International Financial Management - Coursework Example

International Financial Management Question (a) Introduction Firms transacting in foreign currencies face the risk of adverse fluctuations in foreign exchange rates. To help mitigate the risk of foreign exchange exposures, firms have adopted hedging strategies with the sole aim of ensuring that their turnover and profitability is sustained and to strengthen their financial position. In the case Medco limited, management has two options that can be used to help avoid the risk of fluctuation. The first method is the option of entering into a money market hedge for a period of 6 months. This option gives the firm the option to borrow a loan of an equivalent amount it expects to receive after six months. On receipt of the receivable, the entity would use the receipt to repay the debt. The second method is the use of the forward contract. Forward contract will enable the company convert the foreign currency at a specified exchange rates on the future determinable date i.e. six months (Brigham & Houston 2004). Given that the firm has two options, the finance manager of the company should evaluate the best option that maximizes the firm’s performance and increases its income. We shall therefore evaluate the net income or loss that the company will have to meet in each case and prefer the method that has the highest net income. Analysis Method 1 Formula Amounts Borrow Euros     Amount of Euro borrowed A 500,000.00 Spot rate B 1.2834 Translation of the Euros to pounds at spot rate c=a/b 389,590.15       Interest expense on the borrowing D 5,000.00 Interest rateper annum E 2% Period in months F 6.00 Interest expense in Euros g=a*e*f/12 5,000.00 Interest expense in Euros L 3,920.03       Interest income on the investment in UK     Interest rate per annum H 4% Number of months I 6.00 Interest earned on investment j=c*h*i/12 7,791.80 Exchange rate after 6 months K 1.2755       Net income on method 1 in pounds m=j-l 3,871.77       Method 2     Forward contract     Forward rate of contract N 1.2755 Spot rate 0 1.2834 Gain on contract p=n-o (0.01)       Net gain in euros q=p*a 3,950.00       Gain on forward contract   3,950.00 Gain on money market hedge   3,871.77 Difference   78.23 As per this analysis, the finance manager should select the forward contract option since it has the highest gain. Forward contract will give a higher return by 78.23 euros. In determining the hedging method to select, finance managers need to carefully evaluate the various options and ensure that the option that maximizes on the firms value is chosen. Question (b) Currency risk is the risk facing a company on transactions that are conducted on currencies that are not the base currency of the company. Currency risk majorly face companies that are in the import or export business nor investors who make foreign investments. Changes in the exchange rates before the transaction dates may cause adverse and severe financial impacts that may result in enormous losses to the investors hence the need for every company to take hedging measures that are aimed at mitigating the magnitude of likely losses due to the movement in exchange rates. There are different types of foreign exchange exposures that companies must hedge against as discussed below. a) Transaction exposure Transaction exposure is the risk that arises from transactions that gives rise to contractual cash flows i.e. payables and receivables that are depended on unpredictable movement in exchange rates because the contract is in foreign denomination currencies. This risk arises from changes in the exchange rate between the date of initiation of a transaction and the date of its settlement. Firms have to convert foreign denominated cash flows to the local currency in order to realize the value of the foreign currencies. b) Translation exposure This is the exposure that arises from financial reporting process for companies that consolidate their foreign operations for financial reporting purposes. International reporting standards will require entities to consolidate their foreign subsidiaries hence will require that the foreign denominated assets and liabilities are translated to the domestic currency at the exchange rate prevailing on the reporting date (Grath 2008). This may have a significant impact on the reported earnings hence affect the stock prices. c) Economic risk This is the risk of fluctuation in the firms present value of future cash flows due to the movements in exchange rates. Economic risks affects future cash flows realized on the revenue and the costs incurred in the purchase of inputs and expenses. d) Contingent Exposure Another currency risks that face companies is the contingent exposure. When making foreign bids or negotiating foreign contracts or making foreign direct investments, firms may face a sudden transactional or exchange risk dependent on the outcome of the negotiation (Mobius 2005). Movement in exchange rates that are due to occurrence of unforeseen circumstances could result in currency losses for a company (Lucey 2012). Gaining an understanding of the types of exchange risks is a critical step in developing effective strategies that will shield a firm from the adverse impacts from exchange fluctuations. Depending on the type of currency risk that faces a company, firms’ can adopt different hedging strategies to help cushion from the adverse effects of changes in foreign exchange risks. The following ways can be used to hedge against transaction exposure: a) Forward contracts Firms may enter into forward contract which entails getting into an agreement to pay or receive a certain fixed amount of the foreign currency at a future determinable date by determining today the price at which it will purchase or sell the foreign currency. This contract will clearly specify the rates to be used in converting the foreign currency at a future date and the amount of the foreign currencies to be bought or sold must be of fixed amount. Firms can cushion themselves using forward contract since the rates to be used will be as per the contract and will not take into consideration any exchange rates movement during the life of the contract. b) Future contracts Future contracts are similar to forward contracts but they differ in several important ways. Future contracts are exchange traded and are thus standardized and limited to contract sizes, initial collateral, maturity dates and other characteristics (Wihlborg 2008). Unlike forward contracts, future contracts are traded on an exchange and have a liquid market which makes