Business and financial risk

Question 1 – Exchange rate systems
Discuss the possible foreign exchange risk and economic implications of each of the following types of exchange rate system for multinational companies with subsidiaries located in countries with these systems:
(a)      a managed floating exchange rate,
(b)      a fixed exchange rate linked to a basket of currencies, and
(c)      a fixed exchange rate backed by a currency board system.
(Total: 15 marks)

Example 1 – Transaction risk

A UK company, buy goods from Redland which cost 100,000 Reds (the local currency). The goods are re-sold in the UK for £32,000. At the time of the import purchases the exchange rate for Reds against sterling is 3.5650 – 3.5800.

Required:
(a)      What is the expected profit on the re-sale?
(b)      What would the actual profit be if the spot rate at the time when the currency is received has moved to:
(i)      3.0800 – 3.0950
(ii)     4.0650 – 4.0800?
Ignore bank commission charges.

Solution:
(a)      The UK company must buy Reds to pay the supplier, and so the bank is selling Reds. The expected profit is as follows.

(b)(i)  If the actual spot rate for the UK company to buy and the bank to sell the Reds is 3.0800, the result is as follows.

(b)(ii) If the actual spot rate for the UK company to buy and the bank to sell the Reds is 4.0650, the result is as follows.

This variation in the final sterling cost of the goods (and thus the profit) illustrated the concept of transaction risk.

Example 2

An item costs $3,000 in the US.

Assume that sterling and the US dollar are at PPP equilibrium, at the current spot rate of $1.50/£, i.e. the sterling price x current spot rate of $1.50 = dollar price.

The spot rate is the rate at which currency can be exchanged today.

The law of one price states that the item must always cost the same. Therefore in one year:
$3,150 must equal £2,060, and also the expected future spot rate can be calculated:
$3,150 / £2,060 = $1.5291/£

By formula:

Example 3 – Big Mac Index

An amusing example of PPP is the Economist’s Big Mac Index. Under PPP movements in countries’ exchange rates should in the long-term mean that the prices of an identical basket of goods or services are equalized. The McDonalds Big Mac represents this basket.

The index compares local Big Mac prices with the price of Big Macs in America. This comparison is used to forecast what exchange rates should be, and this is then compared with the actual exchange rates to decide which currencies are over and under-valued.

Example 4

UK investor invests in a one-year US bond with a 9.2% interest rate as this compares well with similar risk UK bonds offering 7.12%. The current spot rate is %1.5/£.

When the investment matures and the dollars are converted into sterling, IRP states that the investor will have achieved the same return as if the money had been invested in UK government bonds.

In 1 year, £1.0712 million must equate to $1.638 million so what you gain in extra interest, you lose on an adverse movement in exchange rates.

The forward rates moves to bring about interest rate parity amongst different currencies:
$1.638 ÷ £1.0712 = $1.5291

By formula:

Advantages

Disadvantages

• Flexibility with regard to the amount to be covered.
• Relatively straightforward both to comprehend and to organize.

• Contractual commitment that must be completed on the due date.
• No opportunity to benefit from favourable movements in exchange rates.

Question 2 – Objectives of working capital management, EOQ, AR management and foreign currency risk management
PKA Co is a European company that sells goods solely within Europe. The recently-appointed financial manager of PKA Co has been investigating the working capital management of the company and has gathered the following information:

Inventory management
The current policy is to order 100,000 units when the inventory level falls to 35,000 units. Forecast demand to meet production requirements during the next year is 625,000 units. The cost of placing and processing an order is €250, while the cost of holding a unit in stores is €0•50 per unit per year. Both costs are expected to be constant during the next year. Orders are received two weeks after being placed with the supplier. You should assume a 50-week year and that demand is constant throughout the year.

Accounts receivable management
Domestic customers are allowed 30 days’ credit, but the financial statements of PKA Co show that the average accounts receivable period in the last financial year was 75 days. The financial manager also noted that bad debts as a percentage of sales, which are all on credit, increased in the last financial year from 5% to 8%.

