Foreign Exchange-Rate Risk Management - Case Study Example

Foreign Exchange-Rate Risk Management for UK Listed Companies Introduction The need for foreign exchange has arisen from the requirements of companies and individuals for foreign currencies when they transact business abroad. Multinational companies and international traders must quote their prices in a vehicle currency such as the U.S. dollar when they export or request quotations in order to purchase equipment and raw materials from another country. In all these, the variability of the exchange rates -- the rate at which one countrys currency can be traded for another countrys currency -- can pose a problem for the party concerned when the changes are adverse. This paper will explore the different ways by which business entities can deal with the exchange rate variations to protect the value of their assets and profits against unpredictable risks. The use of hedging strategies In recent years derivatives have been developed in order to provide some sort of insurance in the face of uncertainty caused by the changes in the foreign exchange rates. Derivative, or hybrid, investments, unlike stocks and bonds, do not represent ownership of shares, such as stocks, or a promise of loan repayment, such as bonds, and are once or twice removed from a real product. For example, a crude oil futures contract is a bet on which way crude oil prices will move, but what happens to the product itself is of no interest to the investor When an individual converts one currency into another in an actual exchange, the risk inherent in this activity is called a transaction exposure. Multinationals often face translation exposure, or the risk that arises from the need to re-state one currency in terms of another currency for accounting purposes. The risk arises because exchange risk volatility can impact the value of net assets and profits at the time of their translation. (See Kolb 1997). Financial derivatives are based on an underlying instrument such interest as debt instruments or foreign currencies. Most predominant among these derivatives are forward contracts, but futures contracts, option contracts, and swap contracts are also used by businesses as means of hedging. Hedging is distinguished from speculation in that the hedger wants to shift risk to others while the speculator hopes to make profits for the risk he is taking. a. Futures contracts A futures contract is an agreement that one party will accept delivery of a particular asset – either real or financial – on some date in the future at a price determined today. If one is intending to buy an asset in the future, one could buy a futures contract (a long position) today to fix the amount one will pay and avoid the possibility of later paying more because of a price increase. Also, if one wishes to sell an asset in the future, one could sell a futures contract (a short position) at a known future price in order to fix the price, thus avoiding the possibility of a price decreasing between now and the date of the actual purchase. Futures have expiry dates of less than a year, although certain financial futures can can last up to 5 years. A futures market, where these instruments are traded, is an organised market in which standardised contracts are bought and sold for future delivery, as distinguished from the cash or spot market where delivery of the item traded is immediate. Futures markets have been created since the early 1970s. Todays electronic trading enables corporate executives and businessman to trade in these exchanges and other exchanges in major cities worldwide at any time of the day. 1) Margins and marking to market The exchanges provide a secondary market for the trading of contracts before maturity and therefore guarantee liquidity. Nearly all financial contracts are reversed before their maturity or delivery dates by buying or selling an equal number of offsetting contracts. Most futures markets prescribe “marking to market” which means the daily marking of the futures contract to its current price, and settlement of any gains or losses to reduce the risk of default at maturity. In this way, the exchanges and clearinghouses protect themselves by requiring payment of small margins (a percentage of the contract value) to be maintained throughout the life of the contract. b. The options contract An option contract gives the holder the right to buy or sell a specific investment or currency at a set price within a preset time period. If the underlying security or futures markets move in the anticipated direction, the investor can exercise an option and realise a profit. Options are traded at a specific strike price or exercise price, the amount one pays or receives if the trade takes place. The price of the option rises or falls depending on the performance of the underlying investment on which it is based. Those who buy call options bet that that the price of the underlying instrument will go up. Those who buy put options take the opposite view that the price of the security will fall. With either type, the potential loss is limited to the premium . The option writer earns the premium. If the underlying security does not move significantly in the investors expected direction, he may just let it expire since he would thus gain nothing, and may even lose, if he exercises his option. Option sellers, however, have to go through with a trade if the option is exercised and assume speculative risk. c. The forward contract If one buys a forward contract, normally with a bank, there is no need to make any payment, except possibly a good-faith check, until delivery. The forward contract, used often with regard to financial securities and foreign currencies, are generally tailored to the specific needs of participants and are traded over the counter. It locks-in the price, which is computed as the current spot price plus the cost of borrowing, storage, and any applicable depreciation for the period until delivery. One gains certainty by eliminating the risk of an unfavorable spot price in the future. Any asset can be traded for future delivery between two parties on whatever terms they can agree on. In contrast to a futures contract, the parties to a forward contract are exposed to the risk that the other party to the contract will fail to perform (counterparty risk). Inasmuch as the positions of the parties are not marked to market, there are no interim cash flows associated with the forward contract as one would find in futures. d. Swaps Two parties can agree to swap something - generally obligations to make specified payments, in terms of either interest payments or currencies. In the case of a currency swap, both parties have exposures in different currencies that they want to insure against. The exchange rate risk is eliminated if both swap payment obligations. Today swaps are transacted between companies and banks instead of the banks acting as intermediaries. A currency swap is a simultaneous purchase and sale of a certain amount of foreign exchange for two different value dates. A common kind of swap is that of spot against forward (See