INSTITUTE OF ACCOUNTANCY ARUSHA

MODULE NAME: FINANCIAL RISK MANAGEMENT

MODULE CODE: FIG 0915

PROGRAMME: MSC FINANCE AND INVESTMENT

TOPIC: FOREIGN EXCHANGE RISK MANAGEMENT STRATEGIES

Unlike when trading domestically, foreign currency risk arises for companies that trade internationally.

In a floating exchange rate system:

• the authorities allow the forces of supply and demand to continuously change the exchange
rates without intervention
• the future value of a currency vis-à-vis other currency is uncertain
• the value of foreign trades will be affected.

Types of foreign currency risk

Since firms regularly trade with firms operating in countries with different currencies, and may operate
internationally themselves, it is essential to understand the impact that foreign exchange rate changes
can have on the business.

Transaction risk

Transaction risk is the risk of an exchange rate changing between the transaction date and the
subsequent settlement date, i.e. it is the gain or loss arising on conversion. It arises on any future
transaction involving conversion between two currencies (for example, if a UK company were to invest
in USD bonds, the interest receipts would be subject to transaction risk). The most common area where
transaction risk is experienced relates to imports and exports.

Test your understanding 1 – Transaction risk

On 1 January, a UK firm enters into a contract to buy a piece of equipment from the US for $300,000.
The invoice is to be settled on 31 March. The exchange rate on 1 January is $1.6 = £1. However by 31
March, the pound may have (1) (2) strengthened to $1.75 = £1 or depreciated to $1.45 = £1. Explain the
risk faced by the UK firm.

A firm may decide to hedge – take action to minimise – the risk, if it is:

• a material amount
• a material time period
• thought likely exchange rates will change significantly.

Economic risk

Economic risk is the variation in the value of the business (i.e. the present value of future cash flows)
due to unexpected changes in exchange rates. It is the long-term version of transaction risk.

For an export company it could occur because:

 • the home currency strengthens against the currency in which it trades
• a competitor’s home currency weakens against the currency in which it trades.

A favoured but long-term solution is to diversify all aspects of the business internationally so the
company is not overexposed to any one economy in particular.

Test your understanding 2 – Economic risk

A US exporter sells one product in Europe on a cost plus basis. The selling price is based on a US price of
$16 to cover costs and provide a profit margin. The current exchange rate is €1.26 = $1. What would be
the effect on the exporter’s business if the dollar strengthened to €1.31 = $1?

Economic risk

Transaction exposure focuses on relatively short-term cash flows effects; economic exposure
encompasses these, plus the longer-term effects of changes in exchange rates on the market value of a
company. Basically, this means a change in the present value of the future after-tax cash flows due to
changes in exchange rates.

There are two ways in which a company is exposed to economic risk

Directly: If your firm’s home currency strengthens then foreign competitors are able to gain sales at
your expense because your products have become more expensive (or you have reduced your margins)
in the eyes of customers both abroad and at home.

Indirectly: Even if your home currency does not move relative to your customer’s currency, you may
lose competitive position. For example, suppose a South African firm is selling into Hong Kong and its
main competitor is a New Zealand firm. If the New Zealand dollar weakens against the Hong Kong dollar,
the South African firm has lost some competitive position.

Economic risk is difficult to quantify but a favoured strategy is to diversify internationally, in terms of
sales, location of production facilities, raw materials and financing. Such diversification is likely to
significantly reduce the impact of economic exposure relative to a purely domestic company, and
provide much greater flexibility to react to real exchange rate changes.

Translation risk

Where the reported performance of an overseas subsidiary in home-based currency terms is distorted in
consolidated financial statements because of a change in exchange rates.

NB. This is an accounting risk rather than a cash-based one.

Translation risk

The financial statements of overseas subsidiaries are usually translated into the home currency in order
that they can be consolidated into the group’s financial statements. Note that this is purely a paper-
based exercise – it is the translation rather than the conversion of real money from one currency to
another. The reported performance of an overseas subsidiary in home-based currency terms can be
severely distorted if there has been a significant foreign exchange movement.
If initially the exchange rate is given by $1 = £1 and an American subsidiary is worth $500,000, then the
UK parent company will anticipate a statement of financial position value of £500,000 for the subsidiary.
A depreciation of the US dollar to $2 = £1 would result in only £250,000 being translated.