Accounts payable management
PKA Co has used a foreign supplier for the first time and must pay $250,000 to the supplier in six months’ time. The financial manager is concerned that the cost of these supplies may rise in euro terms and has decided to hedge the currency risk of this account payable. The following information has been provided by the company’s bank:

Money market rates available to PKA Co:

Assume that it is now 1 December and that PKA Co has no surplus cash at the present time.

Required:

(a)     Identify the objectives of working capital management and discuss the conflict that may arise between them.                                                                                              (3 marks)
(b)     Calculate the cost of the current ordering policy and determine the saving that could be made by using the economic order quantity model.                                             (7 marks)
(c)     Discuss ways in which PKA Co could improve the management of domestic accounts receivable.                                                                                                             (7 marks)
(d)     Evaluate whether a money market hedge, a forward market hedge or a lead payment should be used to hedge the foreign account payable.                                          (8 marks)
(Total 25 marks)

Question 3 – IRP, PPP and foreign currency risk management
ZPS Co, whose home currency is the dollar, took out a fixed-interest peso bank loan several years ago when peso interest rates were relatively cheap compared to dollar interest rates. Economic difficulties have now increased peso interest rates while dollar interest rates have remained relatively stable. ZPS Co must pay interest of 5,000,000 pesos in six months’ time. The following information is available.

Interest rates that can be used by ZPS Co:

Required:

(a)      Explain briefly the relationships between;
(i)      exchange rates and interest rates;
(ii)     exchange rates and inflation rates.                                                           (5 marks)
(b)      Calculate whether a forward market hedge or a money market hedge should be used to hedge the interest payment of 5 million pesos in six months’ time. Assume that ZPS Co would need to borrow any cash it uses in hedging exchange rate risk.             (6 marks)

Advantages

Disadvantages

(a)   Transaction costs should be lower than other hedging methods.
(b)   Futures are tradeable on a secondary market so there is pricing transparency.
(c)   The exact date of receipt or payment does not have to be known.

(a)    The contracts cannot be tailored to the user’s exact requirements.
(b)    Hedge inefficiencies are caused by having to deal in a whole number of contracts and by basis risk.
(c)    Only a limited number of currencies are the subject of futures contracts.
(d)    Unlike options, they do not allow a company to take advantage of favourable currency movements.

Example 5 – Currency futures

A US company buys goods worth €720,000 from a German company payable in 30 days. The US company wants to hedge against the € strengthening against the dollar.

Current spot is 0.9215 – 0.9221 $/€ and the € futures rate is 0.9245 $/€.
The standard size of a 3 month € futures contract is €125,000.
In 30 days time the spot is 0.9345 – 0.9351 $/€.
Closing futures price will be 0.9367.

Evaluate the hedge.

Solution:

1.       We assume that the three month contract is the best available.
2.       We need to buy € or sell $. As the futures contract is in €, we need to buy futures.
3.       No. of contracts -  = 5.76, say 6 contracts
4.       Tick size – minimum price movement x contract size = 0.0001 × 125,000 = $12.50
5.       Closing futures price – we are told it will be 0.9367
6.       Hedge outcome
Outcome in futures market
Opening futures price = 0.9245
Closing futures price = 0.9367
Movement in ticks = 122 ticks
Futures profit = 122 × $12.50 × 6 contracts = $9,150

Net outcome

6.2.1

Key Terms

(1)     Call option – gives the purchaser a right, but not the obligation, to buy a fixed amount of currency at a specified price at some time in the future.
(2)     The seller of the option, who receives the premium, is referred to as the writer.
(c)      Put option – gives the holder the right, but not the obligation, to sell a specific amount of currency at a specified date at a fixed exercise price (or strike price).
(4)     In-the-money option (價內期權) – the underlying price is above the strike price.
(5)     At-the-money option (等價期權) – the underlying price is equal to the option exercise price.
(6)     Out-of-the-money option (價外期權) – the underlying price is below the option exercise price.
(7)     American-style options – can be exercised by the buyer at any time up to the expiry date.
(8)     European-style options – can only be exercised on a predetermined future date.

