Introduction
Globalization and other factors are driving international businesses and trade. In that respect, multinationals are increasingly becoming subject to factors that are not only born in their home country, but also from host countries as well as markets within which they sell their products. One such factor is the exchange rate that determines the value of the payments that exporters receive for their international sales as well as the value those importers pays for their purchases from foreign markets. In that view, it is becoming crucial for managers and business leadership to establish suitable strategies for managing the risks involved. Thus, this analysis seeks to demonstrate how exchange rate risk involving export of wood worth £10,000,000 into the European market can be managed. To achieve the objective, the analysis uses a case of a UAE company that exports wood and provides its background as well as the exchange rate risk it faces. Further, the analysis explains the hedging techniques that are available for the business to manage the risk. A choice is then made from the alternatives in addition to explaining the factors that affect exchange rate. Finally, the analysis explains the political risks that the business could face in its operations.
Analysis
- Company background
Ajbmc International Ltd is a trading business based in UAE and is involved in wood exports to foreign markets including North and South America as well as Western and Eastern Europe. The company sells timber products as well as building materials by acting as an agent for manufacturers, importers, and producers of all types of woods and building materials. The business has more than 30 years of experience in the market and is involved in annual export of over 250,000 cbm wood products. (GMDU, 2014)
- Foreign exchange risk
Exchange rate risk affects international businesses and investments as well as imports and exports. That occurs when money has to be converted to other currencies to make payments for goods and services as well as in repatriating the money from international markets. In that view, Ajbmc International Ltd’s operations are subject to exchange rate risks in its wood export business. That entails the economic and transaction risks that results from the business trade involved in export of wood products that are then paid for after the products receipt by customers in the European market among other markets. Thus, fluctuation in the UAE currency rate against the EUR presents risks in that the company could end up receiving funds whose value is less than that agreed upon during the sale agreement. (Allen, 2003)
- Economic exposure risk
The economic risk exposure presents the extent the unexpected change in exchange rates would affect the export business value. Thus, the risk affects the forms competitiveness as its affects the attractiveness of the wood products compared to competing businesses products in the international market. In that respect, the strength and weakness of the UAE currency would affect the business’s exports value. (Hull, 2011)
- Transaction risk
The risk involves the degrees to which change in exchange rates would affect the future value of the cash transactions involved in the wood export. Thus, it reflects the sensitivity of the currency value of the contractual cash flows related to wood exports. In that view, the exposure is equivalent to the value expected to be received from the exports sales at any given time. (James, Marsh & Sarno, 2012)
A good example is the fluctuation of the EUR/AED rate from the spot rate of £4.5273 to £4.600 given the company had sold wood worth £10,000, 000. That would entail a risk of losing value equivalent to [(10000000/4.5273) – (10000000*4.6000)] = 2208822 - 2,173,913 = £34,909.
- Hedging techniques alternatives
Exchange rate effect on business refers to the impact that the rate’s fluctuations have on the net cash-flows. The risks include the transaction exposure, and there are various techniques applicable in managing the exchange risk. (Pilbeam, K. 2010)
Given the following current rates, the exchange rate hedging techniques are evaluated as follows.
Sources: (HSBC, 2014; Janata ,2014)
- Forward contracts
They involve contracts that businesses or investors obtain specifying a price at which they will sell or buy foreign currency at a specified future date. That applies when a company has an agreement that involves receiving or paying a fixed amount in foreign currencies. The techniques convert future uncertainty in the domestic currency value to certain domestic currency value that will be received on a specified date that is independent of the exchange rate fluctuation over the remaining life of the involved contract. Thus, it involves agreeing to sell foreign currency at the current rate hence entering a short position if the business expects to receive foreign currency in the future. (Allen, 2003)
Source: (FxStreet. 2014a)
Given the above forward rates and the spot rate, the business expecting to receive wood sales payment worth £10,000,000 would sell the Euro at the forward rate of £7.96 per USD and then the USD at 2.00 PER AED given that the EUR/USD 3M Forward rate is 7.96 and the USD/AED 3M Forward is 2.0000. In that respect, compared to the current spot rate USD/AED of 3.67, the business would be in a favourable position if the USD depreciated against the AED from the $3.67 but not beyond $2.00. That is because a depreciation to $2 result to a loss equivalent of [(3.67-2) * {10,000,000/7.96}] = (1.67*1,256,281) = 2,092,990AED equivalent and covered by the amount realized when the company buys dollar at the same $2 hence gaining the same 2,092,990 AED. However, any depreciation beyond $2 would mean a higher loss than what the forward contract gains the business.
