Hedging has been defined in various ways to mean the approach which a company utilizes to eliminate foreign exchange risk while still maintaining its business operations with regard to financial transactions with other countries (Oliver, 2000, p. 41). It follows therefore that when corporations are dealing with payables and receivables, they must exchange their home currencies with foreign currencies and vice versa. Following the increased volume of world trade and the permission of exchange rates of major currencies to float freely against one another, there has been a significant escalation of foreign currency risk which has greatly affected many international trade companies (Raimond Shohreh, n.d). In addition, for investors planning to diversify their portfolios in the international market fluctuating exchange rate together with investments in domestic assets, have also escalated foreign currency risk. It follows therefore that unlike in some major multinational companies that utilize various tools to minimize on foreign currency exposure other companies on the other hand are limited to their hedging options to their foreign exchange rate risk (Raimond Shohreh, n.d).
Raimond Shohreh notes that in order to manage the currency risk effectively, different approaches have been utilized ranging from multi-currency diversification, currency swaps as well as hedging techniques such as future, forward and options providing different degrees of profits potential and risk reduction. As a result hedging has been very instrumental not only in protecting corporations from incurring and offsetting losses but also ensuring that these corporations realize profits from foreign exchange.
Hedging with Forwards
These are the customized agreements among parties to fix the exchange rate for a determined future transaction meant to eliminate risks associated with exchange rate volatility. One assumption made in this form of hedging is the provision that a party will easily get a counter party who will agree to fix future rate for the time period and amount in question.
Hedging with futures
Here the parties agree today to buy or sell a particular currency at a future date at a particular price which they agree today. Despite future hedging sounding more like forward contract, future hedging is considered more liquid because it is traded in an organized exchange of the future market. In future hedging, one needs to buy futures if the risk constitutes an appreciation of value. On the other hand, if the risk involves depreciation of value then one need to sell futures (Oliver, 2000, p. 4).
Hedging using Options
In currency option, the parties enter into contract whereby the buyer of an option has no obligation but the right to sell or buy a specified currency from the seller of the option at a specific exchange rate before or at a specified date. Hence in hedging option, the buyer enjoys the right while the seller of the option on the other hand enjoys an obligation. Therefore with option market hedge, the current MNC will be protected from adverse exchange rate movements and still allow this MNC to benefit from favorable exchange rate movements (Oliver, 2000, p. 3)
Through call options, this MNC will be able to cover currency risks for the accounts payable
Call option helps MNCs to manage currency risks for accounts receivable
Money Market Hedge
This involves entering into a contract and then looking for the source of the fund to implement that contract. Hence in order to hedge exposure of transaction this technique differs from forward contract in that in money market hedge the cost is determined by the differential interest rate while in forward hedge cost is from discount or premium (Oliver, 2000, p. 7).
Other hedging Techniques
A cross Hedge- is normally applicable when there both forward and future markets are not available. The technique is designed to hedge exposure in one currency through the utilization of other contract or future on another currency that has an association with the first currency (Nerijus, 2008, p. 71).
