Page 1 of 2 BFW2341 INTERNATIONAL FINANCIAL MANAGEMENT SEMESTER 2 2017, ASSIGNMENT TASK 1 ASSESSMENT WEIGHTAGE: 30% DUE DATE: FRIDAY 22 rd SEPTEMBER 2017 by 12.00 noon Part A: Managing Transaction Exposure (20%)
American Fast Track Inc. (AFT) operates high speed rail services in the U.S. AFT has placed an order to purchase rail cars from the Xinjiang Locomotives of China in June 2017. AFT has ordered 20 units of Multi-speed rail cars at the quoted price of USD2.5 million each, which totals to a payment of USD50 million. All the 20 units of this rail cars will be delivered deli vered to AFT in December 2017. AFT has agreed to pay 50% of its payable when the order is delivered and another 50% to be settled in June 2018. Xinjiang has invoiced this order in i n USD and will receive its receivables in i n USD. As the receivable amount is substantially large in USD, Xinjiang will face the exchange rate risk if i f USD continue to depreciate against the Chinese Yuan. Background
Since the beginning of 2017, the U.S. dollar had been steadily depreciating against the t he Chinese Yuan (CNY). In January 2017, the dollar was trading around CNY7.22573/$ and by June 2017, i t softened to 6.72475/$. This represented a 8% depreciation of the dollar against the CNY. Although many analysts had concluded that the U.S. dollar was undervalued during this period, it continued to show signs of weakening. Government interventions to strengthen the dollar was not being discussed at this time. time. Issue
While many forecasters were predicting an eventual appreciation of t he U.S. dollar, for Xinjiang, the size of this contract which was denominated in U.S. dollars was seen as too large a transaction to be left uncovered. Therefore, you have been contacted by Xinjiang to analyze and recommend alternatives as to how this locomotive company can hedge its U.S. dollar transaction exposure. Data
Having collected the CNY/US$ exchange rates from various financial institutions that have a dedicated foreign exchange department, you are provided with the following quotes: Spot Exchange rate 180-day Forward 360-day Forward CNY 6.72475/$ CNY 6.62335/$ CNY 6.22755/$
Page 2 of 2 Not satisfied with the lack of risk risk management opportunities, opportunities, you decided to contact a few banks banks to obtain the latest interest rates: U.S. 180-day interest rates : 4.000 – 4.345% 4.345% p.a. U.S. One year interest rates : 4.255 – 4.500% 4.500% p.a. China 180-day interest rates : 2.323 – 2.452% 2.452% p.a. China One year interest : 2.001 – 2.225% 2.225% p.a. rates The risk management executives at the banks you contacted also provided you with another alternative, which is to manage the exposure via currency options contracts. The available derivatives are as follows: Option Contract On USD On CNY Strike Premium Strike 180-day Call Option CNY 6.500/$ CNY 0.03/$ 180-day Put Option CNY 6.650/$ CNY 0.05/$
Premium CNY 6.700/$ CNY 6.600/$
360-day Call Option 360-day Put Option
CNY 6.300/$ CNY 6.250/$
CNY 0.02/$ CNY 0.04/$
CNY 6.520/$ CNY 6.500/$
(a) Based on the information provided, analyze all possible alternatives for managing the foreign exchange risk exposure in the scenario above, and make a recommendation for the best alternative. (15%) (b) Justify your recommendation(s). (5%) Part B (continuation of the above scenario, 10%)
On December 2017 and in June 2018, if the actual exchange rates between the U.S. Dollar and the Chinese Yuan is CNY6.8255/$ and CNY6.950/$ respectively: 1. How much unrealized gain / loss did Xinjiang face through your recommendation(s) from Part A during both the settlement periods? (3%) 2. In not more than 1,500 words: (7%) i.
Explain how the unrealized gain / loss happen in each period of settlement.
ii.
Explain whether managing foreign exchange risk is worth the amount of effort required.
iii.
Explain whether a company like Xinjiang should just choose to remain unhedged.
Please note that this is an essay. Therefore, all essay requirements, as can be found in your Qmanual applies. Students who do not abide by the guidelines will be penalized. Your marks will depend upon accurate calculations of the hedge alternatives and logical decisions made as the outcome of the analysis in part A. As for part B, marks will be awarded for clear explanation on issues raised and logical explanation backed by appropriate choice of theories articulated based on the units teaching.