them easier to close out or unwind in cases where the contract timings does not match the exposure timings. Because future contracts are only available in specific sizes, maturities and currencies, it is impossible to get exact offsetting position to fully eliminate the exposure. c) Money market hedge This hedging strategy utilities the covered interest parity that the forward price must be equal to the current spot currency exchange rate times the ratio of the two currencies riskless returns (Berk & DeMarzo 2007). It can as well be viewed as a form of financing for the foreign currency transactions by entering into an accord to pay foreign currency at a particular specified date in the future by determining the present value of the foreign currency obligation at the currency lending rate and converting the amount of home currency given the current spot exchange rate. This is therefore a way of financing a foreign currency transactions. It converts the obligation into base currency payable and eliminates all exchange risks. Alternatively, the firm expecting to receive foreign currency in the future determinable time may determine the present value of the foreign expected cash flows at the foreign currency borrowing rate and enter obtain a loan of the same amount in the foreign currency which is then converted into home currency at the current spot exchange rate (Levinson 2006). This option is normally preferred by firms that are in need of short term debt financing and which also need to pay off some previously highly rated borrowing. d) Options Foreign currency options are contracts that gives the owner the right but not an obligation to trade in the base currency for foreign currency in a quantity specified at a specified price over a specified duration. Different types of options include puts and calls, American options, European options and future styles (Peirson 2002). What differentiates options from the three other hedging alternatives is the nonlinear payoff profile. Options as well allows removal of downside risk i.e. the risk of adverse change in the exchange rates without reducing the benefits in instances where the movement in rates is favorable (Southard 2011). Apart from the four strategies explained above, a firm can also take operational measures that are geared at avoiding or reducing the risk of exchange rate fluctuations. These strategies include: i) Risk shifting This is an obvious way of reducing the exposure risk by opting to invoice all transactions in the home currency of a firm to eliminate transaction exposure completely (Denis 2011). For example, a firm whose base currency is the Euro may decide to invoice all its customers in Euros and not any other currency e.g. USD irrespective of the location of the customer. The technique may face challenges for every firm since someone must bear the currency risk hence this will impact on the final contract price. ii) Leading and lagging This in an operating strategy that reduces the transaction gains and losses arising from timing of foreign cash flows. This method advocates for taking receivables when the currency of the nominal contract is depreciating and delaying paying your vendors when the currency of the nominal contract is appreciating. This currency management strategy thus requires delaying paying your obligation or receiving your receivables at times that the rates are favorable. iii) Currency risk sharing This is the method of currency management which enables both parties of a transaction share the risk of movement in exchange rates. The contract will thus be designed in a manner that any change in the currency rates after an agreed upon rate for the date for the transaction will be borne by the two parties (Fund 2012). This method does not eliminate or reduce currency exposure rather it splits the exposure to the parties. iv) Reinvoicing Centers A reinvoicing center is a subsidiary that manages all transaction exposure for intercompany trade in one location. The manufacturing entity will sell goods to the foreign distribution entities y selling to the center. The foreign distribution centers will then sell in their local markets at the local currencies and therefore reducing the exposure levels. Other operational strategies that may be adopted include market selection, pricing policies and promotional strategies. Market selection entails the determination of which market to transact with i.e. making sales in a market whose currencies are depreciating and moving away from markets where foreign currencies are appreciating (Rheinländer & Sexton 2011). This strategy will depend on other factors such as fixed costs and other structural requirements. Pricing policies on the other hand is where a firm determines the best price that optimizes the company’s returns by taking into considerations the likely movement in currency rates. Economic exposures may be mitigated by diversifying operations and sourcing of inputs from different locations (Calamos 2003). v) Swaps Finally, swaps can also be applied as a way of managing currency exposures. Swaps are financial instruments that gives the buyer the right to exchange one set of cash flow for another (Sharma 2010). The buyer may therefore agree to make periodic payments dependent on the financial price and receive periodic payments based on some other financial price. The most common swap is the interest rate swap which gives a firm fixed periodic payments of interest and at the same time receiving fixed interest rates on the payments over time (Nyström & Önskog 2010). The rates are determined in a way that the present value of the interest payments equals the present value of fixed receipts hence a zero net present value contract. Conclusion Firms which transact in currencies that are not necessity base currencies must encounter currency risks. This risk will pose a significant threat on the performance of the business and must therefore be mitigated by selecting carefully from the different hedging techniques the most viable way of eliminating likely losses. Finance professionals of the company must therefore weigh from the various options the best means of ensuring no major losses arise because of their foreign operations or from settlement of transactions with foreign customers and suppliers. References Berk, J. B., & DeMarzo, P. M. (2007). Corporate finance. Boston: Pearson Addison Wesley. Brigham, E. F., & Houston, J. F. (2004). Fundamentals of financial management (10th ed.). Mason, Ohio: Thomson/South-Western. Calamos, N. (2003). 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