Example 6 – Currency options: Euro call option against Dollars

A euro call option against dollars gives the buyer the right, but not the obligation, to purchase a certain amount of euros, such as €1 million, with dollars at a particular exchange rate, such as $1.20/€. If the spot exchange rate of dollars per euro in the future is greater than the exercise price of $1.20/€, the buyer of the option will exercises the right to purchase euros at the lower contractual price. When exercise the option, the buyer pays the seller of the option:

€1 million × $1.20/€ = $1,200,000

And the seller delivers the €1 million. The buyer of the option can then sell the euros in the sport market for dollars at whatever spot rate.

For example, if the spot rate is $1.25/€, the net dollar revenue from exercising the euro call option on €1 million is
($1.25/€ – $1.20/€) × €1 million = $50,000

Notice also that the right to buy €1 million with dollars at the exchange rate of $1.20/€ us equivalent to the right to sell $1,200,000 for €1 million. This option is described as a dollar put option against the euro with contractual amount of $1.2 million and a strike price of
1 ÷ $1.2/€ = €0.8333/$
These options are the same; they are just described differently.

Also, note that the buyer of the option could accept a payment of $50,000 from the seller of the option to close out the position rather than take delivery of the €1,000,000 and resell the euros in the spot market. Many option contracts are closed in this way, and this is how options on the NASDAQ OMX PHLX are settled.

Example 7 – Currency options: Yen put option against Pound

A Japanese yen put against the British pound in a European contract gives the buyer of the option the right, but not the obligation, to sell a certain amount of yen, say ¥100,000,000, for British pounds to the seller of the option at the maturity of the contract. The sale takes place at the strike price of pounds per 100 yen, say £0.6494 > ¥100. If the spot exchange rate of pounds per 100 yen at the exercise date in the future is less than the strike price, the buyer of the option will exercise the right to sell the ¥100,000,000 for pounds at the higher contractual price. When exercising the option, the buyer delivers ¥100,000,000 to the seller of the option, who must pay
(£0.6494 ÷ ¥ 100) × ¥ 100,000,000 = £649,400

Suppose that the spot exchange rate at maturity is £0.6000/¥100 yen, which is less than the strike price. Then, the buyer of the option can purchase ¥100,000,000 in the spot foreign exchange market for £600,000 and sell the yen to the person who wrote the put contract. By exercising the option, the buyer of the yen put generates pound revenue equal to the difference between the exercise price of £0.6494/¥100 and the current spot price of £0.6000/¥100 multiplied by ¥100,000,000:
[(£0.6494 / ¥ 100) – (£0.6000 / ¥ 100)] × ¥ 100,000,000 = £49,400

Notice, also, that the right to sell ¥100,000,000 for British pounds at the exchange rate of £0.6494 / ¥100 is equivalent to the right to buy £649,400 with yen at the exchange rate of
¥ 100,000,000 / £649,400 = 1 / (£0.6494 / ¥ 100) = ¥ 153.99 / £

This latter option is a British pound call option against the Japanese yen.

Example 8 – Currency swap

Consider a UK company X with a subsidiary Y in France which owns vineyards. Assume a spot rate of £1 = 1.6 Euros. Suppose the parent company X wishes to raise a loan of 1.6 million Euros for the purpose of buying another French wine company. At the same time, the French subsidiary Y wishes to raise £1 million to pay new up-to-date capital equipment imported from the UK. The UK parent company X could borrow the £1 million sterling and the French subsidiary Y could borrow the 1.6 million Euros, each effectively borrowing on the other’s behalf. They would then swap currencies.

Question 4 – Debt finance, bond valuation and foreign currency risk management
Three years ago Boluje Co built a factory in its home country costing $3.2 million. To finance the construction of the factory, Boluje Co issued peso-denominated bonds in a foreign country whose currency is the peso. Interest rates at the time in the foreign country were historically low. The foreign bond issue raised 16 million pesos and the exchange rate at the time was 5.00 pesos/$.

Each foreign bond has a par value of 500 pesos and pays interest in pesos at the end of each year of 6.1%. The bonds will be redeemed in five years’ time at par. The current cost of debt of peso-denominated bonds of similar risk is 7%.

