Foreign Exchange
Rapid globalization has transformed the international business environment with a growing volatility of foreign exchange rate movements and interest rates that have significant ramifications for the method in which multinational companies handle their financial risks. These risks cannot only affect the firm’s profits, but it can dictate its survival; thus, in today’s turbulent financial markets, it is important to manage these risks.
Foreign Exchange Rate Risk
It refers to the effect of changes in the value of the corporation caused by unpredicted fluctuation in the exchange rate. It mostly results in a loss of the company’s net profit, assets, and liabilities, cash flows, and ultimately its stock market valuation (Melvin, & Taylor, 2009). Through their international operations, multinational firms engage in currency markets and are exposed to three major categories of exchange rate risk:
a) Economic risk whereby it poses a threat to the enterprise’s current value of future operating cash flows; thus it entails the effect of rate fluctuations on operating expenses including cost of imports and local inputs and revenues including exports and local sales. Economic risk affects both the parent company’s cash flow operations, as well as its foreign subsidiaries.
b) Translation risk entails the changes in the rate affecting the balance sheet. It mostly influences the value of a foreign subsidiary, and consequently its consolidation to the parent firm’s financial statements. Through consolidating financial statements at the mean exchange rate, income statements are adjusted, but balance sheets of subsidiaries are mostly translated at the current rate.
c) Transaction risk, which influences cash flows and affects the transactional account linked to the repatriation of dividends, payables, such as import contracts, and receivables including export contracts.
Over the past decades, the financial markets have become more unpredictable than ever. Corporate management views financial risk as a critical threat to company’s profitability, especially interest rate risk and foreign exchange risk, and require proper management. Thus, most companies utilize derivatives including swaps, options, futures, and forwards to hedge the risks (Bekaert & Hodrick, 2009).
Derivative Instruments and Markets
In the market for assets, sales and purchases demand that the highlighted asset be delivered shortly after or immediately. Payment is also made instantly, but credit can also be offered. These features cause the markets to be referred as spot or cash markets. On the contrary, derivative markets entail sale and purchase of contractual instruments whose potential is decided by the performance of another instrument (Bartram, Brown, and Conrad, 2011). Derivatives are contracts; thus, they are an agreement between two parties, a seller and a buyer, whereby each party performs a duty for the other. These contracts consist of a price, and sellers try to dispose of as expensive as possible while buyers try to purchase as low-cost as possible (Hong Kong Accounting Standard, 2011).
According to Bank of International Settlements (BIS), the global listed trading volume for derivatives in 2015 was 24.75 billion contracts comprising 78 derivatives exchanges globally. The trading volume was composed equally of future contracts and options with the top volume categories including equity indices, individual equities, foreign currency, interest rate, and agriculture commodities. The high growth was attributed to the increase in trading activities in Asia. The global listed derivatives volume by geographical locality for 2015 was 9.7 billion for Asia-Pacific, 8.19 billion for North America, 4.77 billion for Europe, 1.45 billion for Latin America, and others including Greece, South Africa, Israel, and Turkey for 658.1 million (BIS, 2015).
1. Option
It is a contract between the seller and the buyer, which allocates the buyer the right to sell or buy an item later at a price agreed upon right now. The option buyer remunerates the seller some money known as the premium or price. On the other hand, the option seller stays ready to buy or sell in line with the contract terms when the buyer wishes. An option to sell an item is called put while an option to purchase is called a call.
Though options are traded in coordinated markets, a larger percentage of the trading is performed privately between parties who recognize that contracting with each other may be suitable than public arrangements on the exchange, which is referred as over-the-counter options market. Common options include those for the sale or purchase of financial assets including bonds and stocks, options on foreign currencies, metals, and the futures contract, and options on financial undertakings, such as insurance, loan guarantees, and lines of credit. Additionally, stock is an option on the company’s assets.
2. Forward Contracts
It is a contract between the seller and the buyer to sell or buy an item at a later date at a price negotiated upon today. Although it sounds similar to an option, an option consists of the right, and not the obligation to conduct the transaction; thus, if the price of the highlighted product changes, the option holder may resolve to refrain from selling or buying at the fixed price. On the other hand, in a forward contract, both parties are obligated to sell ultimately or purchase the product.
Although forward markets have been in existence for a long period, they are less familiar, and unlike options markets, they are not organized, with no formal corporate body or any physical facilities. The transactions are strictly over-the-counter entailing direct communications among large financial corporations. Foreign exchange dominated the forward markets; however, recent rapid development of derivative markets has increased varieties to include oil and stock index. Forward contracts are essential in facilitating the comprehension of the futures contract.
3. Futures Contracts
It is also a contract between two parties, a seller, and a buyer, to sell or purchase something at a future period at a consideration negotiated upon today. Although future contracts develop from forward contracts and contain similar features, such as liquidity, future contracts trade on coordinated exchanges known as futures markets. It is such that, the seller who under the futures contract is obligated to sell the item at the later date, may purchase back the contract in the futures market, releasing her of the commitment to sell the good. Likewise, the buyer of a futures contract, who has the obligation to purchase the product at the later date, can vend the contract, which releases him of the commitment to buy the item (Schepker, Martynov, & Poppo, 2014).
