Managing Interest Rate and Exchange Rate Volatility - Essay Example

Interest rate risk measures the sensitivity of a firm’s cash flows, profit and firm value to interest rate fluctuations. In addition to the interest risk that a company might face as a result of changes in its cash flows, profit and firm value. Buckley (1996) identifies two other types of interest rate risk, which include basis risk and Gap risk. If interest rates are determined on a different basis for assets and liabilities then a firm having loans and debts will face basis risk. A company faces basis risk when the interest rates on its loans and debts are determined using different basis. (Buckley, 1996) Assume for example that Junor Plc issues a fixed rate bond to fund its financing needs and at the same time gives out a loan to another party at a floating interest rate. Her interest payments will therefore be fixed while interest receipts will be variable and will depend on prevailing rates. She will therefore be facing basis risk since her interest expenses and revenues will be determined on different basis. A company faces gap risk when it has both fixed rate liabilities and assets. When fixed rate liabilities exceed fixed rate assets then there is positive Gap, with a positive gap a rise in short term rates increases margins while declining rates decrease margins. On the contrary if fixed rate liabilities are less than fixed rate assets, then there is negative gap. In this case a rise in short-term rates decreases margins while a decrease increases margins.(Buckley, 1996). Changes in interest rates will therefore affect both the cash flows and expected cash flows of Junor Plc in that an increase in interest rates will mean higher cash outflows for the company. Changes in interest rates have also been the major determinants of business cycles or trade cycles in emerging markets such as Thailand in recent times. (Elekdag and Tchakarov, 2006). The figure above is an indication of how interest rates and business cycles are related in Thailand. High interest rates lead to low output whereas low interest rates lead to high output. Therefore Junor Plc is likely to face decreases in demand for its products during a period of the high interest rates and increases in demand during lower interest rates. ii) Measuring and Managing Foreign Exchange Risk. The degree to which a company is affected by currency fluctuations is referred to as foreign exchange exposure. (Shapiro, 2003). Foreign Exchange exposure can be divided into two main types-Accounting exposure and Economic exposure. Transaction reflects the firm’s risk to exchange rate movements regarding its balance sheet assets and liabilities... The terms of these transactions are established and settled at a given time period and their exposure can easily be measured by accounting systems (Mullem & Verschoor, 2005). The implicit or explicit contractual agreements have to be taken into account as well as when measuring the overall exchange rate exposure. (Mullem & Verschoor, 2005). The last component of a company’s exposure to currency fluctuations is called competitive or economic exposure. As exchange rate variations affect the relative prices of goods sold in different countries, they affect a firm’s competitive position and indirectly influence its economic environment and future growth possibilities (Mullem & Verschoor, 2005). Although a firm may hedge its foreign exchange contracts, limiting its transaction exposure, economic exposure is difficult to estimate and further, hedge. Economic exposure arises because future profits from operating as importer or exporter depend on exchange rates, and due to its nature, this type of exposure is difficult to mute. (Faff & Iorio 2001, Mullem & Verschoor). (Mullem & Verschoor, 2005). However, there is greater complexity between the relationship between exchange rate fluctuations and competitiveness and this leads to difficulty in correctly estimating economic exposure and hence hedging it efficiently (Mullem & Verschoor, 2005). Firms that do business abroad must be ready to account for changes in exchange rates that lead to variability in their cash flows. (Solt & Lee, 2001). Transaction exposure reflects the risk that exchange rates change between the time a transaction is recorded and the time actual receipt of cash or payment of cash is made. (Solt & Lee, 2001). Due to its short-term nature futures and forwards can be used to hedge transaction exposure and thereby eliminate its influence on the value of a firm. (Solt & Lee, 2001). Economic exposure on the other hand is the long-term effect of exchange rate changes on the future cash flows and thereby on stock returns. (Solt & Lee, 2001). The table below summarises the different types of exchange rate risk faced by firms: Comparison