Unless managers believe that the company's share price will fall as a result of showing a translation
exposure loss in the company's accounts, translation exposure will not normally be hedged. The
company's share price, in an efficient market, should only react to exposure that is likely to have an
impact on cash flows.

Managing foreign currency risk

When currency risk is significant for a company, it should do something to either eliminate it or reduce
it. Taking measures to eliminate or reduce a risk is called:

• hedging the risk or

• hedging the exposure

Practical approaches /Internal hedging techniques

Practical approaches to managing foreign currency risk include:

• Dealing in your home currency

• Doing nothing
• Leading
• Lagging
• Matching receipts and payments
• Netting
• Foreign currency bank accounts
• Matching assets and liabilities

Practical approaches to managing risk

1) Deal in home currency/Home currency invoicing

Insist all customers pay in your own home currency and pay for all imports in home currency.

This method:

• transfers risk to the other party

• may not be commercially acceptable.

2) Do nothing.

In the long run, the company would ‘win some, lose some’.

This method:

• works for small occasional transactions

• saves in transaction costs
• is dangerous!
3.Leading

Receipts – If an exporter expects that the currency it is due to receive will depreciate over the next few
months it may try to obtain payment immediately.

This may be achieved by offering a discount for immediate payment.

Payments- If the importer expects that the currency will in fact appreciate, then it should settle the
liability as soon as possible (leading), although this will lead to increased working capital funding costs,
which should be taken into account.

4.Lagging

Payments – If an importer expects that the currency it is due to pay will depreciate, it may attempt to
delay payment. This may be achieved by agreement or by exceeding credit terms.

Receipts- if an exporter expects the currency to appreciate, it may try to delay the receipt of payment by
offering longer credit terms (lagging).

NB: Strictly this is not hedging – it is speculation – the company only benefits if it correctly anticipates
the exchange rate movement!

5.Matching payments and receipts

When a company has receipts and payments in the same foreign currency due at the same time, it can
simply match them against each other. It is then only necessary to deal on the foreign exchange (forex)
markets for the unmatched portion of the total transactions. Suppose that ABC plc has the following
receipts and payments in three months’ time:

6.Netting

Unlike matching, netting is not technically a method of managing exchange risk. However, it is
conveniently dealt with at this stage. The objective is simply to save transaction costs by netting off
inter-company balances before arranging payment between group companies.

7.Foreign currency bank accounts

Where a firm has regular receipts and payments in the same currency, it may choose to operate a
foreign currency bank account. This operates as a permanent matching process. The exposure to
exchange risk is limited to the net balance on the account.

8.Matching assets and liabilities (asset and liability management)

A company that expects to receive a significant amount of income in a foreign currency will want to
hedge against the risk of this currency weakening. It can do this by borrowing in the foreign currency
and using the foreign receipts to repay the loan. For example, Euro receivables can be hedged by taking
out a Euro overdraft. In the same way, Euro trade payables can be matched against a Euro bank account,
which is used to pay the suppliers.

A company that has a long-term foreign investment, for example an overseas subsidiary, will similarly try
to match its foreign assets (property, plant etc.) by a long-term loan in the foreign currency.
External hedging techniques

This involves the use of :

i. Forward exchange contracts

ii. Money market
iii. Currency futures
iv. Currency options
v. Currency swap

Hedging with forward exchange contracts

Although other forms of hedging are available, forward exchange contacts (which enable a business to
fix a currency price now for a future transaction) represent the most frequently employed method of
hedging.

Illustration 3 – Forward exchange contract

It is now 1 January and Y plc will receive $10 million on 30 April. It enters into a forward exchange
contract to sell this amount on the forward date at a rate of $1.60 = £1. On 30 April, the company is
guaranteed £6.25 million. The risk has been completely removed. In practice, the forward rate is quoted
as a margin on the spot rate. In the exam, you will be given the forward rate.

Test your understanding 7 – Hedging with forwards

The current spot rate for US dollars against UK sterling is $1.4525 – $1.4535 = £1 and the one-month
forward rate is quoted as $1.4550 – $1.4565 = £1. A UK exporter expects to receive $400,000 in one
month.

If a forward exchange contract is used, how much will be received in sterling?

Advantages and disadvantages of forward exchange contracts

Forward exchange contracts are used extensively for hedging currency transaction exposures.