Future contracts are also distinct from forward contracts because they are subject to a daily settlement process, whereby investors who make profits receive them from investors who have made losses. Future prices fluctuate on a daily basis, and contract sellers and buyers aim to profit from these changes in price or minimize their transaction risks in the underlying items. An option on a future contract is called futures option or commodity options and allocates the buyer the right to sell or purchase a futures contract at a later period at a consideration negotiated upon now.
4. Swap
It is a contract whereby the two parties agree to trade cash flows. In this case, one party who is acquiring revenue from one investment may prefer another category of investment where the cash flows are distinct. The party notifies a company working in the over-the-counter market called a swap dealer, who in turn swaps cash flows. Depending on the changes in interest rates or prices, one party may profit while the other incur losses. In 2015, Foreign exchange and forwards swaps contributed to 52% of foreign exchange derivatives contracts amounting to $70 trillion notional amount outstanding. Currency swaps, however, accounted for a major 52% of the gross market value. The gross market values and the notional amounts are distinct because foreign exchange derivatives have a shorter maturity than currency swaps, which are sensitive to alterations in market prices.
Some swap contracts are complex combining different elements of other types of contract and are referred as hybrids. They are an indication of financial engineering, which is the process of developing new financial products. It shows the evolving innovation of parties in today’s financial markets, who are frequently creating new and practical products to fulfill the diverse requirements of investors. These innovations and changes have resulted in enhanced opportunities for risk management.
Foreign Exchange Risk Management
Managing foreign exchange risk is a significant part of the sound and safe management of all organizations that are exposed to foreign currencies. It involves carefully controlling foreign currency positions to regulate the effect of exchange rate changes on the financial performance of the company. Over the past twenty years, there has been an exponential growth in the markets for derivative financial instruments and OTC instruments on interest rates and foreign exchange rates. Simultaneous with the rise, legislation for the disclosure of the derivative was established, compelling institutions in many nations to incorporate data on their derivative’s position in their annual financial statements (Ojo, 2010).
Although the components of foreign exchange risk management will vary among companies depending on the complexity and nature of their foreign exchange transactions, they mostly involve (a) developing and executing prudent and practical exchange risk management policies; and (b) establishing and implementing effective and suitable exchange risk control and management procedures. Managing these risks provides the following benefits:
a) Temporarily protect a firm’s competitiveness if the value of the domestic value increases, thereby providing the company time to enhance productivity,
b) Facilitates the computation of product prices traded on export markets,
c) Removes the need to precisely predict the future movement of exchange rates,
d) Increases the capacity of forecasting future cash flows,
e) Reduces the effects of exchange rate shifts on profit margin (Campello et al., 2011)
Managing foreign exchange risk is done through a four-step procedure including determining and measuring FX exposure; creating the company’s FX policy; hedging exposure using controls; periodical evaluating and adjusting. In step one; companies identify the foreign exchange exposure, mostly transaction risk. Measuring currency risk is strenuous especially about economic and translation risk. However, the major recognized method is the value-at-risk (VaR) model (Bekaert & Hodrick, 2009). Here the value at risk is represented as the maximum loss for a particular exposure over a certain period with y percentage confidence.
The VaR method can be utilized in measuring various types of risks; however, it does not describe what occurs to the exposure at (100-y)% point of confidence, which is the worst situation. Thus, corporations mostly target operational limits including eliminating loss orders and nominal amounts, to achieve the highest attainable coverage. The VaR measure of exchange risk is used to approximate the level of risk of a foreign exchange position caused by the company’s activities, over a given time under prevailing conditions.
The VaR computation relies on three parameters including the unit of currency to be utilized for the value of the VaR; the confidence level that will be used to establish the estimate; and the holding period, which is the duration of time over which the exchange position is to be maintained. There exist various models to calculate VaR with the dominating being (1) Monte Carlo simulation, which presumes that there will be a random distribution of the future currency returns. (2) The variance-covariance that supposes that there is always a normal distribution of monetary returns on a company’s total foreign exchange position and the effect on the value of the position is reliant on overall currency returns. (3) The historical simulation, which assumes that there will be a similar distribution of the currency returns to a corporation’s foreign exchange position as in the past (Mancini, Ranaldo, & Wrampelmeyer, 2013).
In step two, the company develops a foreign exchange policy and the senior management endorses it. It will entail when the exposure is hedged, instruments and tools to be used, the duties and responsibilities of the respective parties, the measurement of the company’s hedging performance, and highlight the regular reporting requirements. Step three involves implementing hedges and control procedures that are consistent with the firm’s policy.
