Ch09 Currency risks.docx

Corporate Finance – Semester 2 -5080635000 CURRENCY RISKS We shall cover following topics in this hand out: Types Of Currency Risks Transaction exposure Translation exposure Economic exposure Methods Of Protection Against Transaction. -Exposure to Internal Methods Exposure to External methods Currency Risks We can classify foreign risk exposure into three broad categories: Transaction exposure Translation exposure Economic exposure Translation Exposure: In real world, a single transaction (sales and receipt) may take some period of time. For example, you sold goods to a foreign customer on 15 December 2005, and customer promised payment after two months. Now during these two months the exchange rate may fluctuate on either side and this will result in exchange gain or loss. These transactions may include import or export of goods on credit terms, borrowing or investing in foreign currency, receipt of dividend from foreign subsidiary. This type of exposure can be safeguarded by using hedging instruments. Translation Exposure: When a business has several subsidiary located in different foreign land, then it needs to consolidate its financial results of overall operations. Translation exposure effects the financials of the group when it translates its assets, liabilities and income to home currency from various currencies. The widely used mean of protecting against translation exposure is known as balance sheet hedging. In this method, assets and liabilities are matched of offset in order to reduce the net effect of translation. For example, a company may try to reduce its foreign currency dominated assets if it fears a devaluation of foreign currency. At the same time, it may increase its liabilities by seeking loans in the local currency and slowing down payment to creditors. The firm may try to equate its foreign currency assets and liabilities then it will have no net exposure to change in exchange rates. Economic Exposure: This type of exposure affects the value of the company. Any adverse exchange rate fluctuation will reduce the present value of all the future cash flow, thus reducing the value of the company. It is difficult to measure the dollar value effect on the value of the firm. For instance, a Kenyan firm is operating in other country through a subsidiary. Assuming that the foreign country in question devalues it currency unexpectedly, this will be a bad happening for the home firm. This is because every local currency unit of profit earned would now be worthless when repatriated to Kenya. On the other hand, if could be a good news as the subsidiary might now find it profitable to export goods to the rest of the world. If a firm manufactures all its products in one country and that country’s exchange rate strengthens, the firm will find its export expensive to the rest of the world. Sales will be stagnant if not lowering and the cash flow and value of the firm will also deteriorate. On the other side, if a firm has decentralized production facilities around the world and bought its inputs from all over the world, it is unlikely that the currencies of all its operations would revalue at the same time. It would therefore, find that although it was losing exports from some of its productions facilities, this would not be the case in all of them. When borrowing in more than one currency, firms must be aware of foreign exchange risk. Therefore, when a firm borrows in US dollars it must settle this liability in the same currency. If US $ then strengthens against the home currency this can make interest and principal repayments far more expensive. However, if borrowing is spread across several currencies it is unlikely they will all move in one direction – upward or downward and economic exposure is reduced to considerable extent. Borrowing is foreign currency is justified if returns will then be earned in that currency to finance repayment and interest. Protection against Transaction Risk Fluctuations in foreign exchange market do not stop. A company may have several thousand foreign currency units in payable and receivable transactions. Such payments and receipts are going to take place in future thus exposing a company to adverse fluctuations, resulting in exchange losses. For example, a Kenyai enterprise is required to make US $ 100,000 to a US exporter within two months time. The company anticipates that dollar will strengthen against the local currency (or local currency will weaken against the US $), it means that Kenyai firm will need to spend more local currency units to buy the dollars in question. This type of risk can be reduced if not eliminated, by hedging. There are two types of measures that can reduce the transaction exposure. These are: Internal methods: Invoicing in home currency Leading and lagging Multilateral netting External methods: Forward contract Money market hedges Currency futures Currency options Currency swaps Internal methods: Invoicing in home currency This will eliminate the need of exchange of currency upon receipt. However, the seller would be compelled to revise its prices periodically. Seller can invoice: In home currency Currency that is stable than home currency Currency with a positive