currency risks, followed by OTC options, and then swaps (2001). Various reasons have been gathered from UK companies with their use of derivatives (Demirag & De Fuentes 1999). These include “to hedge contractual commitments; to hedge expected transactions which are less than 12 months; to hedge expected transactions which are more than 12 months; to hedge foreign dividends; to hedge balance sheet; to hedge economic/competitive exposure; to reduce funding costs by arbitraging the markets; [and] to reduce funding costs by taking a view (Mallin et al. 2001, 71).” In using derivatives, certain objectives are kept in mind by these companies. The highest of these include hedging for account earnings, being followed by hedging for cash flows, then hedging for the market value of the firm, with hedging for balance sheet ratios as the objective given the least importance (Mallin et al. 2001, 72). C. Case in point: GlaxoSmithKline According to the companys 2008 annual report, GlaxoSmithKline or GSK utilizes different kinds of financial instruments in order to hedge various types of risks in its operations (GSK Annual Report 2008 156-157). For managing foreign exchange risks, the company uses derivatives in the form of forward foreign currency contracts and foreign currency swaps (GSK Annual Report 2008 156-157). These derivatives are used to swap borrowings and liquid assets into the required currencies that are needed to manage the foreign exchange risk that the firm faces (GSK Annual Report 2008 156-157). GSK manages its transaction exposure by matching local currency income with local currency costs (GSK Annual Report 2008 156-157). According to the company, exposure that arise on internal and external trade flows is not included in its hedging objectives. Instead, the internal trading transactions centrally matched, while inter-company payment terms are managed (GSK Annual Report 2008 156-157). According to the company, for the exceptional currency cash flows, the Corporate Treasury crafts a different hedging strategy instead (GSK Annual Report 2008 156-157). For subsidiary companies of GSK, short-term cash surpluses and borrowing requirements are managed with the use of forward contracts when it comes to future repayments, a hedge to the originating currency (GSK Annual Report 2008 156-157). Borrowings are also denominated in the currencies of the companys principal assets and cash flows, which include US dollars, Euros and Sterling. According to the company, only when it is required that certain borrowings are swapped into other currencies (GSK Annual Report 2008 156-157). When it comes of other investments of the company overseas, a hedge in the form of borrowings denominated in foreign currencies to match the level of its relevant assets is used (GSK Annual Report 2009 156-157). Aside from this, forward contracts are also used as hedge in major currencies. D. Case in point: Marks & Spencer Marks & Spencers operations are mainly exposed to transactional exposures when it comes to foreign currency risks due to the import of materials and goods from overseas suppliers, as well as the export of inventories from the UK to the companys subsidiaries outside the country (Marks & Spencer Plc Annual Report 104). In order to hedge these exposures, the company has used forward foreign exchange contracts. The currencies in which the company hedges against foreign exchange risk includes US dollar and Euro (Marks & Spencer Plc Annual Report 104). Inter-company loans are also hedged in the form of forward foreign exchange contracts (Marks & Spencer Plc Annual Report 104). For the companys translation exposures, Marks & Spencer uses foreign-denominated debt/local borrowings from the point of view of its subsidiaries in order to hedge its relevant assets in its overseas operations (Marks & Spencer Plc Annual Report 104). Marks & Spencer has also been applying the theories that are proposed by academics in order to manage foreign currency risk in its practices. III. Conclusion When companies have investments outside their home countries, these investments are usually exposed to foreign exchange risk. There are three types of exposure to foreign exchange risk—translation exposure, transaction exposure and economic exposure. Translation exposure occurs because of the differences in the amounts accounted for in terms of the currency that the subsidiary firm uses. Hence, when these amounts are translated into the currency being used by the parents company, the risk results in the difference due to foreign exchange rate when the amounts are translated. Transactional risks, or foreign exchange risk arising from transaction exposure have more direct effect on the profitability of the company. Because of the lag before transactions are completed, the fluctuation in the foreign exchange rate can have a significant effect on the contract price of the transaction. In order to minimise these risks, they have to be managed. Managing this risk will also depend on the type of exposure that the firm faces. The three methods in order to manage these risks—cash management policies, local borrowings or foreign-denominated debt, and foreign currency derivatives are also proven to be used by UK listed companies such as GSK and Marks & Spencer. IV. Recommendations The recommendation for a fast-growing firm listed in the UK will depend on the type of exposures that the firm faces in managing foreign exchange risk. For example, if the firm faces translation risk, it can either employ some cash management policies, or foreign-denominated debt—local borrowings, from the point of view of the subsidiary. As for transactional risk, derivatives in the form of futures, options and swaps are used instead. References Belk, P. A., and M. Glaum. 1990. "The Management of Foreign Exchange Risk in UK Multinationals: An Empirical Investigation." Accounting & Business Research 21, no. 81: 3-13. Business Source Premier, EBSCOhost (accessed October 18, 2009). Collier, P., and E.W. Davis. 1985. "The Management of Currency Transaction Risk by UK Multi-national Companies." Accounting & Business Research 15, no. 60: 327-334. Business Source Premier, EBSCOhost (accessed October 18, 2009). Collier, P., E. W. Davis, J. B. Coates, and S. G. Longden. 1990. 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