Foreign Currency Risk Management - Assignment Example

Foreign Currency Risk Management Q1. The importance of effective foreign exchange-rate risk management According to Johnson (2000), foreign exchange risks are real and can affect the cash flow and valuation of the company adversely. Transaction, translation and economic risks are caused by fluctuations in the foreign exchange rates. This is true when the domestic currency appreciates against the foreign currencies. Depreciation of a foreign currency corrodes the profitability of domestic goods and services. Consequently, the price of domestic goods and services increases in the export market and cause reduction in value of both profits and assets of the company. It also makes products in the export market less competitive. Managing exchange rate risk effectively is important for proper functioning of companies that trade beyond their borders. The importance of managing the foreign exchange risks includes the following. Mitigating foreign exchange risks, protecting profit margins, improve cash management, stabilize payments and revenues and reduce the difficulties that come with international payments. First, it improves profit margins of the company. Managing foreign exchange rate risks effectively mitigate losses resulting from exchange rate fluctuations. The losses caused by fluctuations in currency exchange rates are reflected in the profit and loss statements of the company. The losses occur under transactions where a company receives revenues from exporting products or services in foreign currencies or makes payments for the products or services bought from foreign country in foreign currencies. If the domestic currency appreciates, the amount of money received from products and services sold abroad reduces due to foreign currency exchange losses. For example, ASL Company UK company received USD200000 in exchange for transportation services from an importer in the United States of America. The current exchange rate is 1.53924 USD/ GBP. Therefore, the money after exchange is 129934 GPB. However in the near future, the exchange rate will be 1.56 USD/ GBP. If the British pound (GBP) appreciates against the dollar from 1.53924 USD/ GBP to 1.56 USD/ GBP. The new value of transport services will reduce by 1728.872 GPB from 129934 GPB to 128205.1 GBP. Consequently, ASL Company will record foreign exchange loss of 1728.872 GPB in their books. However, prudent exchange risk management will help the company avoid the losses by invoicing/billing the importer with British Pound currency or entering into a forward exchange rate contract with the importer (Rai 2010:133). Secondly, well managed foreign exchange risks reduce and may eliminate the difficulties associated with international payments. International trade involves a lot foreign currency calculation when one currency is being converted to the other. However, effective risk management enable company and its clients to know in advance the amount of currency they will have to pay their suppliers for the products or services supplied. Therefore, the seller does not have to calculate what is due to him or her. On the other hand, the buyer is saved the trouble of calculating what they owe the supplies, especially in an environment where exchange rates are highly volatile. Third, effectively managed foreign exchange rate risks improve the cash flow of the company. The revenue and payment streams of the company are stable when foreign exchange currency risks are managed effectively. It is evident that losses incurred due to changes in foreign exchange rates are significant. Therefore, if the company is adversely affected by the foreign exchange rate losses, the amount of money available for company’s operations may be reduced. Consequently, the company may find it difficult to meet its financial obligations as they fall due. However, effective foreign exchange risk management cushion the company against extreme fluctuations of the exchange rates and ensure that the value of cash flow is predictable and constant in value. Fourth, effective management of foreign currency exchange risks ensure that the company’s value is not adversely affected. For example, when domestic currency appreciates against the foreign currency used, the net assets of the company depreciate in value as a result of fluctuations in foreign exchange currencies. Q2. Appraisal of a relevant range of methods and techniques available to manage foreign exchange-rate risk Managing foreign currency exchange risks is mandatory for all companies that operate internationally. This is because of currency changes in making payments to foreign suppliers or receiving money from international customers. Internal and external foreign exchange currency risks hedging techniques are available for both international suppliers and foreign customers. Internal foreign exchange currency hedging techniques refers to hedging techniques that can be used by individual companies and do not operate via the foreign exchange market. The techniques are cheaper because transactions caused are avoided. Invoicing/billing in home currency, leading and lagging, indexation clauses, shifting the production base, establishing a re-invoicing centre and matching are internal hedging techniques (Collier 2009). On the other Hand, forwards, futures, options and swaps contracts are external hedging techniques. Internal hedging techniques First, invoicing/billing in home currency refers to asking the supplier to accept payment in company’s home currency or the customer to pay for the products or services in the company’s domestic currency. This enables the company to receive exact amount of revenue from foreign customers and pay exact amount of money to international suppliers. In this approach, the foreign currency exchange risk is transferred to the company’s suppliers and customers. This approach is appropriate to the company having high demand for its products or services globally. It is also good with the product that has very low price elasticity, low competition as well as less substitutes. Globalization and cut throat competition makes invoicing/billing in domestic currency difficult to implement. Second, leading and lagging is another technique that may enable a company to manage its foreign currency exchange effectively. According