forward markets Buyer’s preferable currency is: Own currency Stable than own currency Currency he has Currency of the industry Leading & lagging: Leading refers to making payment before falling due. Lagging means to defer or delay the payment or settling the payment well past due date If the currency of payer is weakening against the other currency (of buyer) than it is beneficial to pay early. For example, if a Pak importer need to pay for import bill and predicts that Pak rupees will weak against the dollar in future, then it is advisable to pay as early as possible. However, if Pak rupee is foreseen strengthening against dollar, then delaying payment would be financially advantageous. These issues are from payer’s standpoint and will be opposite for payee. Matching of receipts and payments: For-ex exposure can be partially hedged by matching payments and receipts of same currency. For example, a company will receive US $ 1 million during the next quarter and will need to pay US $ 1.2 million in the same period, and then the net exposure will be US $ 200,000/- as 1 million payments and receipt are net off. Matching receipts and expenditures is a very useful way of hedging currency exposure. It can be organized at group level by the finance department so that currency income for one of the group companies can be matched with the expenditure of another company. In order to reduce the transaction exposure to maximum level, it is of immense importance that forecast of amount and timings of foreign currencies are reliable. External Hedging Methods: Forward Rate Agreements: Under this method, hedging refers to making an investment to reduce the risk of adverse price movements in an asset. Normally, a hedge consists of taking an offsetting position in a related security, such as a futures contract. Using this method, we can fix the exchange rate now for a future transaction of the needed currency. Because spot rates are changing every day and fixing the exchange rate for future date ‘now’ reduces the risk to significant extent. A forward contract is binding upon both the parties – currency dealer and a company/client. This means that both parties must honor their commitment to sell or buy the foreign currency on the specified date and amount. By hedging against the risk of an adverse exchange rate movement with a forward contract, the company also closes an opportunity to benefit from a favorable change in the spot rate. Hedging is based on the assumption or estimate that it will be expensive to pay US $ in three months’ time because of the fact the PKR will be weakening against US $. Therefore, a company enters into a contract to buy x dollars after 3 months at an exchange rate of Rs 60/ US $ decided now. At the maturity date both parties have to honor their respective commitments of buying and selling of US $ at agreed rates. Now if on the maturity date, the spot ex rate is Rs 61/US $, (PKR weakened against US $), then the company has actually eliminated the loss and benefited financially. However, if the spot rate on maturity date is Rs. 59/US $, (contrary to its estimation of weak local currency, local currency strengthened) then the company has missed the opportunity to benefit from this favorable sport rate. For best results, one must possess the knowledge of Forex market with a vision of future to estimate that which currency will weaken against which other one. Timing of cash flow is of crucial importance in hedging contract. Money Market Hedging: Money markets are wholesale (large-scale) markets for lending and borrowing of money for short term. Bank are major player of money markets and companies seek their services to hedge against the ex-rate fluctuations in short term. As forward ex rate (which is agreed now) is derived from sport rates using interest rates, a money market hedge can produce the same results as of forward contract. There will be two situations: A company is to receive money in foreign currency (FCY) at a future date and will exchange it into local currency, and A company needs to pay foreign currency (FCY) at some future date and will use local currency to buy the FCY to make payment Scenario: Future Income in FCY What is needed at this point is to fix the exchange value of the future currency income. A hedge will be created by fixing the value of income now in local currency. We can do it: Borrow now in foreign currency (the same that the company will receive in future). The maturity of both – loan and receipt should be the same. The loan + interest on FCY loan should equal the amount of FCY future receipt. When the FCY receipt hit the account, loan will be paid off. The FCY loan can be converted to local currency immediately and may be put to a short-term deposit to earn interest. CURRENCY RISKS We shall take care of following topics in this hand out: Future payment situation – hedging Currency futures – features CF – future payment in FCY Money Market Hedge – future FCY payment scenario A similar approach will be taken to create the hedge when a firm is expecting to pay in FCY in future. In this scenario, a hedge can be created by exchanging local currency for FCY now using spot rates and putting the currency on deposit until