Advantages include:

• flexibility with regard to the amount to be covered

• relatively straightforward both to comprehend and to organise.
• No payment of premium as done in options
• Not limited in availability because is the over the counter contract

Disadvantages include:

• contractual commitment that must be completed on the due date (option date forward contract
can be used if uncertain)
• no opportunity to benefit from favourable movements in exchange rates.
• Subjected to counterparty risk I.e can not traded in the secondary financial market

A money market hedge

The money markets are markets for wholesale (large-scale) lending and borrowing, or trading in short-
term financial instruments. Many companies are able to borrow or deposit funds through their bank in
the money markets.

Instead of hedging a currency exposure with a forward contract, a company could use the money
markets to lend or borrow, and achieve a similar result.

Since forward exchange rates are derived from spot rates and money market interest rates, the end
result from hedging should be roughly the same by either method.

NB Money market hedges are more complex to set up than the equivalent forward.

Hedging a payments- If you are hedging a future payment:

• buy the present value of the foreign currency amount today at the spot rate:

– this is, in effect, an immediate payment in domestic

-and may involve borrowing the funds to pay earlier than the settlement date

There are three steps to calculate how much of the home currency is needed for the payment:

• Divide the foreign currency payment amount by (1 plus the foreign currency deposit rate for the
time period in question)
• Take the figure calculated and translate it to the home currency at the spot rate
• Take the figure calculated and multiply it by (1 plus the home currency borrowing rate for the
time period in question)

Note that the deposit and borrowing rates will normally be given as annual rates and will have to be
adjusted for the time period in the question. Assume that simple interest applies so, for example, divide
the annual rate by 4 for a 3-month time period.

Test your understanding 8 – Hedging a payment

Liverpool plc must make a payment of US $450,000 in 3 months' time. The company treasurer has
determined the following:

Spot rate $1.7000 – $1.7040 = £1

3-months forward $1.6902 – $1.6944 = £1

6-months forward $1.6764 – $1.6809 = £1

Money market rates:

Borrowing Deposit

US $ 6.5% 5%

Sterling 7.5% 6%

Decide whether a forward contract hedge or a money market hedge should be undertaken.

Additional question – Hedging a payment

Bolton, a UK company, must make a payment of US$230,000 in three months' time. The company
treasurer has determined the following:

Dollar: Sterling Spot rate $1.8250 – $1.8361 = £1.

3-months forward $1.8338 – $1.8452 = £1

Money market rates:

Borrowing Deposit

US $ 5.1% 4%

Sterling 5.75% 4.5%

Ascertain the cost of the payment using a forward contract hedge and a money market hedge

Statement of financial position hedging

All the above techniques are used to hedge transaction risk. Sometimes transaction risk can be brought
about by attempts to manage translation risk.

Translation exposure:

• arises because the financial statements of foreign subsidiaries must be restated in the parent’s
reporting currency, for the firm to prepare its consolidated financial statements
• is the potential for an increase or decrease in the parent’s net worth and reported income
caused by a change in exchange rates since the last translation.

A statement of financial position hedge involves matching the exposed foreign currency assets on
the consolidated statement of financial position with an equal amount of exposed liabilities, i.e.: a

• loan denominated in the same currency as the exposed assets and for the same amount is
taken out
• a change in exchange rates will change the value of exposed assets but offset that with an
opposite change in liabilities.

This method eliminates the mismatch between net assets and net liabilities denominated in the same
currency, but may create transaction exposure.

As a general matter, firms seeking to reduce both types of exposure typically reduce transaction
exposure first. They then recalculate translation exposure and decide if any residual translation
exposure can be reduced, without creating more transaction exposure.

Foreign currency derivatives

Foreign currency risk can also be managed by using derivatives:

Futures

Futures are like a forward contract in that:

• the company’s position is fixed by the rate of exchange in the futures

 • contract it is a binding contract.