- Future contracts
They are similar to the forwards contracts in their function but differ in various key features. In that respect, the future contracts involve exchange trading hence have a standardized as well as limited maturity dates and initial collateral. Thus, given their nature of certainty in maturities, size and currencies, it is not possible to fully eliminate the risk exposure. Further, it takes the position takers to post their bonds on the basis of their positions value. Thus, it eliminates the credit risk involved in the futures trading. (Hull, 2011)
For the forward and futures, buying US instruments would not be suitable as the interest rate for the 90 days treasury is relatively low compared to the UAE rate. In that respect, it would be suitable to wait band receive the amount in UAE. The only situation, when the business should buy Futures and/or forwards, would be when the expected depreciation in the UAE currency would be greater than the interest rate differential as shown below. Given the following EUR/AED spot rate
Futures and forwards hedging would be effective if the business could get futures that could get contracts whose spread could cover the exchange rate fluctuation. For example, if the AED was expected to depreciate from £4.5273 to £4.6000, the difference in the value would be compensated if the Future or the forward provided a large gain to compensate for the resulting loss equivalent of [(10,000,000/4.5273)- (10,000,000/4.6000) ] = 34,909 AED in the exports value.
- Money market hedge
The technique is also known as the synthetic forward contracts and utilizes the situation that in covered interest parity, the forward price has to be equal to current spot rate multiplied by the two currencies riskless returns. In addition, the contract can also be bought as a means of financing foreign currencies transactions. Thus, a business that has an obligation to make payment in foreign currency at specific future date can establish the present value of the foreign currency liability at the foreign currency lending rate and convert the amount of the domestic currency provided the current spot exchange rate. (Beneda, 2004)
The technique helps convert the obligation to the domestic currency that is payable as well as eliminate the exchange rate risk involved. In the same way, a firm with agreement to receive payments in foreign currencies at a specific future date can establish the present value of the expected receipt in foreign currency borrowing rate. Then it can borrow the amount of the foreign currency as well as convert the amount to domestic currency. Thus, transactions that have pure hedging needs replicates a forward with the exception of when there is an additional transaction thus will usually dominate by futures and forwards. However, in case of a need for hedging as well as short term debt financing or wants to pay for some previous high rate borrowing at an earlier date or a situation of domestic currency that sits around, the technique is attractive than the forward contract.
The method considers the interest rate differential between the two markets.
If the company expected to receive £10,000,000 from a customer in the Europe region sale and given the spot rate, Euro treasury rates as well as UAE borrowing rates, the following is a demonstration of the hedging results.
If the business borrowed an amount equivalent to the present value of the expected receipts, it would get 2,208,822AED discounted by the 0.599 thus could get [2,208,822AED / 1.0599] = 2,083,991AED. In that respect, if the business bought the Euro 3 Months Treasury, the borrowed 2,083,991 AED would be equal to £10,000,000 in three months if the two markets rates had been the same. However, the two different markets have different rates in terms of the borrowing rate in UAE that is 5.99% while the treasury rate in Europe is 0.06282%.