Page 2 of 2
Introduction
Exchange rate risk management is an integral part in every firm’s decisions about foreign currency exposure (Allayannis, Ihrig, and Weston, 2001). Currency risk hedging strategies entail eliminating or reducing this risk, and require understanding of both the ways that the exchange rate risk could affect the operations of economic agents and techniques to deal with the consequent risk implications (Barton, Shenkir, and Walker, 2002). The issue of currency risk management
for
non-financial
firms
is
independent
from
their
core
business and is usually dealt by their corporate treasuries. Most multinational firms have also
risk committees to oversee the treasury’s strategy in managing the exchange rate (and interest
rate) risk (Lam, 2003). A common definition of exchange rate risk relates to the effect of unexpected exchange rate changes on the value of the firm (Madura, 2006). This essay will analyze the alternatives of how Xinjiang Locomotive of China can hedge its U.S. dollar transaction exposure as the exchange rate risk of USD continue to depreciate against Chinese Yuan, as Xinjiang is involved in receivable transaction exposure.This is an important matter for Xinjiang to hedge its exchange risk as the transaction involved a huge amount of money, USD50 million with American Fast Track Inc, (AFT) from United States. The issue regarding this situation is although many forecasters were predicting an eventual appreciation of the U.S. dollar, for Xinjiang,the seize of the contract which was denominated in U.S. dollar was seen as too large a transaction to be left uncovered. Therefore, this essay will suggest the best alternatives on how Xinjiang company can hedge its U.S. dollar transaction exposure. Transaction exposure is a degree to which the value of future cash transactions can be affected by exchange rate fluctuations (Madura, 2006). In this essay, there are four hedging alternative techniques that will be discussed. These are to remain unhedged (remain exposed), hedging with currency forward contracts, hedging with money market hedge (MMH) and hedging with options contract (Part A). It also will discuss relating to the how much unrealized gain or loss did Xinjiang face through the alternative that will be chosen as well as whether managing foreign exchange risk is worth the effort required followed by a question whether a company like Xinjiang should just choose to remain unhedged (Part B).
The first technique is by remain unhedged. Suppose that Xinjiang decides to accept the transaction risk by not entering any hedging propositions.According to IRP if calculate the future spot rate of receivable at 180-day and 360-day, the future spot rate would be CNY6.66596/$ and CNY6.57885/$. Therefore the expected value of cash to be received by Xinjiang is CNY 166,649,000 which is uncertain, receivable in December 2017 and CNY164,471,250 receivable in June 2018. If we add the two periods of the receivable amount above, the total expected value of cash to be received is CNY331,120,250 for Xinjiang as a result of the foreign exchange transaction with American Fast Track Inc, (AFT) from United States. However, if the future spot rate is CNY6.72475/$, Xinjiang will receive only
CNY168,118,750, which is CNY1,469,750 lower in December 2017 and CNY3,647,500 lower receivable in June 2018.
Receivable
Expected
Future Expected Value from Remain
time
Spot Rate
Unhedged
December
CNY6.66596/$
CNY166,649,000
($25,000,000×
(uncertain)
CNY6.66596/$)
CNY164,471,250
($25,000,000×
(uncertain)
CNY6.57885/$)
2017 June 2018
CNY6.57885/$
Total
CNY331,120,250
The second technique is by using Forward Market Hedge. Forward contracts allow a company to set the exchange rate at which it will buy or sell a given quantity of foreign currency in the future (on either a fixed date or during a fixed period of time). They are flexible instruments that can easily match future transaction exposures (generally up to one year). Hedging in forward market here means selling $25,000,000 forward at the 6-month (180-day Forward) rate of CNY6.62335/$. And selling the othe $25,000,000 forward at the 12-month (360-day Forward) rate of CNY6.22755/$. In 6-month (December 2017), Xinjiang will receive $25,000,000 and exchange them at a rate of CNY6.62335/$, receiving CNY165,583,750 with certainty. In 12-month (June 2018), Xinjiang will receive $25,000,000 and will also exchange them at a rate of CNY6.22755/$, receiving CNY 155,688,750. In December 2017, the amount money received is CNY1,065,250 less than the uncertain CNY 166,649,000 expected from the unhedged position.While for December 2018, the amount receive is CNY 8,782,500 less than the uncertain CNY 164,471,250 expected from the unhedged position. The total amount receivable in both settlement period of December 2017 and June 2018 is CNY 321,272,500 which is certain.
The forward contract creates a foreign exchange loss of CNY 2,535,000 {($25,000,000×(6.72475-6.62335)}in
December
2017
and
CNY12,430,000
{($25,000,000×(6.72475-6.22755)}.