A swap-market hedge- this takes the form of a credit swap, a currency swap, an interest rate swap, and back to back loans. It is an agreement between two parties to exchange cash flows in two different currencies between two MNCs (Nerijus, 2008, p. 79)
Exhibit 1. Review of Techniques for Hedging Transaction Exposure
Hedging techniqueTo Hedge PayablesTo Hedge ReceivablesFuture HedgePurchase a currency futures contract(s) representing the currency to the PayablesSell a currency future(s) contracts representing the currency and amount related to the receivablesForward hedgeNegotiate a forward contract to purchase the amount of foreign currency needed to cover the payablesNegotiate a forward contract to sell the amount of foreign currency that will be received as a result of the receivablesMoney market HedgeBorrow local currency and convert to currency denominating payables. Invest these funds until they are needed to cover the payablesBorrow the currency denominating the receivables, convert it to the local currency, and invest it. Then pay off the loan with cash inflows from the receivables.Currency Option HedgePurchase a currency call option(s) representing the currency and amount related to the payablesPurchase a currency put option(s) representing the currency and amount related to the receivablesSource International financial management By Jeff Madura online on fileCkimkimhedgingHEDGINGbest20material20for20hedging20techniques.htmvonepageqffalse
Forward Exchange Rate
Forward exchange rateSpot Price future value of quote currencyfuture value of Base currency
Forward exchange rate S(1rq)n
(1rb)n where Sspot Price
rq interest rate of quote currency
rb interest rate of base currency
n number of compounding periods
httpthismatter.commoneyforexfx_forwards.htm
Cash flows on the other hand have been defined to mean the difference between the money in and the money out. It is from cash flow that a company will realize that an over flight of debt is normally an indication of a company failure whereas an over flight of the liquid funds is a sign of success. Altogether, cash flow as a factor of valuation is a fundamental attribute for prediction regarding the future of the company.
Computation of cash flows
Foreign transaction hedged using Money Market Hedging under Interest Rate Parity and FX spot-forward arbitrage or covered interest arbitrage method
The current research will utilize Cross forward contract but under Interest Rate Parity and FX-spot forward arbitrage which is also known as Covered Interest arbitrage. This is based on the underlying problem of having alternative options in hedging using option while lack of data and other information which could allow making of future predictions poses a great problem of utilizing the future hedging technique (Khoury Chan, 1988, p. 13) The application of forward hedging technique presumes that in hedge receivables the forward contract representing the amount receivables will be sold. On the other hand, in hedge payables it is presumed that currency amount representing all payables will be bought. This as a result will help to easily eliminate the exchange rate risk. More still, the model will assume that there is a formal trading facility between parties (Sayuri, 1997, p. 47).
Let X and Y be the domestic currency and foreign currency respectively in which payables or receivables are dominated. In this case if the amount payable or receivable is K units of Y due at (tn), where t represents the time at which the transaction is concluded, it follows that the domestic currency value payables or receivables under no hedging decision, (Schooley White, 132)
Hence, VN KStn (x y)..(1)
Where Stn (xy) is the spot exchange rate that will prevail at time tn
However, since the exchange rate at time t is not known, it means that fluctuations of the spot exchange rate between time t and tn will result to the rise of foreign exchange risk.
Money Market Hedging
In order to meet the payables or receivables the MNC will require the present value of K. in this case K(1i) where i is the interest rate of foreign company. The domestic currency value of the present value of receivables or payables is equivalent to KS (1i). This amount is initially borrowed and finally when it is repaid at time tn, the total of interest and principal amounts to KS (1i) (1i), here I is the interest rate of the domestic company covering period between t and tn. based on this therefore, the domestic currency value of receivables or payables which is locked with the help of market hedge is
Vr KFt where F-bar is the interest parity forward rate, hence
Ft (F-bar) St (1it). (2)
(1it)
It should be noted that whenever FtFt (bar) then the covered interest parity holds hence there is no difference between money market hedging and direct forward hedging. Tabulations are as per Excel sheet attached.
RECEIPTS
Letin Inc. in Mexico (amount MXN 2,600,000 spot rate 18.5665).
Hence Forward rate 1 (4.5 35360) 1 (8.10 35360) spot rate
(1 0.004375) (1 0.007875) 18.5665
0.996527347 18.5665 18.50202499
Forward rate 18.50202499 peso per pound on 4th February. 2010.
Now using Covered Interest Arbitrage
MXN 2,600,000
At 4.5 interest (0.0452,600,000)...............2,717,000
MXNUK Spot rate18.5665
Sell MXN 2,600,000 worth of Euros (18.56652,600,000)48,272,900
Value at 8.1 (0.081 48,272,900) (48,272,900) 52,183,004.9
Forward rate 18.50202499
(52,183,004.918.50202499) 2820394.25
The company will sell MXN 2,600,000 at forward rate 18.50202499 thus receiving amount of money in pounds 2820394.25-2717000 103,394.25 on 4th Feb. 2010.