Hill 2004). Interest-rate swaps arise when two firms agree to exchange interest rates on a notional amount. A cross-currency interest rate swap uses two different currencies. Multinationals such as British American Tobacco use interest rate swaps to hedge their exposure to interest-rate volatility abroad. A historical example of hedging: Merck Lewent and Kearney (1993) present a textbook example of how multinational deals with its foreign exchange risks. With currency exposure in 40 countries, Merck had to design a model that would protect its net assets and revenues against adverse fluctuations in foreign currencies. At first the company wanted to redeploy its resources to shift dollar costs to some countries, but it later decided that this approach was not cost effective Next, company executives tackled the issue of when or under what circumstances to hedge. Where the companys risk profile can accept the volatility (e.g., the loss in earnings and cash flows in one year is recouped in the next year or so), hedging could be unnecessary. The companys share prices, they found out, were also not significantly affected by foreign exchange gains and losses, so that it was concluded that such gains and losses are a "second-order factor" in determining the share prices of a pharmaceutical company such as Merck. It was not clear how shareholder value was affected by the fluctuations. The focus therefore shifted to actions that would maximise shareholder value via an appropriate hedging strategy. After considering various hedging alternatives and techniques, Merck decided on currency options as its risk management tool. It “accommodated the companys risk preferences." While forwards, futures, and swaps fixed the value of the hedge amount regardless of currency movements, currency options enabled the firm to retain the opportunity to benefit from natural (unhedged) positions. Because the exchange rate movements could move in either direction, the possibility of the dollar weakening would provide insurance because the downside risk in an options contract is limited. The Merck case is a good example of how a firm evolves a hedging policy to achieve its long-term strategy goals.. Two UK multinationals hedging strategies Vodafone and British American Tobacco Corporation are examples of UK-based companies with currency exposures and which have developed their own hedging strategies to protect their net assets and profits from currency fluctuations. a. Vodafone. Vodafone’s Annual Report 2008 mentions that the use of derivatives is governed by policies based on the Groups risk management strategy. The policy is to use derivative instruments -- primarily interest-rate swaps -- to convert part of the fixed rate debt to floating rates due to interest-rate risk arising from capital market borrowings. Certain derivatives are used as instruments for "fair value hedges" of recognised assets and liabilities. The Group hedges its foreign exchange risks on transactions denominated in other currencies above certain minimum levels. Foreign currency transaction exposure is maintained at the lower of euro5 million per month or euro15 million per currency per semester. This provides a partial hedge when translating future cash flows. The weakening of the pound sterling served to increase cash and cash equivalents in the firms financial statements. b. Brit ish American American Tobacco Corporation (BAT) Accordng to Note 16 of its 2008 Annual Report, BAT used derivatives, namely forward contracts and cross-currency interest-rate swaps as cash-flow hedges, with classification according to the timing of cash flows. Most of these derivatives had maturities of one year or less, but cross-currency swaps have maturities that are longer than one year up to five year or more. In addition, the Group had fixed-to-floating swaps to manage interest rate exposure for internal as well as external financing. Forward foreign currency contracts are used to hedge transactions as well as internal and external assets and liabilities vis-a-vis a number of currencies of countries where the firm has its subsidiaries. To minimise currency translation exposure of net assets into the reporting currency, the Group borrows in the foreign currency in the amount that closely matches the currency of the cash flows generated from operations. There is a matching of currency assets and currency borrowings. Profits from foreign currency subsidiaries are also subject to similar exposures but they are not normally hedged; when hedged, however, the Group uses forward contracts and options. Forecast dividend flows are also hedged wherever it is cost effective to do so. Advice to a fast-growing UK company The first alternative to consider is not to hedge at all, thus saving transaction costs. There will be rough times but in time currencies will correct themselves in the medium or long term future. But if the company executives feel that the stockholders are unsettled by the swings in the companys earnings due to foreign exchange volatility, then it will have to hedge. One tactic used by multinationals is to borrow in the local currency of the subsidiary. There is a positive exposure in the case of current liabilities but negative exposure in the case of current assets. As a rule, the weakening of the domestic currency is good news because it means higher sterling proceeds. Conversely, it would take less amount of sterling to buy another currency to repay obligations abroad. Iqbal et al. (1997) cite some non-financial tactics that can include negotiating with the supplier/buyer in a foreign country to use the sterling as the functional currency of the transaction. However, as demonstrated in the examples given above, the conventional methods are still currency forwards, swaps, and options. Bibliography British American Tobacco Corporation website. Viewed December 2, 2009 at http://www.bat.com/servlet/SPMerge?mainurl=%2Fgroup%2Fsites%2Fuk__3mnfen.nsf%2FvwPagesWebLive%2FDO52AK34%3Fopendocument%26amp%3BSKN%3D1 Clarke, RG 1995, Measuring and managing investment risk, in Bernstein, PL, The Portable MBA in investment, John Wiley & Sons, New York. Iqbal, MZ, Melcher, TU & Elmallah, AA 1997, International accounting: A global perspective, South-Western College Publishing, Cincinnati, OH Hill, CWH 2004, International business: Competing in the global marketplace, McGraw Hill, New York Kolb, RW 1997, Futures, options and swaps, 2nd edn. Blackwell Publishers, Malden, MA Lewent, JC & Kearney AJ 1993, Identifying, measuring, and hedging currency risk at Merck (David H. Chew, ed.), McGraw Hill, New York. Madura, J 1989, International financial management, 2nd edn, West Publishing Co., St. Paul, MN Reilly, FK & Brown, KC 1997, Investment Analysis and portfolio management, 5th edn. The Dryden Press, Orlando, FL Smith Jr, CW, Smithson, CW, & Wilford, DS 1993, Managing financial risk, in Chew Jr, The new corporate finance: where theory meets practice, McGraw Hill, New York. Vodafone Annual Report 2008. Viewed December 2, 2009 at http://www.vodafone.com/static/annual_report09/financials/notes_cons_fin_statements/note24.html Read More