Hedging Strategies
Transaction risk is hedged selectively to maintain earnings and cash flows, depending on the managements perspective of the future shifts of the currencies engaged. Most institutions utilize strategic hedging to control their currency transaction risk concerning short-term payable and receivable transactions. Translation risk is hedged non-systematically and less frequent, mostly to prevent the effect of potential sudden currency movements on net assets. It mainly involves long-term foreign exposures, such as a parent’s company valuation international investments, debt structure, and foreign subsidiaries. For companies to minimize the impact of exchange rates on the variability of earnings they require to develop an optimal set of hedging methods to manage its debt composition (Clark and Judge, 2008). Since economic risk signifies the effect of exchange rate shifts on the current value of future cash flows, it ‘s hard to quantify it, and thus, it is often hedged as a residual risk.
Natural hedging aims at minimizing the variation between payment and receipts in a particular foreign currency. For example, if a manufacturer exports to Europe and estimates to receive €6million over the next year, and making payments of €1 million, their forecasted exposure to the Euro is €5 million. However, the management can decide to hedge this exposure by borrowing €1million to increase its procurement from European suppliers by €2million, thus decreasing the company’s exposure to €3million. Although this strategy is effective at reducing the exchange risk, it involves long-term commitments, such as borrowing in foreign currencies and is time-consuming, such as locating new suppliers in another nation.
Financial Hedging Instruments
The rapid increase in hedging needs by today’s firms has led to the availability of a large variety and complexity of hedging instruments including both exchange-traded and OTC products. The widely-used OTC currency hedging instruments are cross-currency swaps and currency forwards. Currency forwards include two types: non-deliverable forwards that involve cash terms and outright forwards that require physical consignment of currencies. Forward contracts fully hedge a company, but the threat of the exchange rate shifting in the opposite direction and the high costs are major setbacks.
For example, if a firm identifies that it will have a foreign exchange exposure over the next year where it will incur more than US$500,000 more than it requires to remunerate monthly, it can engage into forward contracts to sell, at an identified rate that is equal or lower to the current rate. Because they do not consist of a purchase price and are simple to use, they are popular with firms of all sizes. However, if the company does not fulfill the obligation to purchase the currency at the future date, the contract could be terminated, or a fine could be imposed. It is the main reason why brokers and banks put a limit on the amount that an organization can hedge utilizing forward contracts.
The most recognized cross-currency swaps include the cross-currency basis swaps and cross-currency coupon swap. Cross-currency basis swaps involved purchasing a currency swap, simultaneously compensating floating interest in the currency, and getting floating in another. It has the benefit of enabling a company to determine current interest rate variations. However, its major disadvantage is that the principal risk for the enterprise is interest risk, instead of currency risk (Mengle, Kuprianov, and Pachos J, 2009).
The cross-currency coupon swap entails purchasing a currency swap, simultaneously remunerating and receiving floating interest income. It main advantage is that it allows companies to regulate their interest rate and foreign exchange rate risks; however, it leaves the corporation vulnerable to both interest rate and currency risks. For example, if a firm receives a $6600,000 payment today, and expects to make a payment of $300,00 in two months, it could engage in a swap arrangement, in which it sells $300,000 and commits to buying the same amount in US dollars after two months at a predetermined exchange rate; thus, it eliminates the exchange exposure during this time.
In exchange-traded instruments, the main types used in hedging include currency futures and currency options. The type of option structure often used is called the plain vanilla call, which involves purchasing an upside shift in an exchange rate with no obligation to conduct. Its benefits include its predicted premium, lower cost than forward, and simplicity; however, it is costly than other options, such as spreads. For example, if a multinational has bought an option allocating it the right to sell US dollars at an exchange rate of 0.78USD/CAD one year from today. If at the date, the exchange rate is 0.70USD/CAD, the firm will not use its right to sell its US dollar. However, if the exchange rate is 0.81USD/Cad, then the enterprise can exercise its right to dispose of the US dollars.
Conclusion
Because of the impact of the past global financial crisis; multinationals have been concerned about foreign exchange risk. It is evident in the study how various financial derivatives can be utilized to manage these risks. It is compelling to consider that a majority of companies prefers using forward contracts to hedge foreign exchange rate and interest rate swaps to manage interest rate risks. In the future, more research should be performed to evaluate the trend of the financial derivatives and their effectiveness.
References
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Clark, E. and Judge, A., (2008). Foreign currency derivatives versus foreign currency debt and the hedging premium. European Financial Management, Vol. 15, No.3, 606–642.
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Mengle D, Kuprianov A. and Pachos J. (2009). ISDA Research Notes. International Swaps and Derivatives Associaton. No. 2, 1-10, Spring. Available at: http://www.isda.org/researchnotes/pdf/ISDA-Research-Notes2.pdf
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Campello, M., Lin, C., Ma, Y., & Zou, H. (2011). The real and financial implications of corporate hedging. The journal of finance, 66(5), 1615-1647.
Bekaert, G., & Hodrick, R. J. (2009). International financial management (p. 809pp). Upper Saddle River, New Jersey, NJ: Pearson Prentice Hall.
Schepker, D. J., Oh, W. Y., Martynov, A., & Poppo, L. (2014). The many futures of contracts moving beyond structure and safeguarding to coordination and adaptation. Journal of Management, 40(1), 193-225.