Contract
Rate
Receive from Forward Contract
180-day Forward
CNY6.62335/$
CNY165,583,750 (certain)
($25,000,000×6.62335)
360-day
CNY6.22755/$
CNY155,688,750
Forward
(certain)
Total
CNY321,272,500
($25,000,000×6.22755)
(certain)
The third technique which can be use by Xinjiang is using Money Market Hedge. A money market hedge on receivables involves borrowing the currency that will be received and using the receivables to pay off the loan (Madura,2006). To hedge in the money market, Xinjiang will borrow dollar in New York (country where the receivable originates). The first step that Xinjiang can do is by calculating the amount to borrow. Xinjiang needs to discount the present value of $25,000,000 at the U.S. borrowing rate. Thus Xinjiang must borrow $24,468,423.4995 today and repay $25,000,000 in 180-day (6 months) with the proceeds from sale. This hedge creates a dollar denominated liability that offsets with a dollar denominated assets, thus creating a balance sheet hedge. In December 2017, the total assets is $25,000,000 while liabilities and equities which is include the bank loan (principal) with $24,468,423.4995 and interest payable $531,576.500527 ($24,468,423.4995×0.021725). In June 2018, the total assets also $25,000,000, and from the liabilities and equity side the bank loan(principal) contribute for $23,923,444.9761 and interest payable is $1,076,555.02392. Therefore, Xinjiang should borrow $24,468,423.4995 today and and in 6 month time repay this amount plus $531,576.500527 in interest ($25,000,000) from the proceeds of the sale directly from American Fast Track Inc, (AFT). The next step is to convert the sum borrowed in New York ($24,468,423.4995) for 180-day and $23,923,444.9761 for 360-day at the spot rate of CNY6.72475/$. And it will get CNY164,544,030.928 receivable in December 2017 and CNY160,879,186.603 in June 2018. The next step is the sum borrowed and converted earlier can now be invested in 6 months and 12 months at the China investing rate of 2.323% and 2.001%.The future value will then beCNY166,455,209.847 and CNY164,098,379.127. The total expected value of cash to be received on both periods is CNY 330,553,588.974. These amounts are guaranteed. Amount
U.S 180-
to borrow
day
$25,000,000/(1+0.04345:2)
$24,468,423.4995
$25,000,000/(1+0.045)
$23,923,444.9761
interest rates U.S. One year
interest rates Convert
180-day
$24,468,423.4995× CNY6.72475/$
CNY164,544,030.928
360-day
$23,923,444.9761× CNY6.72475/$
CNY160,879,186.603
Invest in
180-day
CNY164,544,030.928×(1+0.02323:2
CNY166,455,209.847
China
(2.323-
interest
2.452%)
CNY160,879,186.603×(1+0.02001)
CNY164,098,379.127
the
sum
borrowed
rates 360-day (2.0012.225%) Total
CNY 330,553,588.974
The last technique is by using Options Market Hedge. Currency options are other tools that can be used to mitigate transaction exposure. Standard options give a company the right, but not the obligation, to buy or sell foreign exchange in the future at a pre-determined exchange rate. Because these options do not oblige the company to sell or buy foreign currency (contrary to forward contracts), they are often used by companies that bid on contracts. Currency options allow companies to benefit from favourable movements in exchange rates, which is why most types of currency options carry an upfront cost(EDC, 2010). In the case of Xinjiang, it could cover $25,000,000 exposure by purchasing a put option on USD. The limits downside risk while allowing for gains if the dollar appreciates. Xinjiang could purchase a 180-day Put Option on USD with strike price of CNY6.650/$ sells at CNY0.05/$ premium. The cost (premium) of this options would be CNY1,250,000 payable now, and need to borrow this money at the borrowing rate of 2.452%p.a, the result will be CNY1,265,325(CNY1,250,000×(1+2.452%:2). If exercised, the $25,000,000 will be sold for CNY at the strike price agreed CNY6.650/$ equals to
CNY166,250,000.