In addition to domestic sales, Boluje Co exports goods to the foreign country and receives payment for export sales in pesos. Approximately 40% of production is exported to the foreign country.

The spot exchange rate is 6.00 pesos/$ and the 12-month forward exchange rate is 6.07 pesos/$. Boluje Co can borrow money on a short-term basis at 4% per year in its home currency and it can deposit money at 5% per year in the foreign country where the foreign bonds were issued. Taxation may be ignored in all calculation parts of this question.

Required:

(a)      Briefly explain the reasons why a company may choose to finance a new investment by an issue of debt finance.                                                                               (7 marks)
(b)      Calculate the current total market value (in pesos) of the foreign bonds used to finance the building of the new factory.                                                                         (4 marks)
(c)      Assume that Boluje Co has no surplus cash at the present time:
(i)      Explain and illustrate how a money market hedge could protect Boluje Co against exchange rate risk in relation to the dollar cost of the interest payment to be made in one year’s time on its foreign bonds.                                                   (4 marks)
(ii)     Compare the relative costs of a money market hedge and a forward market hedge.                                                                                                                  (2 marks)
(d)      Describe other methods, including derivatives, that Boluje Co could use to hedge against exchange rate risk.                                                                                 (8 marks)
(Total 25 marks)

Question 5 – Different bonds with different cost of debt
Discuss the reasons why different bonds of the same company might have different costs of debt.                                                                                                                             (6 marks)

Example 9

Subsidiary A of a company might be investing in the money markets at LIBOR and subsidiary B is borrowing through the same market at LIBOR. If LIBOR increases, subsidiary A’s borrowing cost increases and subsidiary B’s return increase. The interest rates on the assets and liabilities are therefore matched.

Example 11 – Interest Rate Futures

Interest rate futures can be used to hedge against interest rate changes between the current date and the date at which the interest rate on the lending or borrowing is set. Borrowers sell futures to hedge against interest rate rises, lenders buy futures to hedge against interest rate falls.

Interest rate futures are notional fixed-term deposits, usually for three-month periods starting at a specific time in the future. The buyer of one contract is buying the (theoretical) right to deposit money at a particular rate of interest for three months.

Interest rate futures are quoted on an index basis rather than on the basis of the interest rate itself. The price is defined as:

P = 100 – i
Where P = price index;
i = the future interest rate in percentage terms

• On 29 November 2004 the settlement price for a June three-month sterling future was 95.28, which implies an interest rate of 100 – 95.28 = 4.72 per cent for the period June to September.
• The September quote would imply an interest rate of 100 – 95.33 = 4.67 per cent for the three months September to December 2005.
• The 4.72 per cent rate for three-month money starting from June 2005 is the annual rate of interest even though the deal is for a deposit of only one-quarter of a year.
• If traders in this market one week later, on 6 December 2004, pushed up the interest rates for three-month deposits starting in June 2005 to, say, 5.0 per cent then the price of the future would fall to 95.00.

Example 12 – Hedging three-month deposits

• The treasurer of a company anticipates the receipt of £100m in December 2005, almost 13 months hence
• The money will be needed for production purposes in the spring of 2006 but for the three months following late December it can be placed on deposit
• The Sterling 3m Dec. future shows a price of 95.33, indicating an interest rate of 4.67, that is 100 – 95.33 = 4.67
• To achieve certainty in December 2005 the treasurer buys, in November 2004, December 2005 expiry three-month sterling interest rate futures at a price of 95.33
• She has to buy 200 to hedge the £100m inflow (assume £500,000 per contract)
• Suppose in December 2005 that three-month interest rates have fallen to 4 per cent

Futures profit

• The 200 futures contracts were bought at 95.33
• The futures in December have a value of 100 – 4 = 96.00
• The treasurer in December can close the futures position by selling the futures for 96.00
• Therefore the gain that is made amounts to 96.00 – 95.33 = 0.67
• A tick is the minimum price movement on a future
• A tick is a movement of 0.01 per cent on a trading unit of £500,000
• One-hundredth of 1 per cent of £500,000 is equal to £50
• £50/4 = £12.50 is the value of a tick movement in a three-month sterling interest rate futures contract
• We have a gain of 67 ticks with an overall value of 67 × £12.50 = £837.5 per contract, or £167,500 for 200 contracts