to Khan 2004: (35.9-35.10), leading approach refers to initiating strategies aimed at reducing the adverse effect of anticipated changes in domestic currency. For example, when the domestic currency is expected to appreciate, the domestic company lead to collect foreign currency from all its debtors and lead in paying the foreign creditors before the due date. On the other hand, lagging refers to delaying foreign payments and receipts when the domestic currency is expected to depreciate in the near future. This will ensure that the company gains from domestic currency depreciations and currency exchange losses are avoided by making payments and collecting debts before the domestic currency appreciates. Third, indexation clauses involves inserting clause to agreements or contracts stipulating an extend to which the buyer and the seller will bear the losses resulting from fluctuations of foreign currency rates in the international market. The proportion of risk between the buyer and the seller depends mainly on the bargaining power of either the seller or the buyer. If the exporter is stronger than the seller, then an agreement may be drawn and a clause stating that the importer bears all the foreign exchange losses may be inserted to the agreement. However, if both parties are equally strong, they importer and the exporter may bear 50 percent of the losses each. Fourth, shifting the production base refers to relocating the production unit of a company to a suitable location. A multinational corporation with foreign subsidiaries may decide to shift to a location where the market is readily available or where the raw materials are plenty. This is in order to avoid unnecessary foreign exchanges. For example, the company may establish a production unit in a country where there is adequate market share. This ensures that goods are bought by customers and company sells to customers on the domestic currency. Consequently, currency exchanges are minimized to strategic and very few occasions. This reduces exposures to fluctuating foreign exchange rates. Fifth, re-invoicing centre refers to a subsidiary of a foreign parent company that is identical to a clearing house in a banking system. It is located in a country that has less constrains on the convertibility and repatriation is not tightly controlled. The re-invoicing centre receives money in foreign currency and makes payments that are equivalent to in value to the national currency. Consequently, it helps to reduce the volume of foreign currency transfers as well as hedging costs. Through this approach exposures to foreign currency exchange rates fluctuations is avoided or limited. External hedging techniques First, according to Collier (2009 Pg152), forwards contracts refers to an agreement between two parties where on party agrees to supply a specified amount of currency at a stipulated exchange rate and time in the future. Forward contract is a long term position taken by an investor. Second, futures refer to standardized contract that obligates the buyer to purchase or a seller to sell a given amount of currency at a given exchange rate at a specified time in future. Both the seller and the buyer have unlimited risks. Futures are standardized, formally traded and requires that margins are settled daily. Third, an option refers to a contract that confers a right to the purchase or sale foreign currency at a specified time in future. The buyer has a right to purchase when the date is due or not. Fourth, foreign currency swaps refers to an agreement to pay specified value of a currency in exchange of a given values of currency from another party Chance & Brooks 2010 pg 407. Q3. Current corporate examples Most companies in the world have embraced the use of various foreign currency exchange hedging techniques. Most companies scrutinized make use of forward, call options and currency swaps contracts to hedge against the foreign currency exchange swaps. According to Royal Caribbean (2010), Royal Caribbean International was established in 1968 but was later changed to Royal Caribbean Cruises Ltd in July 1985 in Liberia. It is the world second largest cruise company operating over thirty eight ships. It cruises operates in over four hundred destination world wide. The company has subsidiaries in London and New York. Its presence in other countries makes its susceptible to the foreign currency exchange risks. Consequently, the company deals with at least three foreign currencies including the Euro, British Pound and the US Dollar. In particular, the company face foreign currency exchange rate risk because the proceeds from the construction and repair of the ships are under the Euros. To manage the fluctuations between the Japanese Yen and the Euro, the company uses the forward contract, currency swaps and fuel call options hedging techniques to manage the foreign exchange currency fluctuations. For example, Royal Caribbean Cruises Ltd foreign currency exchange risks originate mainly from fuel prices. The company uses fuel swap contracts and fuel call options to manage fuel related foreign currency exchange rate risks. The fuel swap agreements were about 10.2 percent, 11.1 percent and 8.9 percent of the total revenues in 2009, 2008 and 2007 respectively. Royal Caribbean Cruises Ltd had about $680,400,000 worth of fuel swaps as at the December 31, 2009. The company also had fuel call options to purchase fuel at $120 and $150 per barrel for about 2,800,000 barrels. According to the Royal Caribbean Cruises Ltd (2010 pg. 52) annual report, the company entered into forward contract worth $3,300,000 due on November 31, 2009. This is because it was estimated that the 9 percent of the total cost of all the ships would be exposed to the fluctuation of the Euro to Japanese Yen exchange rate. The Euro was estimated that it will strengthen by about 10 percent by the end of December 31, 2009. This may be possible if there would be no changes in the comparative interest rates. Furthermore, the company also entered into cross currency swap contracts worth €€ 300,000,000 million to hedge against Euribor debt valued at $ 389,100,000 as at December 31, 2009. This was to eliminate or reduce the anticipated foreign exchange currency losses to be caused by 10 percent strengthening of the Euro as at December 31, 2009. Finally, the