Converting the 2,208,822AED to Euros at the spot rate of £4.5273, the amount would be [2,208,822 AED * 4.5273] = £10,000,000. Then the amount would Earn the 0.06286% interest hence by end of three months would be [10,000,000* 1.0006286] = £10,006,286. If the rate had not changed over the three months, the amount would be equivalent of [£10,006,286/4.5273] = 2,210,210.5 AED hence more than the borrowed 2,208,822 AED. In that view, the business would have effectively hedged against the exchange rate if the AED had depreciated to equate the accumulated amount with the borrowed amount. That rate would be [10,006,286/2,208,822] = £4.53 Thus if the AED was expected to depreciate to 4.2983 and beyond, the hedging would be efficient and an appreciation beyond that would earn the business extra amount. (HSBC, 2014)
- Options
They are contracts that entail upfront fees and provide the owner with the right but not the obligation to trade home currency for foreign currency and vice versa. That is done in a specified amount at a particular price and period. In addition, there are various types of options including calls and puts. They provide flexibility in hedging against the currency downside, but preserving the upside potential. It entails hedging by calls or puts with calls involving buying the domestic currency at the call exercise price when if it depreciates. On the other hand, the put entails buying the puts if the domestic currency appreciates and the firm is to receive foreign currency. Thus, the option allows a business to sell the currency at the put exercise price. (Beneda, 2004)
Assuming the business exports worth £10,000,000 AED to the European market that is expected to be received in three months. If the business’ management has concerns that the UAE Dirham may depreciate from the current spot rate of £4.5273 to £4.300 that would reduce the value of the export payments, it would buy an available put option with a strike of 4.2 in March 2015. (Eurexchnage, 2014) The business would be in the money because the exchange rate would be greater than the put strike price of 4.2. If the AED appreciated to 4.1 and the strike price 4.2, there would be a gain equivalent of the difference between the higher AED exchange rate and the option strike price. Thus a loss of (10,000,000/4.1) – (10,000,000/4.2) = 58,072 AED hence would be in money. However, if the business had not taken the option, it would lose an equivalent of [(10,000,000/4.5273) - (10,000,000/4.1) = 230,202 AED. That can be represented on a graph as follows
- Hedge technique Choice
Mainly, corporate risk management chooses exchange risk hedging techniques by considering outlook on the inherent factors such as interest rate, exchange rates, and other relevant factors. However, the best choice of hedging techniques should be chosen acknowledging that markets movements are uncertain hence a hedge should focus on minimizing risk and not a gamble with the price movement. Thus, a well-managed hedge reduces both the costs and risks involved. In that view, the hedge frees up resources hence allowing the management to focus on the key aspects of the business. In addition, hedging increases shareholders wealth through cost reduction and enhancing earnings’ stability. (Hakala & Wystup, 2002)
The choice of the suitable hedging technique involves consideration of the costs involved as well as the ultimate domestic currency cash flows that are adjusted for time value of each technique based on the prices that are available to the business. That is because different techniques involve different cash-flow types at different points in time that must be taken into account by the business. Thus, under efficient market conditions that have the assumption of risk neutrality, all the contracts are priced for their expected net present value to be zero. In that respect, the contracts that do not entail upfront payments have zero expected payoffs that have a discounted value equivalent to the upfront premiums. (James, Marsh & Sarno, 2012)
In that view, the key factors to consider in choosing the hedging techniques is whether the business is seeking to reduce variance for purposes of easier budgeting and insurance against loss. Further, there should be other features to consider including the differences between the three techniques. All the techniques have the effect of reducing the variance to the ultimate payoff on the contracts denominated in foreign currency. In cases of money market hedge and the forward contracts, there is the entire elimination of the final cash-flows variance. In addition, for options and futures contracts, there is volatility but it is substantially reduced. (Hakala & Wystup, 2002)
Rationale for put option’s choice
Options offer insurance to purchasers through the guarantees they offer against losses above a preset amount without necessarily locking the transaction to a fixed price in case it later turns out to be wrong. (Beneda, 2004) Thus, because the business is involved in export and has receivables that are denominated in foreign currency it needs to buy the put options. In that case the business will be managing the risk because if the currency value decreases, the put locks in a lower limit on the dollar value of its exports. On the other hand, if the currency value rose, the business has a choice to sell foreign currency at a higher price.) That applies in that the business could choose not to exercise the contract if the currency moved in their favor hence capitalizing on the gain. On the other hand, executing a contract at the strike price if the currency movement were not in favor of the business would hedge against that risk. Thus, the put option would hedge against the downward movement and also preserve the upward potential hence a better choice compared to the other techniques. (Allayannis, Ihrig & Weston, 2001)
- Factors affecting exchange rate and their effects
In addition to factors such as inflation and interest rates, exchange rate is a crucial factor that determines an economy’s relative economic health. That is because the factors play a crucial role in determining a country’s trade level that is increasingly becoming critical in a free market economy. Thus, exchange rate becomes one of the most watched as well as analyzed and government manipulated measures. That is because the rates affect the real return on business and investors portfolios. In that view, the factors determining the rate are crucial to the economy’s health, and their effects are summarized as follows. A currency with high value makes exports more expensive in the international market relative to imports that become cheaper. On the other hand, a low-value currency makes exports cheaper while imports become more expensive in the international market. Thus, high currency values tend to lower an economy’s balance of trade that is otherwise increased by a low-value currency. (Valdez & Molyneux, 2012)
On the other hand, the factors determining exchange rate are usually related to trading relationships between countries. The factors include inflation differentials, current accounts deficits, interest rates differentials, and terms of trade, public debt as well as political stability and economic performance. (Beneda, 2004)
- Inflation differential
Changes in inflation results to change in exchange rate with economies that have low inflation rate exhibiting increase in currency values. Thus, economies with high inflation rate experienced currency depreciation relative to their trading partners. Rising interest rates usually accompanies the trend in depreciating currencies. (Copeland, 2008) The following chart uses the case of New Zealand exchange rate and inflation (NZ prices).