of translation, transaction and operating Exposure Translation exposure Operating exposure Fluctuations in income statements items and book values of balance sheet assets and liabilities that are caused by exchange rate fluctuations. Subsequent exchange rate gains and losses are determined by accounting rules and reflect nominal gains and losses only. The measurement of accounting exposure is retrospective that is it is applied to prior period accounts. Its only impact is on liability and assets that already exist. Movements in the amount of future operating cash flows occurring as a result of fluctuations in exchange rates. Subsequent exchange translation gains and losses are determined by changes in the firm’s future competitive position and are real. The measurement of operating exposure is prospective That is it is based on future periods unlike the retrospective measurement applied to translation exposure. The impacts of operating exposure are more serious than those of translation exposure as it affects revenues and costs associated with future sales. Taken from Shapiro (2003). Measuring Foreign Exchange Exposure Shapiro identifies four methods of measuring currency translation gains and losses or translation exposure. They include: the current/concurrent method, the monetary/nonmonetary method the temporal method and the current rate method. The current/non-current Method The current method translates all the foreign subsidiary’s assets and liabilities in the home country currency at the current exchange rate. Non-current assets and liabilities are translated at their historical exchange rates, that is, the rates prevailing at the period the assets were purchased or the period the liabilities were incurred. The translation in the income statement is done by applying the average exchange rate of the period except for those revenue and expense items associated with non current assets and liabilities. (Shapiro, 2003) Depreciation expenses are translated at the at the historical exchange rate of the corresponding asset in the balance sheet, thereby making it possible for different income statement items with same expiration dates to be translated at varying exchange rates (Shapiro, 2003). The Non-Monetary/Monetary Method Under this method, monetary assets and liabilities are separated from non-monetary assets and liabilities. Monetary assets include assets such as cash and accounts receivable whereas monetary liabilities include accounts payable and long-term debt. (Shapiro, 2003). Non-monetary items include trading stock, long-term investments and fixed assets such as land property, plant and equipment (PPE). After separating the assets and liabilities into monetary and non-monetary assets, the current rate is then applied to translate the monetary assets whereas the non-monetary assets are translated by applying the historical rates. The translation of income statement items is done by applying the average exchange rate except for revenue and expense items related to monetary assets and liabilities. The monetary items are translated using the current rate as earlier stated above. (Shapiro, 2003). The Temporal Method Under this method, the same procedures applied for the translation of the balance sheet and income statement items using the monetary/non-monetary method apply. However, the only difference is that inventory which is normally translated at the historical cost can be translated at the current rate if the inventory is shown on the balance sheet at the market values. (Shapiro, 2003). Current Rate Method The current rate method translates all income statement and balance sheet items using the current rate and if the firm’s foreign-currency-denominated assets exceed its foreign-currency-denominated liabilities, then depreciation in the home currency value will result in a loss while an appreciation in the home currency value will result in a gain. Managing transaction and Economic Exposure. Transaction exposure can be managed through well-structured hedging strategies. Hedging refers to the process of establishing an offsetting currency position so as to lock in a home currency value for the currency exposure thus, eliminating risk associated with movements in the currency. Locking in a home currency value means that the strategy is established in such a way that the value of the foreign currency in terms of the home currency to be received or paid at a future date is known with certainty. For example, if we assume that a US citizen is expecting to receive 10million pounds in 3months. The current exchange rate is 2 US dollars per pound. Therefore the current home currency (US Dollar) value of the future receivable will be 20million dollars. However, because the US citizen is unaware of what the exchange rate will be in three