Example 13 – Hedging a loan

• In November 2010 Holwell plc plans to borrow £5m for three months beginning in June 2011
• Holwell hedges by selling ten three-month sterling interest rate futures contracts with June expiry
• The price of each futures contract is 95.28, so Holwell has locked into an annual interest rate of 4.72 per cent or 1.18 per cent for three months
• The cost of borrowing is therefore: £5m × 0.0118 = £59,000
• Suppose that interest rates rise to annual rates of 6 per cent, or 1.5 per cent per quarter

£5m × 0.015 = £75,000

• However, Holwell is able to buy ten futures contracts to close the position on the exchange
• Each contract has fallen in value from 95.28 to 94.00 (100 – 6); this is 128 ticks. Bought at 94.00, sold at 95.28:

128 ticks × £12.50 × 10 contracts = £16,000

Example 14 – Interest rate option

Zuma has US$20 million of borrowings at a floating rate, US$ base rate + 0.75%, with a three month rollover. The treasurer is considering hedging the interest rate for the period starting on the next rollover date and has been offered a cap at 10% interest for a premium cost of 1% per annum payable quarterly in arrears.

The effective interest rate paid for the quarter if Zuma buys the cap under each of the following scenarios is:

Use of 10% option (cap):

The option effectively caps Zuma's borrowing cost at a maximum of 11.75%, but allows the company to take advantage of any fall in interest rates.

Example 15 – Interest rate collar

Suppose in the previous example (Example 14) Zuma is offered the cap at 10% interest, but the treasurer regards the cost of 1% per annum (pa) as too expensive. Upon negotiation, he discovers that bank is prepared to buy an 8% floor from Zuma for a premium cost of 0.75% per annum payable quarterly in arrears. Zuma purchases the 10% cap for 1% pa and sells the 8% floor for 0.75% pa giving a net cost of the collar of 0.25% pa.

The effective interest rate paid for the quarter (under the same four scenarios) if Zuma buys the cap and sells the floor (ie buys the collar) is:

The collar between 9% and 11% effectively fixes Zuma's borrowing cost.

Example 16 – Interest rate swap

• Cat plc and Dog plc, both want to borrow £150m for eight years
• Cat would like to borrow on a fixed-rate basis
• Dog prefers to borrow at floating rates

• Dog has an absolute advantage in both
• Cat has an absolute disadvantage in both, but has a comparative advantage in the floating-rate market
• Cat borrows floating-rate funds, paying Libor +2 per cent, and Dog borrows fixed-rate debt, paying 8 per cent

There is a saving of 50 basis point or £750,000 per year.

Example 10

A company’s financial projections show an expected cash deficit in two months' time of $8 million, which will last for approximately three months. It is now 1 November 2010. The treasurer is concerned that interest rates may rise before 1 January 2011. Protection is required for two months.

The treasurer can lock into an interest rate today, for a future loan. The company takes out a loan as normal, i.e. the rate it pays is the going market rate at the date the loan is taken out. It will then receive or pay compensation under the separate FRA to return to the locked-in rate.

A 2-5 FRA at 5.00 – 4.70 is agreed.

This means that:

• The agreement starts in 2 months time and ends in 5 months' time.
• The FRA is quoted as simple annual interest rates for borrowing and lending, e.g. 5.00 – 4.70.
• The borrowing rate is always the highest.

Required:

Calculate the interest payable if in two months’ time the market rate is:
(a)      7%
(b)      4%.

Solution:

In this case the company is protected from a rise in interest rates but is not able to benefit from a fall in interest rates – it is locked into a rate of 5% – an FRA hedges the company against both an adverse movement and a favourable movement.

Note:

• The FRA is a totally separate contractual agreement from the loan itself and could be arranged with a completely different bank.
• They can be tailor-made to the company’s precise requirements.
• Enables you to hedge for a period of one month up to two years.
• Usually on amounts > £1 million. The daily turnover in FRAs now exceeds £4 billion.