Part B
Possible sources of international short-term financing to reduce cash deficit
In reference to Hallit (1999, p.88) diversified Multinational Corporations which have their operations in different countries are better positioned to utilize more debt in financing as opposed to domestic firms. This is based on the notion that these MNCs are more likely to diversify their cash flows which reduces their potential in experiencing fluctuation in their profits while helping in reducing risk of bankruptcy (Rawls Smithson, 1990, p.88). However, many corporations periodically require short-term financing decisions mainly to support other parallel operations. Based on the fact that MNCs have access to other sources of funds, their decisions for short-term financing are complex as compared to other corporations. However, they are advised to determine for the availability of any internal funds before they opt for outside sources. Parent corporations for various MNCs can provide for short term financing and especially by increasing their markups on the supplies that they send to their subsidiaries. In this case, financial managers have great tasks in determining the various advantages as well as disadvantages associated with various short-term financing.
Euro notes
These are unsecured debt securities with a maturity rate ranging from 1-3-6 months and underwritten by commercial banks. The interest rate on these notes is normally based on the interest rate that any Euro bank will charge the respective interbank loans. Euronotes could take the form of such facilities like note issuance facilities (nifs), standby note issuance facilities (sniffs) which are considered substantially cheaper source of short-term funds as compared to syndicated loans the reason being that Euronotes are placed directly with the investor public in form of underwritten and securitized form that normally allow the establishment of liquid secondary markets. To this end, some MNCs will tend to roll over Euro notes as a form of intermediate-term financing to maximize the value of that particular MNC (Jeff, 2007, p.582).
Use of Euro-commercial papers (ECP)
Many MNCs will seek to obtain short-term financing through the issuance of Euro-commercial paper. This approach is fundamental with regards to the fact that many dealers will take to issue the paper without reference to back up of an underwriting syndicate. The method has advantages based on the provision that, it is possible to tailor the maturities in preference to the issuer. On the other hand, dealers normally offer to repurchase the Euro-commercial paper right before its maturity through its secondary market the paper is normally sold at a discount or with a stated coupon. However despite the fact that many banks are in a position to issue the note in any major currency, 90 of the issue of the note is mainly through the U.S Dollar (Jeff, 2007, p.583).
Direct Euro bank loans
Another source of short-term financing for MNCs is the direct loans from Euro banks which is normally made use off immediately other sources of short-term financing is unavailable. This source of financing is meant to maintain a relationship with Euro banks and especially through credit arrangement with various banks worldwide (Jeff, 2007, p.583).
Part C.
Revaluation and devaluation under the system of a fixed exchange rate is the official changes in the value of a particular countrys currency relative to the currencies of other countries. On the other hand, under the system of floating exchange rate, a country experiences currency depreciation or appreciation in respect to the value of other countrys currency which are normally generated by market forces. Under the system fixed exchange rate, and by the influence of market forces, both revaluation and devaluation may be conducted by the policy makers (David, 2002, p. 7).
Macroeconomic factors
The microeconomic factors that should be considered are GDP (Gross Domestic Product), unemployment rate, inflation rate, interest rate and the level of exports and imports. Below is a comparison of Russia and Japan in the macroeconomic factors to determine the appropriate investment destination between the two countries. Russias commodity driven economy GDP growth rate for the first quarter 2010 is 2.90 which is 2.59 of the worlds economy, in 2009 and 2008 the GDP averaged at -7.93 and 5.90 respectively. The GDP has been on a constant decline over the past four quarters. This years growth is attributed to the increases in oil prices, low rates of interest and economic stimulus programs. Japans industrialized economy GDP growth rate for the first quarter of 2010 is 5.00 . This makes up 8.2 of the world economy the second largest economy in the world. In 2009 and 2008 the GDP averaged at -0.98 and -4.18 in that order. Japan has a well educated human capital and is largely efficient in its international trade but has expenditures of raw materials which are deficient in the country (Fedec, 2010). Japans interest rate is 0.10 while Russias interest rate is 7.75. Though higher than Japans, Russias interest rate has been low historically, this has caused a cut back in the refinancing rate to 8 by its central bank and thus its future growth prospects are assured (Fedec, 2010).