months, he is facing foreign exchange risk. If the pound goes below 2 US dollars per pound, he/she will make a foreign exchange loss equal to 10million times the amount of decrease. If the pound goes above 2US dollars per pound he will make a gain. Let’s assume that there is a forward contract on the exchange rate with a forward price of 1.9US dollars per pound. This US citizen can decide to sell his pound receivables forward at the price of 1.9US dollars per pound. By so doing he is locking in a minimum value of 19million US dollars (Home currency value) to be received in 3 months. Anything that happens to the exchange rate in three months will not affect his future receivable. Economic Exposure is difficult to manage. However, it can be managed by using Marketing management, pricing strategy and production management. (Shapiro, 2003). Managing Foreign Exchange Exposure. Junor Plc can mange its currency exposures through hedging. By so doing Junor Plc will take a position such as acquiring a cash flow or an asset or a contract that will rise or fall in value and offset the fall or rise in value of an existing position. (Moffet et al, 1995). Shapiro (2003, pp 329) states that hedging a particular currency refers to establishing an offsetting position so that whatever is lost or gained on the original currency exposure is exactly offset by a corresponding foreign exchange gain or loss on the currency hedge. Juno Plc can use currency futures, currency swaps, currency forwards and currency options to hedge its expected future exposure to exchange rates. Forward market Hedge If JunoPlc has to receive a future stream of cash flows in a foreign-currency, she can sell the stream of cash flows in a forward market. On the other hand if Juno Plc has liabilities to pay in foreign currency, then it can buy a forward contract to hedge against an appreciation of the foreign currency. That is a company that is long in a foreign currency will sell the foreign currency forward while a company that is short in a foreign currency will buy the currency forward. (Shapiro, 2003). For example, assume that Juno Plc has to receive 10million Thai Bhat in 3 months. The current spot exchange rate between the Thai Bhat and the pound is 100 Thai Bhat/pound. Also assume that the three-month forward rate is going to be 110Thai Bhat/pound and Juno Plc wants to hedge itself against further depreciation of the Thai Bhat. She can do this by selling forward its receivables and therefore lock in a minimum value of 110Thai/pound. Therefore she will be sure of receiving 10,000,000/110 = £90,909.09 in three months. If Juno Plc fails to establish this hedging strategy, then she will have a 10 million Thai Bhat asset whose value will fluctuate with the exchange rate. The forward contract creates an equal Thai Bhat liability, offset by an asset worth £90,909.09. The Thai Bhat asset and liability will cancel each other out and she will be left with an asset equal to £90,909.09. This is illustrated in the T-account below: Juno Plc T-Account Account receivable 10million Thai Bhat Forward contract payment 10million Thai Bhat Forward contract receipt £90,909.09. However, by establishing this hedging strategy, Juno Plc also foregoes any benefits that may accrue if on the other hand the Thai Bhat appreciates relative to the pound. Therefore downside risk is protected at the expense of upside potential. (Shapiro, 2003). Options Market Hedge Instead of establishing the hedge with a forward contract Juno Plc could hedge its 10million Thai Bhat receivable by buying a put option. By using this technique she will be able to speculate on the appreciation of the Thai Bhat as well, while limiting downside potential. A currency put option gives the holder the right but not the obligation to deliver a currency at a specified price known as the exercise price at the expiry date. (Moffett et al, 1995; Shapiro, 2003). Thus if we assume that instead of the forward contract, there is a put option on the Thai Bhat with exercise price 110Thai Bhat/pound, then Kaufman & Connelly Plc purchase this contract and lock in a minimum value of £90,909.09. In this case she protects herself against downside risk but upside potential is unlimited. Should the value of the Thai Bhat fall below 110Thai/pound at the expiry date, she will exercise her option to sell the Thai Bhat at 110Thai Bhat /Pound. On the other hand if the value of the Thai Bhat is above the exercise price of 110Thai Bhat /Pound at the expiration day, she will not exercise her option to sell the Thai Bhat at 110 Thai Bhat/Pound since she has the right but not the obligation. Instead, she will convert her 10million receivable at the current exchange rate. Thus downside risk is limited but upside potential is unlimited. If we assume the put option premium is 