Currency Riskmanagement

Currency Risk Management

ABC plc is a UK manufacturing company which operates within the UK and mainland Europe. It has recently put in a competitive bid on a contract, which if won would result in a receipt of Ð'Ђ12 million in 12 months time. However the winner of the bid will not be announced for 3 months

In simple terms, the contract is not announced until three months time and if won payment will not be received until another nine months. ABC Plc would like to know what approaches are available to minimise the uncertainty caused by fluctuating exchange rates on cash flows both payable and receivable in euros and the best means of hedging the potential future cash flow of Ð'Ђ12 million.

Before explaining the effects of the exchange rates on a company's cash flow we have to understand what the determinants of exchanges rates. To understand this we have be aware of Purchasing Power Parity or PPP. Ð''The exchange rate between two currencies depends on the purchasing power of each currency in its home country and the exchange rate changes to keep the home purchasing power of the currencies equal.' (Howells, P and Bain, K. 2000)

Within the forex market, more commonly know as the foreign exchange market, there are two types of markets. The first being the spot market and the second being the forward market. In the spot market Ð''currencies are bought and sold for delivery within two working days' (Howells, P and Bain, K. 2000). However this market or type of transaction is somewhat dangerous because the rates are prone to fluctuations. For example if on one day you bought Ð'Ј100.00 worth of euros at the value of 1.5 that would mean that you would receive Ð'Ђ150.00 however because it is prone to fluctuations when you come to buy your euros the rate may have fallen to a conversion rate of 1.4 which would mean that you would lose out slightly and only receive Ð'Ђ140.25 in the value of the converted money meaning a reduction to your cash flow. However on the other hand it could well increase, which would benefit your cash flow.

One way of insuring yourself against changes in the exchange rate is buying and selling currency ahead. This is known as the forward market, the second of the two markets. Ð''Forward foreign exchange rates are quoted as being at either a premium or discount to the spot exchange rate.' (Howells, P and Bain, K. 2000). If you get a discount, it means that it is less expensive forward than the spot rate and if the spot and forward rates for a given currency say the Euro for example are equal this means the currency is flat. Let's put the theory into practice. Company A and company B both have Ð'Ђ1million to invest in a secure from say a bank for three months. Company A buys French securities at a rate of 3%. But company B spots the sterling securities are offering a rate of 5% which is higher than the Euro interest rate. So decides to invest there. Here is the math below.

At the end of the three months Company A finishes up with Ð'Ђ1,007,500. Company B converts and finishes up with Ð'Ј675,000 and converts back into euros. To make money Company B would need an exchange rate of Ð'Ј1:Ð'Ђ1.49. Company B would have been hoping that in the beginning that the exchange rate would not decrease by any more than half a percent. If this is the case than obviously Company A would be better off. The position of company A and Company B Ð''are thought to produce the same result is know as uncovered interest parity.'(Howells, P and Bain, K. 2000). However this is where the forward rate comes into action. If Company B decides to purchase a forward rate or otherwise known as an exchange contract they maybe able to become better off. They need an exchange rate of at least Ð'Ј1:Ð'Ђ1.49 that's the total of company A divided the total at the end of three months of company B. if they were to purchase an forward rate three months ago at the time of the first transaction, of Ð'Ј1:Ð'Ђ1.55 that would mean they would receive Ð'Ђ1,046,250 thus being the better investment and a better result on the companies cash flow because they would receive more money.. Had the exchange rate been lower they would have only been able to get lower rate and thus a reduction on the company's cash flow due to a decrease in the amount received.

However this does all depend on your company's policy on speculating. Due to the fact that it is a risk. So do you allow your company to take a risk and face the possibility of a loss or reap the benefits because of the possible gains or do you take out the fixed contracted rates know as the forward rates? This is where the covered interest parity comes into action. This is Ð''when the gains from investing in a country with a higher interest rate are equal to the forward discount on that country's currency.' (Howells, P and Bain, K. 2000).

Hedging Ð''is a way of covering exchange rate fluctuations so that losses and risks are minimised'. (Lines, D, MarcousÐ"©, I and Martin, B. 2003). Here is a working example of hedging operations. At a time when Ð'Ј1:Ð'Ђ1 and importer agrees to buy a product from Europe for Ð'Ђ20,000. It will be delivered and paid for in say six months time. If the pound falls during that time to Ð'Ј1:Ð'Ђ1, the firm would now have to Ð'Ј20,000 instead of Ð'Ј10,000. So you would have to pay double for that product. Thus having a severe impact on your cash flow because it may have been more than you were expecting to pay. So to cover yourself, you should have bought the euros in the forward market a Ð'Ј1:Ð'Ђ2. If the exchange did not move in that time than hedging fee would be lost. However if the market did move instead of paying Ð'Ј20,000 you only have to pay Ð'Ј10,000 minus the hedging fee thus having a better impact so to speak on you cash flow because you are paying out less. However if you were on the receiving end, the effects on you cash flow wouldn't change, because you would still receive the money, but you may find that the customers may decide not to buy because of the difference in price, so you may find that there may be a decrease in sales revenue.

Let's now look at the possible avenues and best means of hedging the potential future cash flow of Ð'Ђ12 million, should the contract be successful. Ð''One of the most striking developments in financial markets over the past quarter of a century has been the establishment and growth of financial derivatives