Monday, May 14, 2012

foreign currency

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Question 1.


Part a.


1. Manque is exposed to types of foreign currency risk


· Transaction Exposure Transaction exposure is associated with movements in exchange rates where cash flows that result from existing activities are paid in a different currency to that in which the contracted payment is made. Manque is engaged in fixed-price contracts billed in local currencies, but the consultants who carry out the work are paid in Sterling. If Sterling rises against the local currency then Manque’s profit margins are squeezed, conversely, if Sterling falls then Manque stands to gain.


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· Translation Exposure Translation exposure or accounting exposure occurs when a foreign subsidiary has to prepare accounts for its parent company. The cash flows have to be converted into the currency of the parent company which can lead to a distortion of the cash flows either through changing exchange rates or differing accounting practices. Manque has subsidiary companies in Germany, France, Russia and Hong Kong � each of these countries differs from the UK in either the market or accounting practices.


· Economic exposure Economic exposure describes the measure of change in the present value of a firm that results from a change in future operating cash flows caused by an unexpected variance in exchange rates. According to Eitman et al (15) the change in value depends on the effect of the exchange rate change on future sales volume, price or costs. Manque has subsidiaries in 4 countries, of which are outside the EU, and 1 of which, Russia, operates in a relatively unregulated fashion in matters of business finance, as well as being potentially more unstable politically. A sudden devaluing of the Rouble is probably more likely than that of the European currencies, therefore, that market may be considered to carry more Economic risk than France or Germany.


Part b.


Quantify the risk


· The Finance Director stated that traditionally the directors of Manque have been risk averse; therefore they have not wished to become involved in foreign exchange dealings and have not undertaken any hedging. In having 4 subsidiary companies procurig cash flows in different foreign currencies, which are then converted to Sterling it should be pointed out that Manque is already engaged in foreign exchange dealings. In not hedging its currency flows, Manque’s financial policy is divergent from the wishes of the directors who wish to avoid risk.


· Risk is not necessarily a negative concept. It can be viewed as a quantified boundary around uncertainty, which is measured by looking at the past. For example, Manque is exposed to types of foreign currency risk, this can be viewed as systematic risk that is associated with Manque’s method of operation. The unsystematic risk that Manque’s Directors may be averse to is that they cannot accurately predict the effect that foreign exchange risk will have on their results.


· There are several strategies that can be employed to reduce unsystematic risk and hedging is one of them. However, as there is the possibility that Manque may become listed, the Directors may wish to consider whether a higher-risk company with an associated higher return is more attractive to shareholders than a low-risk company that may be competing with blue chip companies for investors’ attention.


· The Finance Director had been informed that losses and gains on hedging currency flows evened themselves out eventually. Many British companies use this reason not to hedge their foreign currency risk as hedging requires management resource and funding. However, to be statistically sound this belief assumes a long-term view over business with many transactions. It is also statistically skewed by unsystematic risk such as September 11, the expiry of the Hong Kong lease, German reunification or default of payments by Russian banks. If Manque’s Directors wanted to follow a risk-averse strategy they may wish to consider hedging as a means of predicting their financial results more accurately.


· The Bank manager’s offer to restructure the way in which the overseas subsidiaries are funded may have some merit if there was a requirement to fund them. However, such a benefit would only accrue if there was actually a need to finance the subsidiaries from the parent company. There is not enough detail in the brief to give a definitive answer, but if Manque is seeking to raise share capital, thus funding its activities through equity, there must be a question as to why Manque would want to take on additional debt as well. The bank manager will earn commission for his bank on any arrangement he makes and this may not necessarily be in the best interests of Manque.


· The Finance Director alluded to the possibility of shareholders hedging for themselves, thus negating the need for Manque to do so. Any risk spreading activities that the shareholders may carry out would be as part of an overall portfolio balancing exercise to gain maximum benefit for least risk. The level of risk that the shareholder indulged in would be an individual decision. The kind of risk management that Manque would carry out directly involved the cash flows that Manque’s Directors are responsible for managing. Manque’s future shareholders may wish Manque to be a relatively risk avers company, in which case the Directors would have a duty to maximise the value of the company, by hedging against potential losses if necessary. In any case, shareholders are likely to respond more favorably if there are fewer surprises in the yearly financial report- something which may become increasingly important if there are a few, but significant, institutional shareholders; indeed, they may insist on it.


