Foreign Currency Exposures of Medco - Essay Example

This report aims at two aspects regarding foreign currency exposures of Medco especially in relation to the invoice amount of €500,000 which is payable in 6 months. Among many different hedging strategies, two hedging strategies have been applied for the sake of minimizing the unfavorable fluctuations in the foreign currency exposures for Medco. These hedging strategies are as follows: a) Analysis of the two hedging methods Money Market Hedging Money market hedging strategy is mainly based upon channelizing the interest rate exposures of the currencies involved i.e. the home currency and the foreign currency (Shim, and Siegel, 2008). Under the existing scenario, home currency is Pounds whereas the foreign currency is Euros. This strategy has reciprocal way of dealing with the foreign currency risk in receipt and payment case. As the existing case is the receipt case, therefore, Borrow-then-invest strategy is followed. From the below-mentioned table, it can be viewed that at the first step an amount equivalent to the amount receivable in 6 months i.e. €500,000 are borrowed at an interest rate of 2% per annum equivalent to 1% semi-annually. The amount received from bank is immediately converted into amount in pounds at the spot rate of 1.2834 producing a sum of £385,733. This amount is then invested at a rate of 4% per annum equivalent to 2% semi-annually thus producing a sum £393,477. Forward Exchange Rate Hedging Forward exchange rate hedging is mainly based upon the mechanism of locking in a pre-determined future rate at today’s rate (Watson, and Head, 2009). In other rate, when the invoice amount will be remitted, the exchange rate will not be the spot rate after 6 months rather the exchange rate will be the rate determined today i.e. forward rate. In the existing scenario, the fixed forward for 6 months is 1.2755. After 6 months, when the amount is remitted, €500,000 will be converted at 1.2755 which is the forward rate determined 6 months earlier and will generate a sum of £392,003. In this way, whether the home currency is appreciated or depreciated against the foreign currency, Medco will take the forward rate as the fixed rate and either the loss or the gain will be the sole liability of the forward rate dealer. Money Market Hedging       Borrow €500,000 ÷ 1.01 = €495,050 Convert €495,050 ÷ 1.2834 = £385,733 Invest £385,733 x 1.02 = £393,447 Forward Rate Hedging € 500,000 x 1.2755 = £392,003 From the above two techniques, it is quite evident that the money market hedging strategy is going to yield in a higher amount i.e. £393,447 as compared to the forward rate based hedging strategy which will yield in £392,003. In this way, it can be noted that money market hedging based seems more effective given the interest rates and other factors remains constant. The Board of Directors of Medco is advised to follow money market based hedging strategy, as the same will earn a marginal benefit of £1,444 to the company. However, the arrangement of money market hedging will require substantial efforts of management in fulfilling the requirements of bank providing this money market hedging facility to Medco. b) International risks relating to changes in foreign exchange rate Transaction Risk Transaction risk is that amount of risk which is incurred during the period of entering into some type of contract or agreement, and when the contract is settled (Lal, and Shrivastva, 2009). Certainly, the purchase of almost every type of security involves some degree of changes during this period; the transaction risk is usually greater in those markets where change takes place rapidly. Transaction risk is highly associated with foreign exchange where changes in relative value of different currencies are linked with transaction (Fabozzi, Gupta, and Markowit, 2002). Both the parties are usually in hope that exchange rate between the currency of both parties i.e. buyer and seller, remain relatively same until the contract is completely settled. If there is stability among exchange rates, then both, buyer and seller reap what they expected to gain from the contract. However, if there is significant shift in exchange rate, then one party incurs losses while the other stands to gain substantially. Translation Risk Every company constructs balance sheet and income statement. Balance sheet includes the valuation of liabilities and assets of the firm (Berk, and DeMarzo, 2010). Amendments in the valuations of these assets and liabilities may result in gains and losses that have to be reported in income statement. If a capital gain or loss in incurred, nothing can be done about it. Changes in balance sheet due to changing valuation of asset and liabilities can be a problem for companies dealing in international operations. It is due to fluctuations in exchange rate as they can result in paper losses or gains to the parent company. Instabilities in exchange rate could result in substantial gains or losses and transmitting these changes into income statement of the company might result in distorted image of the company. Economic Risk In today’s dynamic market environment, heightened currency fluctuations, and increased globalization, exchange rate volatility has significant impact on the profitability and operations of the company (Jaffe, and Ross, 2004). It is not only large corporations and multinationals that are affected by the volatility in exchange rate, but small and medium sized firms are also influenced by these fluctuations. Economic risk is occurred by the effect of unpredicted currency fluctuations on the market value and cash flows of the company. In nature, it is long term. The impact of economic risk can be significant as unanticipated exchange rate can immensely impact the competitive position of the company even if the company does not sell or operate internationally. For instance, a Chinese furniture manufacturer who sells only in domestic market still has to compete with imports from Europe and America, which might get cheaper and therefore more competitive if dollar is strengthened. Methods for managing foreign exchange risk There are various types of methods that are used for mitigating international risk faced by the companies being involved in foreign currency exposures. These methods are known as hedging strategies. The following discussion takes a snap view of each of the hedging strategy