5Thai Bhat per Pound, then we can graph the profit and payoff to the hedged position as shown in the figure below: As can be seen downside risk is limited while upside potential is unlimited. The minimum loss that can be made will be the premium paid for the put option to establish the hedge. This type of hedge is analogous to establishing a protective put position in the case of hedging against stock price decreases. (Bodie et al, 2002). Swap Hedging. A currency swap contract is a contract between two counter-parties (Parties to the contract) where one counter-party exchanges a stream of cash flows (debt-service obligations) in one currency for a stream of cash flows in another currency. By so doing both counter-parties can achieve their desired currencies. (Shapiro, 2003). By entering a currency swap contract, Juno Plc can also manage its currency exposure. In this way Juno Plc which has borrowed, Thai Bhat at a fixed interest rate can transform its Thai Baht debt into a fully hedge pound liability by exchanging cash flows with another counter-party who desires to have a fully hedged Thai baht liability. The two loans comprising the currency swap have parallel interest and principal repayment schedules. At each payment date, Juno Plc will pay a fixed interest rate in pounds and receive a fixed rate in Thai Baht. The counter parties also exchange principal amounts the start and end of the swap arrangement. (Shapiro, 2003). In a nutshell, Juno Plc can engage in a currency swap by borrowing a foreign currency and converting its proceeds to pounds, while simultaneously arranging for the other counter-party to make requisite foreign currency payments at each period. In return for this foreign currency payment, Juno Plc pays an agreed-upon amount of pounds to the counter-party. Given the fixed nature of the periodic exchanges of currencies, the currency swap is equivalent to a package of forward contracts of currencies. (Shapiro, 2003). From the foregoing, Juno Plc can hedge its £200million expected pound liability, which will be borrowed in bath by swapping it with another counter-party who desires to hold liabilities in pounds which have been borrowed in the bath. Futures Hedging Currency futures contracts are contracts for specified quantities of a given currency, in which the exchange rate is fixed at the date of the contract. (Shapiro, 2003). For contracts traded on the International Monetary Market (IMM), the delivery date of the contract is determined by the board of directors of the IMM. Futures contracts can be used to eliminate currency risk. (Shapiro, 2003). Currency futures contracts are currently available for the Australian dollar, Brazilian real, British pound, Canadian dollar, euro, Japanese yen, Mexican Peso, New Zealand dollar, Russian ruble, South African rand, and Swiss Franc. (Shapiro, 2003; pp 267). Therefore no futures contracts presently exist for the Thai baht as can be seen from the list in the above paragraph. Thus Juno Plc will have problems hedging its thai baht by using futures contracts because they are not readily available. In addition, these contracts have limited delivery dates and are traded only in small quantities. Thus designing a hedging strategy using futures contracts can be very difficult. (Shapiro, 2003). Managing interest rate risk with Swap Contracts. Swap contracts can also be used to manage the interest rate risk. For example, Juno Plc can hedge against movements in its interest rates by swapping its floating rate interest payments for fixed rate interest payments. This will help to mitigate the effect of the changes in the LIBOR. By so doing it reduces the risk of paying too much if interest rates rise. However, it also forfeits any decrease in payments that it may achieve if interest rates fall. REFERENCES Bodie Z., Kane A., Markus A. J. (1999). Investments. Fifth International Edition. McGraw-Hill Irwin. Fraser S . P., Pantzalis C. (2004). Foreign exchange rate exposure of US multinational corporations: a firm-specific approach Journal of Multinational Financial Management Vol. 14, pp 261-281. Mullem A., Willem F.C., Verschoor (2005). Asymmetric foreign exchange risk exposure: Evidence from U.S. multinational firms. Journal of Empirical Finance. Vol. 13, pp 495-518. Economic Report of the President. Currency Markets and Exchange Rates downloaded from: http://www.whitehouse.gov/cea/ch7-erp07.pdf Faff R., Iorio A. (2001). A test of stability of exchange rate risk. Evidence from the Australian equities market. Global Finance Journal. Vol 12, Pp 179-203. Shapiro A.C.(2003). Multinational Financial Management. Seventh Edition Wiley and Sons Inc. Solt M. E., Lee W. Y. (2001). Economic exposure and hysteresis Evidence from German, Japanese, and U.S. stock returns Global Finance Journal. Pp 217-235 Read More