the future payment is to be made. The amount borrowed and the interest earned on the deposit should be equal to the FCY. If it is not the case then it will not be a clean hedge. The cash flows are fixed because the cost in local currency is the cost of buying FCY on spot rates that was put under a deposit. Mechanism: Step 1: determine the FCY (assume US $) amount to be put to a deposit that will grow exactly to equalize the future payment in dollars. You need to calculate this using the available spot rates and interest rate on dollar deposit. Step 2: in order to deposit dollars in interest bearing account, the company will buy dollars at spot rates. Step 3: the company will borrow local currency for the period of hedge. These steps will ensure that the hedge created a definite cash flow regardless of exchange rate or interest rate fluctuations. The exchange rate has been fixed. Currency Futures: A currency future is a standard contract between buyer and seller in which the buyer has a binding obligation to buy a fixed amount, at a fixed price and on a fixed date of some underlying security. Fixed amount = contract size Fixed date = delivery date Fixed price = future price Futures are forward contracts traded on future and option exchanges. There are several such exchanges around the world and although some trade in similar forward contracts, as a general rule each exchange specializes in its own future contracts. This means that if a company wants of trade in future contracts it has to go to exchange where those contracts are traded. Futures are only traded on exchanges using standardized contracts. Each future contract is in particular item having identical specification. For example, every sterling contract has same specification. Settlement of future contracts is made at predetermined times during a year. These are usually in March, June, September and December each year. This means, for example, that sterling future contracts are traded on the exchange for settlement in these months. Futures are traded at a price agreed between the buyer and the seller. This price reflects the price of the item traded by the contract. Most of the futures do not run to their final settlement date. These contracts may be cash settled or physical delivery settled. With cash settlement, there is payment in cash from one party to the other. With physical delivery, the underlying item is delivered by one party to other. When a trader buys future, this represents taking a long position in futures. Such a trader having a long position can close his position at any time before the settlement date by selling the same number of contracts. On the other side, when a trader is selling futures then it represent his or her short position. It is possible to sell future even you don’t have them. A trader who is in short position can close her position by buying the same number of future before the final settlement date. Ticks: A tick is the minimum price movement of a contract. For example, the movement in US$ / PKR rate from 60.1501 to 60.1505, means the rate has risen four ticks. Every tick movement in price has same money value. For example, sterling/us$ contract standard size is sterling 62,500/-. The price is in us$ and tick size is $ 0.0001, which means each tick value is $ 6.25. If a trader is holding a long position and price of future increases, then there’s profit and fall in value represents loss. If trader is holding is short position, rise in future value represent a loss, fall in price profit. Like forward contracts, currency futures have also two-scenario: receipt of FCY and payment involving FCY. Currency Market Hedging – FCY payment in future: A company might have an exposure to a future payment in a foreign currency. It can hedge the exposure by arranging to buy the currency forward using futures. When the payment is actual made, the currency to make the payment should be purchase spot. The futures position should be closed. If there is a gain on the future position, this might be used to make some of the payment. Example – currency futures – Scenario - future payment in FCY A Pak company bought goods for $ 900,000/- in December and needs to settle in May. Due to the sensitivity of exchange rate of $/PKR the company intends to hedge this transaction exposure with currency futures. The spot rate when the goods were purchased was us$ 1 = PKR 60.1559. The $/PKR May futures contract is currently priced at us $ 1 = PKR 60.1585. Assuming that the spot rate when goods are paid is US$ 1 = PKR 60. 2171 and June futures are priced at us$ 60.2201. How can company hedge this transaction with currency future? US $ 900,000.00 SPOT RATE DECEMBER PKR 60.1559 FCY FUTURE - DEC PKR 60.1585 SPOT RATE JUNE PKR 60.2171 FCY FUTURE - JUNE PKR 60.2201 BUY IN DECEMBER AND WILL SELL IN JUNE. PKR/$ US$ PKR DECEMBER - FCY FUTURES PURCHASED 60.1585 900,000.00 54,142,650.00 IN MAY - WHEN PAYMENT WILL BE MADE IN US $ 60.2201 900,000.00 54,198,090.00 GAIN ON SALE OF FCY CONTRACTS 55,440.00 MAY - NEED TO BUY US $ AT SPOT RATES TO MAKE PAYMENT 60.2171 900,000.00 54,195,390.00 LESS: PROFIT / GAIN ON FCY FUTURES (55,440.00) NET COST 54,139,950.00 EFFECTIVE EXCHANGE RATE 54,139,950.00 900,000.00 60.1555