company also denominates most of its investments in foreign subsidiaries in relatively stable functional currencies (euros). The company specifically assigned a debt of about €€ 346,800,000 (Pullmantur cruises) and €€ 142,900,000 (TUI Cruises) to hedge their net investments. This would enable the company to address partially the foreign exchange currencies risk exposures on their net investments on various ships in different countries. ASL Marine Holdings Limited was established in 1974 builds. The company repair ships as well as undertakes ship chartering to customers mainly in Europe and Asia. The company is susceptible to foreign currency exchange rate fluctuations that may adversely affect the financial performance of the company in the future. The company uses forward currency contracts as well as interest rate swaps to manage the volatility of the foreign currency exchange rates ASL Marine Holdings Limited (2009 pg 75). Forward currency and interest rates swaps contracts enabled the company to gain $1,092,000 in 2009 and incur a loss of $ 826,000 in 2008. Q 4 Justification and articulation of a recommended approach for effective foreign exchange-rate risk management, which could be adopted by a fast growing UK listed company There are many internal and external approaches for managing the adverse effects caused by foreign currency exchange fluctuations that can be recommended to fast growing UK listed company. The most appropriate internal approaches that would help the company to manage the foreign exchange risks include indexation clauses, establishment of re-invoicing centre and shifting the production base to appropriate locations. On the other hand, the external foreign exchange risk approaches appropriate to a fast growing firm include use of forward currency, currency swaps and call option contracts. Firstly, a first growing company can use indexations clauses to manage their foreign currency exchange risks. Indexation clauses provides an opportunity for both parties involve in the business to mutually agree on the proportion of losses each would carry in case foreign currency exchange losses are realized. However, this approach may be inappropriate where one party has unfair competitive bargaining power over the other. It would best suit the company if there is a 50 percent risk sharing or when the other party is willing to take bigger proportion of the foreign currency exchange loss that may occur. The advantage of this approach is that it avoids the transaction costs. Second, fast growing company may need to establish re- invoicing centre that would handle payments and receive all revenue in the domestic currencies. Re- invoicing centre coordinates all the foreign receipts and payments to ensure that payments are always made in the local or functional currencies. This limits foreign currency exchanges and its risk exposures. Though the method reduces exposures to foreign currency fluctuations and avoids transactional costs, it may not work in countries that have strict foreign exchange currency policies that limit external involvements by multinational companies. Third, shifting the production base is perhaps one of the most effective ways of managing the foreign currency exchange risks. According to Ogilvie (1999), foreign currency risks can be eliminated or avoided by establishing production units in foreign countries. This would ensure that the customers pay for the product in domestic currencies and the suppliers receives payments also in domestic currency. As a result, currency exchanges are limited or eliminated. The approach is enticing because it can eliminate the foreign currency risks and transaction costs but is only appropriate to establish subsidiaries in locations that have excellent environment for doing business. Fourth, the first growing company in the UK can use the forward currency contracts to hedge the foreign currency exchange risks. Forward contracts are more binding to the parties involved and are more likely to be enforced if one party fail to honour one part of the agreement. However, there are transactions costs involved and may reduce the profits of the company. Fifth, currency swaps contract could be more appropriate for the company. This could be more appropriate because it reduces the volumes of money that is exchanged and lower the foreign exchange risks. However, it may be extremely difficult to meet creditors and debtors that meet. Sixth, the company can apply call options contracts. This is more appropriate especially when managing fuel related foreign currency exchange risks because fuel is essential for companies operations and the its supply prices is dictated by the demand and supply forces. The approach is appropriate because cost of fuel has continued to rise and fluctuates more often. Call options contracts have inherent transaction costs. References ASL Marine (2009) STRENGTH IN FUNDAMENTALS Annual Report 2009. Available at: http://aslmarine.listedcompany.com/misc/ar2009.pdf [Accessed 24 August 2010] Chance, D. & Brooks, R., 2010 Introduction to Derivatives and Risk Management. 8th ed. New York: Cengage Learning. ClassNK (2007), ClassNK Annual Report 2007. Available at: http://www.classnk.or.jp/hp/publications/Publications_image/ClassNK_AR07-e.pdf [Accessed 24 August 2010] Collier, P., 2009. Fundamentals of risk management for accountants and managers: tools & techniques. Oxford: Butterworth-Heinemann. Harwood, S., 2006. Shipping finance, 3rd edn. London: Euromoney Institutional Investor PLC. Atrill & McLaney, 2008. Accounting and Finance for Non-Specialists. 6th ed. London Prentice Hall. McLaney, E., 2009. Business Finance, Theory and Practice. 8th ed. London: Prentice Hall. John Ogilvie, J., 1999. Treasury management: tools and techniques for countering financial risks. London: Kogan Page Publishers. Johnson, H., 2000. Global financial institutions and markets. Oxford: Wiley-Blackwell,. Khan, M., 2004. Financial Management: Text, Problems and Cases. 2nd ed. India: Tata McGraw-Hill. Rai, U., 2010. Export-Import and Logistics Management. 2nd ed. New Delhi. PHI Learning Pvt. Ltd. Royal Caribbean (2010). Royal Caribbean Cruises Ltd: 2009 Annual Report. Available at: http://phx.corporate-ir.net/External.File?item=UGFyZW50SUQ9Mzc2MTc5fENoaWxkSUQ9Mzg0NzI5fFR5cGU9MQ==&t=1[Accessed 24 August 2010] Read More