The chart shows that an increase in inflation marked by the red curve line results to a decrease in exchange rate shown by the blue curve.
- Interest rate differentials
There is a high correlation between interest rate, inflation, and exchange rate. In that respect, the central government manipulates interest rate as a means of exacting pressure on exchange rate and inflation in the economy. In that respect, high-interest rates provide lenders in an economy with better prospects for high returns relative to the economies with low interests’ rate. Thus, a high return attracts foreign investors and capital into the country hence increasing exchange rate. However, when interest rate in the country is higher than in the other countries, or there are other factors driving the currency downwards, the interest rate impact is mitigated. (Copeland, 2008) In that respect, the relatively low and stable interest rate in US would reduce the dollar’s attractiveness to foreign lenders. (World Bank, 2014a)
- Current account deficit
Current accounts represent the balance of trade between trading partners in international trade and reflect the payments between such countries for services, goods as well as dividends and interest. In that respect, current account deficit shows that the country spends more on foreign trade than it earns from the trade hence borrowing capital from foreign sources for the purpose of making up for its deficit. (Frankel, Sarno & Taylor, 2003)
In that case, the country has more need for foreign currencies than it earns from its exports and supplies more local currency that the demand by foreigners for its goods and services. Thus, the excess demand results to lowering the local currency rate till when the domestic goods becomes cheaper for the foreigners and the foreign assets becomes expensive hence generating increased sales for domestic products. (US, 2014) Thus, with the US having a relatively large current account deficit, hence the possible effect of depreciating the US currency relative to the UAE currency. (Worl Bank, UAE, 2014b)
- Public Debt
Countries seek large-scale deficit financing for purposes of financing its public sector projects. However, while those activities stimulate the domestic economy, the countries with large public debts and deficits are usually less attractive to foreign investors. That is because the large increases inflation that in turn means that the debt will be ultimately paid off in cheaper real dollars in the future. (World Bank, 2014a)
However, the government may try to solve the problem by printing money to pay the debt increasing the money supply that would eventually increase inflation. In addition, if the government cannot service the debt by domestic means of selling bonds, it then increases the securities supply for sale to foreign investors hence lowering their prices. However, a large debt may finally become a cause of worry for the foreign investors if they expect the country’s default risk to be high hence reducing their willingness to buy those securities. Thus, the debt rating also becomes a crucial aspect in determining exchange rate. (Copeland, 2008)
- Terms of trade
They refer to the ratio that compares the export to imports prices and are related to the currents accounts, as well as the balance of trade. In that respect, a rise in the country’s exports prices more than that of its imports, then there is improvement in term of trade that shows a greater demand for local goods hence increased exports. (Frankel, Sarno & Taylor, 2003) The resulting effect is increasing in export revenues that supply more foreign currency and increased demand for the domestic currency hence its increase in local currency value. However, if export prices rise by a low rate than the imports, the local currency depreciates relatively to ten trading partners’ currency. In this case, the more exports by US compared to UAE would result to weakening of the UAE currency compared to the US dollar. (World Bank, 2014a)
- Political stability
The political stability of a country determines its attractiveness to investors. In that respect, countries with more stable political systems attract more foreign investors hence increasing demand for domestic currency that in-turn increases its value. On the other hand, countries with uncertain political systems do not attract foreign investors but loses them to politically stable countries hence decreasing value of local currency. In that respect, the political stability in UAE could result in more foreign investors hence relatively increasing the value of the dollar. (Copeland, 2008)
- Political risk
For businesses operating in international markets, political risk entails the risk that the host countries could make political decisions that could have adverse effects on the business’ profits and objectives. For, the Company involved in wood export and based in UAE; political risks could relate to the establishment of policies that that limit wood harvesting. A good example is the political system establishing laws that limit wood harvesting. That would affect the business access to wood and its products. Such decisions could be influenced by the systems view on environment protection. Finally, if the political system governing the country chose to implement international trade policies taxing wood products as a means of reducing its export, the business would face reduced profitability.
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