A futures contract differs from a forward contract in the following ways:

• Futures can be traded on futures exchanges. The contract which guarantees the price (known as
the futures contract) is separated from the transaction itself, allowing the contracts to be easily
traded.
• Settlement takes place in three-monthly cycles (March, June, September or December). i.e. a
company can buy or sell September futures, December futures and so on.
• Futures are standardised contracts for standardised amounts. For example, the Chicago
Mercantile Exchange (CME) trades sterling futures contracts with a standard size of £62,500.
Only whole number multiples of this amount can be bought or sold.
• The price of a currency futures contract is the exchange rate for the currencies specified in the
contract. There is always a buy and a sell element to futures contracts. e.g. for futures contracts
denominated in sterling:

– sterling to be sold on a date in the future – buy sterling futures contracts on the same date to
offset the transaction. Sell those futures contracts now.

–sterling to be bought on a date in the future – sell sterling futures contracts on the same date to
offset the transaction. Buy those futures contracts now. Because each contract is for a standard
amount and with a fixed maturity date, they rarely cover the exact foreign currency exposure.

How Future contract works

When a currency futures contact is bought or sold, the buyer or seller is required to deposit a sum of
money with the exchange, called initial margin. If losses are incurred as exchange rates and hence
the prices of currency futures contracts changes, the buyer or seller may be called on to deposit
additional funds (variation margin) with the exchange. Equally, profits are credited to the margin
account on a daily basis as the contract is 'marked to market'.

Most currency futures contracts are closed out before their settlement dates by undertaking the
opposite transaction to the initial futures transaction, i.e. if buying currency futures was the initial
transaction, it is closed out by selling currency futures.

Effectively a future works like a bet. If a company expects a US$ receipt in 3 months’ time, it will lose
out if the US$ depreciates relative to sterling. Using a futures contract, the company ‘bets’ that the
US$ will depreciate. If it does, the win on the bet cancels out the loss on the transaction. If the US$
strengthens, the gain on the transaction covers the loss on the bet. Ultimately, futures ensure a
virtual no win/no loss position.

Test your understanding 9– Future contract hedging

It is currently February and a US exporter expects to receive £500,000 in June.

Current spot rate now is $ 1.65=£ 1

The quote for June Sterling futures is $ 1.65

Standard size of futures contract £ 62,500

 Sterling futures.

In June, the company receives £500,000

The spot rate in June moved to $ 1.70=£ 1

The futures rate in June was also $ 1.70

Show the outcome of the futures hedge.

Currency options

Options are similar to forwards but with one key difference. They give the right but not the
obligation to buy or sell currency at some point in the future at a predetermined rate.

A company can therefore:

• exercise the option if it is in its interests to do so

• let it lapse if:
– the spot rate is more favourable
–there is no longer a need to exchange currency.

The downside risk is eliminated by exercising the option, but there is still upside potential from letting
the option lapse.

Options are most useful when there is uncertainty about the timing of the transaction or when
exchange rates are very volatile.

Options may be:

Two types of option are available –

• over the counter options from banks (tailored to the specific wants of the customer and can be
used by small and medium sized companies) and
• exchange traded options (traded on the same exchanges as futures and which can be used by
larger companies).

The catch:

The additional flexibility comes at a price – a premium must be paid to purchase an option, whether or
not it is ever used.

Illustration 5 – Options exam.

A UK exporter is due to receive $25m in 3 months’ time. Its bank offers a 3 month put option on $25m at
an exercise price of $1.50 = £1 at a premium cost of £30,000.

Required: Show the net £ receipt if the future spot is either $1.60 = £1 or $1.40 = £1

Currency swap
In addition to a basic swap, counterparties can also agree to swap equivalent amounts of debt in
different currencies. This is known as a currency swap. The principal is not transferred and the original
borrower remains liable in the case of default.

Advantages of Currency swap

• Firm can access the loan at cheaper costs than those obtained in the relevant financial market
• It is flexible in respect of amount and maturity dates
• Arrangement fees, legal fees are lesser compared to premium paid in options
• It can be used for hedging transactions with the longer periods than the rest of derivatives

Currency swap is facing three main risks

i. Credit/Default risk
ii. Market risk
iii. Political/Country risk

REVIEW QUESTIONS

QUESTION ONE

Electro Company Ltd is a Tanzanian firm specialised in supplying electronic products to companies
around the world. Its management is considering how best to manage the financial risk of the
transaction entered into on 1st January 2018.

The transaction details are as follows:

It is now 1st January 2018 and the mid- spot rate is TZS 2,430/£. The Zenith Inc a British TV-manufacturer
is new customer and its first payment to Electro Company £ 156,250 is due on 30th June 2018. Electro's
management is considering using one of the following hedge alternatives to hedge the June receipt from
Zenith Inc.