After
paying
the
option
premium
the
net
proceed
is
CNY164,984,675(CNY166,250,000-CNY1,265,325). The option will not be exercised if the spot rate in 6 months is greater than CNY6.650/$. For 360-day Put Option, the strike price is CNY6.250/$ and a premium of CNY0.04/$. The cost(premium) of this options would be CNY1,000,000 ($25,000,000×0.04) and need to borrow this money at the borrowing rate of
2.225% p.a, the amount would be CNY1,022,250 (CNY1,000,000×(1+2.225%). If exercised, the $25,000,000 will be sold for CNY at the strike price agreed CNY6.250/$ equals to CNY156,250,000. After paying the option premium the net proceed is CNY155,227,750 (CNY156,250,000- CNY1,022,250). The total expected value of cash to be received from both periods is CNY320,212,425. However, The option will not be exercised if the spot rate in 6 months is greater than CNY6.250/$. Below are the Summary of all hedging alternatives. The money market hedge gives the highest value of cash amongst the other. Hedging Techniques Remain unhedged
Forward Market Hedge
Money Market Hedge
Option Market Hedge
Term
Receive
180-day
CNY166,649,000(uncertain)
360-day
CNY164,471,250 (uncertain)
180-day
CNY165,583,750 (certain)
360-day
CNY155,688,750(certain)
180-day
CNY166,455,209.847 (certain)
360-day
CNY164,098,379.127 (certain)
180-day
CNY164,984,675
360-day
CNY155,227,750
Firms recognize that hedging techniques such as the forward hedge and money market hedge can backfire when a payables currency depreciates or a receivables currency appreciates over the hedged period. In these situations, an unhedged strategy would likely outperform the forward hedge or money market hedge. The ideal hedge would insulate the firm from adverse exchange rate movements but allow the firm to benefit from favorable exchange rate movements. Currency options exhibit these attributes. However, a firm must assess whether the advantages of a currency option hedge are worth the price (premium) paid for it (Marrison,2002). From the table above, the higher receivable conversion is the Money Market Hedge which can provide CNY166,455,209.847 receivable in December 2017 and CNY164,098,379.127in June 2018, with the total expected value of cash to be received is CNY 330,553,588.974 . The total value from forward contract is CNY321,272,500 which is CNY9,281,088.974 lower compared with the money market hedge. While for options market hedge, the total expected value of cash is the lowest one with CNY320,212,425, the difference is CNY10,341,163.9740 lower than money market hedge and CNY1,060,075 lower than the forward market hedge. Therefore, if the company want a certainty and do not want to risk the loss due to the movement of exchange rate, the money market hedge would be the best alternative for Xinjiang to reduce and minimize the risk of exchange rate movement, which is unpredictable in the future and can be move up or down. Moreover, the cost of money market hedge can be determined with certainty, same as forward market hedge. If the MNC does not
need any short-term funds to support existing operations, it can still obtain a loan, convert the funds to dollars, and invest the dollars in the money market (Madura, 2006). This situation gives a picture for Xinjiang, which it will receive the money in two settlement dates, if the company does not need to fund any of their short term liabilities, then the company can apply for loan and use money market hedging technique to minimize the risk of the exchange rate movement in the future. There are some disadvantages of hedging in money market, such as it is more complicated to organize than using forward market hedge, and fixes the future rate that gives no opportunity to benefit from favourable movements in exchange r ate. However, it will be compensated with the advantages by using this technique such as fixes the future rate ,thus eliminating downside risk exposure, the second one is flexibility with regard to the amount to be covered, and last but not least, money market hedges may be feasible as a way of hedging for currencies where forward contracts are not available. There is unrealized gain for both settlement periods. On December 2017 and in June 2018, if the actual exchange rates between U.S Dollar and the Chinese Yuan is CNY6.8255/$ and CNY6.950/$ respectively. Then, in December 2017 Xinjiang would have realized CNY170,562,500($25,000,000× CNY6.8255/$ ) which is higher by CNY4,107,290.153 (CNY170,562,500- CNY166,455,209.847). This turns out to be unrealized gain by not hedging in
money
market.
And
in
June
2018,
173,750,000($25,000,000×CNY6.950/$),whichis
Xinjiang higher
would by
have
CNY
realized
CNY
9,651,620.873(CNY
173,750,000- CNY 164,098,379.127). This turns out to be unrealized gain by not hedging in money market. Based on the calculation, Xinjiang earns an unrealized gain if not hedging in money market for both periods. Unrealized gain happen when a company earn a higher amount of money by not hedging. In this case, if Xinjiang not hedging in money market, given the current exchange rate on December 2017 with CNY6.8255/$, Xinjiang can exchange the dollar amount with this exchange rate, which is result in a higher amount rather than hedging in money market(CNY170,562,500 > CNY166,455,209.847). This also happen in June 2018, the exchange rate between dollar and yuan is CNY6.950/$, which means that Xinjiang can exchange the dollar amount they receive with this exchange rate. It will earn more than if it hedge in the money market (CNY173,750,000 > CNY164,098,379.127). For some companies, managing foreign exchange risk may seem too complex, costly or time consuming. Others may not know about hedging instruments and techniques or believe that hedging is a speculative activity. Yet companies that choose not to manage foreign exchange risk may be assuming that exchange rates will remain at their present levels or move in a direction that will be favourable to the company something that closely resembles speculation .Numerous studies have found that managing this risk can successfully reduce the company’s foreign exchange exposure. Managing foreign exchange risk provides numerous