Part c.


There are several techniques that can be used to manage foreign exchange exposure, of the ones to be discussed we can broadly divide them into internal and external techniques. Some authorities suggest that it is good practice to use as many internal techniques as possible before resorting to the external ones as the internal techniques are often cheaper and more effective.


Internal Techniques


· Matching. This technique requires a Group’s assets to be considered as a whole, rearranging the balance sheet to keep each subsidiary in balance as much as possible so as to avoid translation exposure before it happens. Sometimes, foreign currency borrowing can be used to match local long term assets with long term liabilities- the bank manager may allude to this technique. If, however, the stream of cash flows is mainly in one direction as in this case � to the UK then matching may not be a suitable technique.


External Techniques


· Invoicing in Sterling. This practice effectively shifts the foreign exchange risk to the customer overcoming Manque’s transaction exposure. The advantage to Manque is that the firm know precisely what its cash flows will be in relation to firm contracts. The effect on the customer is somewhat different. When Sterling is weak, then the firm price agreed will represent a competitive bid, but when Sterling is strong then the price becomes less competitive. If Sterling strengthens after the contract is let then the customer faces a climbing bill for services. As a significant amount of Manque’s business comes from tendering to Governments and there is a significant delay in tender to payment, then Manque may jeopardise their bid by invoicing in Sterling as some Government departments may risk-load their bid as part of the tendering process.


· Forward contracts. This is a contractually binding agreement to deliver a specified amount of one currency for a specified amount of another currency at some future date. The rates offered by the banks will be determined by the bond rate offered in the foreign currency to be exchanged and there will be a commission to pay to the bank. As Manque is aware of the cash flows it receives and the timescales upon contract agreement, forward contracts offer a way of effectively forecasting the Sterling cash inflows. However, should Sterling weaken from contract letting day to payment, then Manque will fail to benefit from the relative movement in exchange rates.


· Options. An option is a contract giving the owner the right, but not the obligation, to either buy or sell (in this case a currency) a given amount of currency for a fixed price on or before a given date. Although there is a premium to pay on the option itself, the option guarantees the owner a price on the currency with the added flexibility that they can exercise the option earlier than the expiry date, if the exchange rates move favourably, or let the option simply expire and use the spot rate if this works out to be more advantageous. In terms of risk, the option is little more than an insurance policy that iteslf can be insured by use of a straddle option. Options may require some management effort, but they are a flexible and risk-free option.


· Currency Swaps. These instruments are brokered agreements that bring together parties which require each other’s currencies. For the premium of an arrangement fee, equivalent amounts of currency can be swapped at the spot rate without paying foreign exchange commission. Currency swaps tend only to be made for very large amounts of money and they are made at prevailing rates. Thus, Manque’ problem of transaction exposure remains.


610 words from 500 � use of matrix


Question


Part a.


· Contingent risk is risk to which we become exposed only if we undertake an activity. For example, if a company tendered for a foreign contract paid in a foreign currency, then the company would only become exposed to the risks posed by the contract if it won the tender.


· A financial option is an instrument which enables contingent risk to be traded. When one party buys the right (but not obligation) to buy or sell shares (known as call and put options respectively) then they take on contingent risk only if they exercise their rights. Obviously, the right is only exercised if the outcome is a desired one; demonstrating that risk is not necessarily a negative phenomenon.


· Contingent risk is managed in this way each time household insurance is taken out. A company may wish to hedge foreign currency risk by taking out options to buy or sell currency at a certain rate in order to guarantee a forecasted income stream. If the currency price moves so that the result is in the money, the option owner can choose to exercise their right and so benefit from the contracted price. In this way, contingent risk only comes about because the option was exercised � the result was positive. If the currency values changes so that the transaction is out of the money, then the option owner may choose not to exercise their right thus avoiding a negative outcome. In the second example the contingent risk was avoided as the action that would have triggered it (exercising the option) did not take place.





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