• A forward Market Cover

• Money Market Hedge or
• Market Traded Currency Options
The following information has been collected:

Foreign Exchange Market

Bid Ask

Spot TZS/£ 2,420 2,440

6 months forward TZS/£ 2,450 2,460

1 Year forward TZS/£ 2,470 2,480

Prices for market traded currency options on 01/01/2018 (Contract size =£31,250)

Exercise Price: TZS 2,445/£

June 2018 Call Puts

 69 135

December 2018 114 157

Premiums are cents per £

Money Market Prices (Stated Rates of Interest)

Country Deposit Borrowing

Tanzania 8% 16%
UK 4% 12%

REQUIRED:

1) Assuming a spot rate of TZS 2,429/£ on 30 th June 2018, Calculate the net Tanzanian shillings
receipts if to hedge its receipts Electro Company uses
a. A forward Market cover
b. Money market hedge
c. Traded currency options
2) With reference to your calculation in part (b) above, advice Electro's management on how it
should proceed

QUESTION TWO

In recent board meeting of Sabra Company, a hot debate arose about whether profit on import-export
deal was realized or not. During the meeting the management claimed to have made a profit on the
deal amounting TZS 15,000,000 but could hardly convince all members of the board. Some members of
the board believe that forward market cover was necessary. The management did not take such a cover.
The details of the deal are as on 1st January 2018, the company purchased a consignment of textile
products from UK at £ 10,000 payable in the three months ( 1st April 2018). The consignment was
shipped directly to a customer in Uganda The customer was invoiced in Uganda Shillings (UGS) at
invoice price of UGS 210,000,000. The Ugandan customer was given three months Credit to 1st April
2018. Shipping costs amount to TZS 2,000,000 has been paid.

The exchange rates were as follows:

Exchange Rates in Dar es Salaam at 01/01/2018

UGS/TZS TZS/£

Bid Ask Bid Ask

Spot 3.0 4.0 2,700 2,800

Three months forward 5.0 6.0 2,900 2,950

Spot exchange rates on the 1st April 2018.

UGS/TZS TZS/£
 Bid Ask Bid Ask

6.0 7.0 3,000 3,100

REQUIRED:

Evaluate the deal and inform the Board of Sabra of whether the management was accurate in its
computation of profit on the deal. Advice the board whether a forward cover could have assisted the
company to avoid loss.

QUESTION THREE

Baraza Trading Company manufactures foot wear for the past ten years it has seen a continual
expansion in its level of operations in Tanzania. It has developed a strong relationship with a major foot
wear wholesaler in the USA. Baraza Company's management has concerns that the company should
start to manage its exposure to exchange rates risk. Baraza Trading Company has sold footwear to the
USA customer worth US $ 50,000 payable in six months time. Assume that today is 1st May 2016 and
interest rate and foreign exchange quotes are as listed below:

Interest rates Deposit Borrowing

TZS 5.0% p.a 6.5% p.a

US $ 7.0% p.a 10.5% p.a

Exchange rates

Spot rates TZS/US $ 1,275-1,278

Three months forward 4-5 premium

Six months forward 4.50-5.1 premium

REQUIRED:

Advice Baraza's board whether it should use forward contracts or money market hedge when managing
the above dollar transaction over next six months.

1.4170 and September Euro future prices at $ 1.4150

QUESTION FOUR

On Tuesday morning, an investor takes a long position in a swiss Franc future contract that matures on
Thursday afternoon. The agreed upon prices is US $0.75 for SFr 125,000. At the close of trading on
Tuesday, The futures price has risen to US $ 0.755 at Wednesday close, the price has declined to US $
0752. At Thursday close the price drops to US $ 0.74 and the contract mature.

Required

Details the daily settlements process. What will be the investor's profit or loss.

QUESTION FIVE
On Monday morning, an investor takes a short position in Euro futures contract that matures on
Wednesday afternoon. The agreed upon price is US $ 0.6370 for Euro 125,000. At the close of trading
on Monday, the futures prices had fallen to US $ 0.6315. At Tuesday close, the price falls further to US $
0.6291. At Wednesday close, the prices rises to US $ 0.6420 and contract matures.

Required

Detail the daily settlement process. What will be the investor's profit or loss.