benefits to many companies such as minimize the effects of exchange rate movements on profits margins, increase the predictability of future cash flows, eliminate the need to accurately forecast the future direction of exchange rates, facilitate the pricing of products sold on export markets, and protect, temporarily, a company’s competitiveness if the value of the domestic
currency moves unfavourable, thereby buying time company to improve productivity (Export Development Canada, 2010). Given the reasons above, for Xinjiang, managing foreign exchange risk is worth the amount of effort required. If a risk can be reduced at a reasonable cost, then it is generally accepted that steps should be taken by managers to protect their companies. The decision to purchase foreign exchange hedging instruments is similar to the one made when the company buys other forms of insurance. The insured risk, in this case, is the reduction in cash flows and profit margins caused by unfavourable changes in an exchange rate (Hakala,2002). Many firms do not hesitate to protect their accounts receivable from the risk of non-payment and all firms obtain property and casualty insurance. They do so in order to protect cash flow and ensure that the company’s efforts and talent are focused on its core
business activities. Many companies, particularly smaller and medium-sized ones, do not actively manage foreign exchange risk, means that they remain unhedged. This is surprising given how costly, in terms of cash flow and profitability. Unfavourable changes in the value of the Chinese Yuan against U.S. dollar. Xinjiang is involved in the foreign transaction with a company from U.S. valued USD 50 million in total, which is a huge amount of transaction. A receivable party, which will receive the money in the U.S. dollar currency than it set on the agreement, the issue faced by Xinjiang is that the USD continue to depreciating against Chinese dollar, means that it will receive the smaller amount of money if the dollar keep depreciating at the settlement dates, which is in December 2017 and June 2018. Such situation in exchange rates directly impact the profit margins of Xinjiang Locomotive that export (and receive U.S. dollars). If Xinjiang remain unhedged , then implicitly (or explicitly) Xinjiang are a ssuming the exchange rate will remain stable or trend in a direction favourable to the company, if this is the case, then Xinjiang can choose to remain unhedged. Unfortunately, this does not happen consistently over time. No one can predict the movement of the exchange rate. Therefore, Xinjiang needs to take into effort for managing foreign exchange risk. Managing foreign exchange risk does not mean Xinjiang need to forecast the future direction of exchange rates. It still can protect the company from foreign risk even if Xinjiang do not know exactly when it will get paid for the company export sales. An effective foreign exchange risk policy does not necessarily eliminate all risk, but focuses instead on protecting against those risks that are unacceptable to your company.(Barton, 2002)
Conclusion
There is no single “best” approach to use when deciding how to hedge foreign exchange risk. For
example, some companies protect only confirmed sales while ot hers protect forecasted sales. Factors such as the company’s risk tolerance, sensitivity of earnings to changes in exchange rates and the
predictability of future sales will influence this decision. The four hedging strategies is remain unhedged, forward market hedge, money market hedge and option market hedge. A company like Xinjiang that involved in a foreign exchange transaction with U.S. based company, will receive USD50 million can hedging by using the money market hedge as from the calculation above it contributes the largest amount of value of cash in the settlement date. Although the method is quite complicated, it is worth to try as the dollar keep depreciating, which will give the company less profit from the transaction. The idea of remain unhedged might be considered if Xinjiang is assuming the exchange rate will remain stable or trend in a direction favourable to the company. Unfortunately, the exchange rate keeps fluctuate in unpredictable trend. Therefore, it would be better for Xinjiang to hedge by using one of the alternative techniques such as money market hedge.
(2958 words)
References
Allayannis, G., J. Ihrig, and J. Weston, 2001, “Exchange -Rate Hedging: Financial vs. Operational Strategies,” American Economic Review Papers and Proceedings, Vol.
91 (2), pp. 391 – 395. Barton, T.L., W.G. Shenkir, and P.L. Walker, 2002, “Making Enterprise Ri sk Management Pay Off: How Leading Companies Implement Risk Management,” (Brookfield,
Connecticut: Fei Research Foundation). Hakala, J., and U. Wystup, 2002, Foreign Exchange Risk: Models, Instruments, and Strategies, (London: Risk Publications).
Jacque, L., 1996, Management and Control of Foreign Exchange Risk , (Norwell, Massachusetts: Kluwer Academic Publishers). Lam, J., 2003, Enterprise Risk Management: From Incentives to Controls, (Hoboken, New Jersey: Wiley) Madura, J, 1989, International Financial Management, 9th. (St. Paul, Minnesota: West Publishing Company). Marrison, C., 2002, The Fundamentals of Risk Measurement, (New York: McGraw Hill). Shapiro, A.C, 1996, Multinational Financial Management, 5th ed. (Hoboken, New Jersey: Wiley).