Inflation is the rise in prices in the general economy against standard purchasing power. Japans rate of inflation stands at 0.7 in June, its average inflation for 2009 and 2008 were -1.70 and 0.40 in that order. This level of inflation was accompanied by a 2.1 drop in consumer prices this however does not divert the pressure on the central bank to address deflation. Junes 2010 inflation for Russia is 5.80, its average inflation for 2009 and 2008 were 8.80 and 13.30 in that order (Trading Economics, 2010). In terms of unemployment, Russias unemployment rate from January to June 2010 averages 8.1 , in comparison with the previous year 2009 whose unemployment rate stood at 8.41. Japans rate of unemployment from January to June 2010 stood at 5.1 a comparative percentage to the previous year 2009 whose unemployment rate stood at 5.1 (Trading Economics, 2010). Japans high levels of unemployment are impeding the economys recovery from recession however the Prime Minister has put in place a package that will lower inheritance tax to encourage the passing of inheritance to young people and in the process spur the creation of jobs (BBC, 2010). Russias unemployment was highest in January where a staggering 6.8 million people did not have jobs and 630,000 lost their jobs in the same month. This trend is expected to continue as the resources given to regional governments to continue paying industrial workers who have been rendered idle by slowing stagnation dries up (Andrea, 2010)
In May 2010, the exports from Russia were US 31.6 Billion, being mainly dominated by oil and natural gas. Thus international energy prices are critical to Russias economy. In 2007 the exports made up for 8.7 of GDP. Russian exports are mainly raw materials such as minerals and fertilizers. Its fishing industry is number four in the world. Exports from Japan were valued at JPY YEN 5027.6 billion in May 2010. Japans economy is heavily reliant on exports for growth, exporting electronics, optical fibres, copiers and automobiles. Although the exports in June 2010 were higher than the previous years the rate of increase however slowed for the fourth consecutive month. This is an indicator that Japans path to economic recovery is being checked by declining oversees demand (Trading Economics, 2010). Russias imports for May 2010 were US 19.4 billion. According to CIA (2010) its imports for 2009 totalled 191.8 billion in comparison to 2008s 291.9 billion which was a remarkable decline. Japans imports for May 2010 were worth JPY YEN 4636.6 billion, these imports are mainly raw materials for processing. Its total imports for 2009 were 499.7 billion a decline from 2008s 708.3 billion (CIA, 2010).
Managing Political Risks
In todays increasingly global market place, risk management is of great importance to the consequences of economic investments. Apart from managing risk, determining the appropriate way and method to mitigate risks is paramount to the ultimate success of the investment. In money market for instance of the major and inherent considerations should be the political risk of the host country. Alan, Aitken Vrooman (2) provides that whenever an investor of foreign currency is evaluating a prospective investment, it is fundamental to also evaluate and manage political risk in addition to market and geological risks. With the current example, while considering devaluation and revaluation of currency in Russia and Japan respectively, there is great importance attached to exchange rate coverage as well as mitigation of political risks of the two nations. This relates to the fact that currencies for the two countries are not in fixed rates rather they are prone to vary dependent on a multitude of factors such as political instability, demand and supply, speculative movements, political-economic situation as well as variations in monetary interest.
Consideration of political risk therefore is paramount in the evaluation of revaluation in Japan as well as devaluation of currency in Russia especially to help cater and protect against any loss due to host government actions which in a way may eliminate or even reduce control. Hence it will cover for nationalizations, explorations and even confiscations.