covered in two broad segments of direct and direct methods of hedging. Direct Methods Direct methods of hedging involve the use of those hedging strategies that do not allow the chance of the company to be exposed at the foreign currency risk. The following discussion highlights those hedging strategies that can protect the organizations in facing such foreign currency risk exposures. Direct Invoicing in home currency from customer or supplier Under this method, the company does not allow such situation which arises due to foreign currency exposure such that in case of remittance, the company makes agreement with the customer to invoice the company in the home currency of the company i.e. transferring the foreign exchange currency risk to the customer (Khan, 2004). On the other hand, in case of payments, the company arranges with the suppliers that it will make the payment in the home/local currency of the company and then the supplier will have to convert the amount into their local currency thus transferring the risk to the other party (Watson, and Head, 2009). Netting Netting that technique of hedging which is used to make payments in foreign currency from the amounts received in foreign currency. For instance if, the company has to receive a remittance in the foreign currency, that remittance will be fully or partially be used for making payments that are due in foreign currency. In this way, the netting strategy eliminates the risk of foreign currency exposure. Matching Matching is that type of hedging strategy in which the foreign exchange loans are made by the company today when it expects to receive a certain remittance at some future time (Baker, and Martin, 2011). The company foresees the unfavorable risk, thus obtains a loan a better price today, and then repays that loan when it actually receives the payment. In this way, the foreign exchange amounts are matched. Leading and Lagging Leading refers to making early payments when it is expected that in future, the exchange rate will not be favorable to the company (Shefrin, and Statman, 2000). On the other hand, lagging refers to creating delays when there is anticipation that the future exchange rate will be beneficial to the company. However, leading and lagging strategies may not be fruitful for the company because the expectations of the future exchange rate are mainly based upon speculations (Kinney and Raiborn, 2008). In case, if the foreign exchange rate does not meet the expectations, it will hit the company even more severely. Indirect Methods Indirect methods of hedging involves the use of around five hedging strategies that specifically devised for the companies so that those companies can act pro-actively and mitigate the foreign currency exposure risk. Below-mentioned are the direct strategies for hedging FOREX risks: Money market hedging Money market hedging is that type of hedging in which in which the amount receivable (payable) is borrowed (invested) at the time of transaction in foreign currency (home currency). The foreign currency (home currency) is then converted in to home currency (foreign currency) and then invested (borrowed) for the time until the amount is remitted (paid). Once the time of remittance (payment) comes, the borrowed (invested) amount is paid (received) from the bank and transaction is settled down (Blume, 1970). However, interest rate risk lies with money market hedging and the arrangement of these borrowing and investing activities can be tricky at times. Forward rate hedging Forward rate hedging is that type of hedging strategy in which the future foreign currency rate is fixed today. No matter what is the spot rate on the given day, the amount will be converted at the rate fixed earlier. These are tailor-made contracts and are not traded to the other parties outside the contracts (Russell, 2001). There are few drawbacks of these hedging arrangements such as counterparty default risk lies such that this arrangement no longer stays valid if any of the party defaults. However, the biggest benefit of this strategy is that the risk is transferred to the other party such that gain or loss becomes irrelevant to the party who secures itself from foreign currency risks. Futures hedging Future hedging is also called as currency futures. The fundamental mechanism of this currency futures is the same that of forwards but they are different from forwards in 2 different ways. Firstly, future contracts are standardized contracts and they have a specific expiry at the end of each quarter. Secondly, these contracts are traded in the foreign currency markets. The biggest advantage of future contracts is that no counterparty default risk is present because the exchange always binds the contract on its own part (Eckbo, 2008). Swap hedging The hedging strategy deals in swapping the foreign currency risk exposures to other party facing the same risk. If the scenario is created for this type of hedging strategy, such strategy works when one party has to make payment in foreign currency of the other party and the other party has to make payment in the home currency of previous party (Vishwanath, 2007). First party swaps its loan with the second party such that it pays the loan of second party which is payable in home currency of first party followed by the payment made by the second party in the foreign currency of the first party. In this way, the loan amounts are swapped. However, the biggest difficulty of making this strategy works is the identification of the party who has the same need i.e. placed abroad and has to pay the amount in the local currency of the first party. Options hedging Option hedging is considered as the best type of hedging such that it saves the party when unfavorable foreign currency movements are going on. However, this strategy provides a benefit to the party at the time when the foreign currency fluctuations are in a favorable manner to the party; this is why this strategy is named as options (Williamson, 1996). There are two types of options i.e. put option and call option. Put option means a right to sell whereas call option means a right to buy. The most common disadvantage of this strategy is that an exclusive amount of premium has to be paid off for buying the relevant option. This amount of premium is obligatory regardless of whether the option is exercised or lapsed. 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