Japans political risk can be viewed in five ways its fiscal dilemma, governance challenges, the independence of central bank, currency intervention and the funding that goes to scandals. The government in place is undecided between recession avoidance through economic stimulation and the growing dissent among the public and investors of the sky rocketing public debt (400 of GDP). There is an increase in the bond yields and government revenue is less than half of government spending. The current government won after a pledge to reduce wasteful spending, but government spending continues to increase. There are plans for extra stimulus budget, but this is worrying as it can renew recession and deflation. On issues of governance, the Democrats in power in their bid to transfer policy making from bureaucrats to politicians have caused rifts in the cabinet. The Democrats need to win to their side some tiny parties if they are to pass any legislation. The delays in the resolution of Futenna Marine Base problem with the U.S could make the relations between the two countries sour, resulting in the loss of major Japanese export market. The Bank of Japan (BOJ) is facing pressure from cabinet ministers who fear that if the bank withdraws from emergency steps to foster corporate funding the economy which is slightly in balance may topple. If deflation persists BOJ will be pressured to purchase more government bonds. The Finance minister has argued that the Yen should be manipulated contrary to economic fundamentals which would make the Yen strong to cut down over dependence on exports, Yen intervention is likely to occur if the currency moves too far. The funding of scandals has cast doubts on the government. Dissent is increasing over this issue and the Prime Minister may be forced to resign if the scandals continue. This occurrence may throw the country into disarray (Marshall Rodney, 2010, par.1-6). On the other hand the according to the Eurasia Group (2010, p.1) Russias ability to withstand both external and internal shocks stands at 63 points, below the 80 point mark of highly stable countries. The relatively unstable state of Russia is due to its war with Georgia which saw a massive withdrawal of investments from the country. In 2008 its Foreign exchange reserves dropped by 16.4 billion in a week (from August 8 to 15). Though the Georgian conflict did not adversely affect the economy it exposed Russias vulnerabilities. Indeed central Asian states are skeptical of the troubled gas routes to the West that bypass Russia.
Under What Circumstances Might a Country Devalue
In a particular country, when the interaction between the policy decisions and the market forces make it untenable the currencys fixed exchange rate, it becomes inevitable for that particular government to devalue its currency (Raimond Shohreh (n.d). It follows that in order to ensure sustenance of fixed exchange rate by a particular country, then that particular country need to have sufficient reserves in foreign exchange mostly in form of Dollars and still be willing and able to spend the same in purchasing of various offers of its currency at the prevailing exchange rate. To this end therefore, when a country is not willing or is unable to do so, then it resorts into currency devaluation to such a level capable of supporting its foreign exchange reserves.
What are the possible implications of currency devaluation
The implication of the Devaluation of a particular countrys currency is two fold. Since it makes the currency of that particular country cheaper, then it follows that devaluation will make that countrys export relatively cheaper for other countries (Raimond Shohreh (n.d).On the other hand, imports from other countries will be discouraged owing to the fact that products from foreign countries will be made relatively more expensive for domestic consumers. This as a result will decrease the imports of that particular country while increasing its export thereby reducing the current account deficit (David, 2002, p. 23).
Relationship between Interest rate and the value of currency
In economics, when the countrys interest rate increases, the value of currency of that country tends to increase in value. This is mainly based on the fact that when interest rate of that particular country goes up, due to the increased rate of return from investments foreign investors are attracted causing the demand for domestic currency to increase in value. On the other hand, when it happens otherwise, (devalues), that countrys export become cheaper relative to foreign countries while imports become more expensive. This as a result reduces the overall aggregate demand with resultant reduced employment (Stephen Agnes, 2009, p. 124).
The case of Russia
For the case of Russia, there is need to devalue its currency as a policy tool to stimulate fledgling export by relieving the unfavorable balance of trade. From the case scenario, Russia has a high interest rate and as well as inflation rate and with zero rates of unemployment it means that in Russia the aggregate demand is high which may result to a further inflation rate. Comparatively, the balance of trade for both Japan and Russia is favorable as indicated by the level of current account balance however, for Russia the situation is relatively better as opposed to Japan. This means therefore, the exports in Russia are more favorable and attractive to foreign countries relative to imports, (Stephen Agnes, 2009, p. 16). This means that weakening the currency exchange rate will make its export prices to rise which will allow it to remain competitive in the short term and more competitive in the long run. This will have a positive implication for the country Russia as well as to the mother company, GHWB Manufacturing Plc, because it will mean that by Russia remaining more competitive while still getting paid less for every export, it will not only benefit from selling more in order goods to earn as much as they did before, but will have an added advantage of utilizing the opportunity fully to sell more by remaining competitive (Halit, 2001, p. 71).
In reference to Raimond Shohreh (n.d) for the GHWB Manufacturing Plc, there will be increased economic strength, balance of payments surplus and profit potentials. Hence with currency devaluation, Russia will be able to adjust the exchange rate, reduce the prices of exports so as to remain competitive in the markets with a resultant massive selling and hence potential increase in total profits. On the other hand, since devaluation of currency means that reduced liabilities and especially with debtor countries, then it means than this MNC will be privileged to service its loans cheaply (Stephen Agnes, 2009, p. 71).
Revaluation
Currency revaluation is defined as the calculated adjustment to a countrys exchange rate with respect to a selected baseline like foreign exchange wage rate among other parameters. Unlike in currency devaluation where the direct cost is borne by the government, the price of currency revaluation is normally paid by the exporters of that country. Based on this therefore, it follows that speculative devaluation are government misfortunes while speculative revaluation mainly concerns the financial risk managers. From the given scenarios in order for Japan to realize sustainability in the growth and development of its economy which will then help the country to integrate efficiently with the global financial markets, then it will be needed to increase the value of its currency, increase interest rate and reduce the rate of unemployment. This will be achieved through currency adoption of market-driven as well as flexible currency, (Nerijus, 2008, p. 9).
In order for Japan to lift capital controls and untether its currency, it will be needed to raise the interest rates geared towards stemming the capital outflow, cool the credit boom and investment without derailing growth. By adopting currency revaluation strategies which will be inflationary in nature as it will make Japanese goods more expensive which will ultimately boost the financial transactions with GHWB Manufacturing Plc. From the case scenario, since Japan has a relatively low employment rate, low interest rate, it follows that there is need to revalue its currency exchange aimed at increasing the aggregate demand to realize full employment and higher favorable balance of trade (Stephen Agnes, 2009, p. 36).
Implication of revaluation policies on GHWB Manufacturing Plc
Following the above discussion, it means that if the GHWB Manufacturing Plc. Decides to invest in Russia, devaluation of the currency exchange will have such implications like.
Increased export devalued currency against a counter foreign currency will boost the performance, profit and revenue by highly encouraging domestic firms to export in return of foreign currency. On the other hand, foreigners will increase their demands for the domestically produced goods (Nerijus, 2008, p. 9).
Discourage importation since devaluation will result to a low value of the domestic currency, then domestic firms will not be able to make higher imports. This as a result will mean reduced competitions between domestic firms and the foreign one hence increased freeness in their operations as well as increased profits (Stephen Agnes, 2009, p. 11).
Increased foreign currency reserve GHWB Manufacturing Plc will benefit from increased foreign currency reserve following increased export above imports. This will ensure its wellness in currency exchange business (David, 2002, p. 12).
Revaluation on the other hand which will reduce competitiveness and increase the flexibility of currency exchange will have a negative impact on increased and heightened uncertainties and particularly in cross-border economic operations following increased investment and rising prices of corporate goods (Khoury Chan , 1988, p.3). On positive aspect, revaluation will help in reducing import prices enhance purchasing power which will ultimately help in curbing inflation. However, as Sohnke (2006) notes, revaluation need to be executed at a moderate pace since a sudden and large revaluation may result to hurting both direct investment and exports that it can help consumption.
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