International Financial Management Of A American Exporting Company

Published Date: 02 Nov 2017

EXECUTIVE SUMMARY: this is a Report to the CEO of a U.S. exporting company. The report evaluates all the options which were considered by the CEO of the firm and suggestions regarding the best one have been made. The purpose of hedging has also been explained and a brief evaluation of all the hedging techniques has been done.

INRODUCTION

Any investment made to reduce the risk of adverse price movements in any asset is known as hedging. It comprises of taking an offsetting position in a related security market like future contracts. Any investor uses this strategy when he/she is unsure of what the market would do. A perfect hedge reduces the risk. It does not insure that the negative event would not occur but it hedges the investor from the impact of the negative event. Portfolio managers, investors and companies implement hedging to protect themselves from various risks. It is a better instrument than stop-loss. It is a strategic instrument used in the market to wave off the risk of adverse price movements. In other words we can say that hedging protects one investment by making another. Technically speaking hedging would invest in two securities with negative correlation. This is a technique where the investor does not make money but potential loss. The participants in the future markets are hedgers, their aim is to use future markets to reduce particular risks that they think they will face. This technique requires the use of complex financial instruments known as derivatives, the two most commonly used derivatives are OPTIONS and FUTURES. The cost of the hedge it can be the cost of an option or lost profits from being on the wrong side of a futures contract, it cannot be avoided. This is the price that we have to pay because the goal of hedging is not to make profit but to protect us from losses. It emphasises on the fact that unless you liquidate a position, all risk cannot be eliminated. It should be kept in mind that hedging is a short term strategy to protect the long term positions and be used to complete the arbitrage transactions. We should preferably not apply long term hedging strategy to a short term position because it can be costly as well as more risky.

The number of hedging techniques available:

PAIRING

SHORT AGAINST THE BOX

EXCHANGE-TRADED FUNDS (ETFs)

FUTURES

OPTIONS

A brief light on each of the technique:

PAIRING: this method helps to offset a position with similar but not identical security.

SHORT AGAINST THE BOX: his is considered to be a unique technique where the stock is hedged by short selling the same exact stock. Earlier it was a widely used method to because it helped in waving off the capital gain taxes on low cost basis holdings.

EXCHANGE TRADED FUNDS: they deal with a whole range of hedging possibilities like the Spyders, Sector specific EDF’s, Inverse and Levered Inverse EDF’s. They lead to imperfect hedging and add more risk to portfolio rather than reducing it.

FUTURES: an obligation of financial contract where the buyer has to purchase an asset at a predetermined future date and price. They facilitate trading on the future exchange.

OPTIONS: they help us to adjust our position according to the ever changing situations. They can be speculative as well as conservative. They are complex securities and can be very risky. With this we can protect a position from decline to outright betting on the movement of the market or any index.

A number of factors determine which hedging techniques to use. Some of the determinants are:

Risk inherent to the derivatives: few derivatives have other risks associated with them which are not inherent to the original underlying position like immediate cash flow, the risk of the downside etc. The risk of the derivatives must be considered before deciding the strategy.

Exposure to the downside: whenever instruments are bought or sold certain risk exists which have not been anticipated by the market. On certain instruments these losses are unlimited and it is possible to suffer even larger losses because of such position and on some instruments the downside is limited like the purchased options.

Effectiveness of hedge: in some cases no direct derivative exists for underlying position that needs to be hedged. This is mainly in case where share portfolio exists that does not represent all share index but the value of portfolio moves in line with the all share index. In order to hedge this portfolio with a short all share index future there is a risk involved that the all share index future and the value of the portfolio move in corresponding directions resulting in losses and as no perfect hedge exists than the risk of the hedge corresponding to the movement of the underlying asset must be taken into account.

Tradability of derivatives used: in certain cases the markets do not move as they are predicted and the underlying positions make profit and the hedging position suffers a loss. It is preferred at this time that the hedging position is sold in the market but this is only possible if the hedging instrument used has an active secondary market and can be traded easily.

Cash flow of the hedging method: whenever we use futures as hedge there can be a daily cash flow as opposed to caps or floors, where cash flow takes place on the date of settlement and only if the benchmark rate was exceeded. This kind of cash flow planning needs to be considered at the time of deciding the hedging method.

Joint enhancing strategy: hedging strategies like writing of options have limited upsides. In this case other policies or strategies must be implemented to stop the loss from exceeding the possible profit on the hedging position.

The techniques that we will be discussing in details are the ones that are considered by the C.E.O of the firm. They are

FORWARD CONTRACT

MONEY MARKET HEDGE

BILLING U.S. DOLLAR

FORWARD CONTRACT: it is a private contract between the buyer and the seller where the buyer agrees to buy and the seller agrees to sell a certain quantity of a security or commodity at a price which has been specified in the contract. the basic difference between the forward contract and the other contracts is that in case of forward contract the delivery and the payment of the instrument takes place at the decided future date rather than immediately. The price specified in a forward contract is called the DELIVERY PRICE or the PRICE AT MATURITY. As the forward contract is privately executed between two parties, the main goal at the time of entering into the contract is that all the terms should be made clear and there should be no uncertainties. All the contract parameters should be well defined in terms of delivery, location, quality specification, payment and credit terms, dispute resolution solution, cancellation provisions, liquidity and price transparency. A forward contract is traded over the counter and all the details of the contract are negotiated between counterparties or the partners. The price specified in the forward contract for the foreign currency, government securities or other commodities may be higher or lower than the actual market price at the time of delivery known as the Spot price. As the participants of the contract have locked in a price which has been earlier specified therefore they know what they will receive or pay for the product, eliminating the market risk. In a forward contract the exchange rate can fixed up to 2 years in advance deciding what is to be paid and protecting the worst market movements. A deposit of approximately 10% is required at the time of placing the order and the balance is at the time or before the completion of the contract.

The payoff from the Long Position in a forward contract is:

P = S – X

Where, S – Spot Price at the time of maturity and X – Delivery price

The payoff from the Short Position in a forward contract is:

P = X – S

The Advantages of Forward Contract:

Both importers and exporters can benefit from these as they cater for a diverse type of commercial and financial transactions.

They protect the company against unfavourable exchange rate fluctuations.

The exact valuation can be done of the export and import orders on the day it is processed.

In case of forward contracts the budgeting and costing are accurate.

These offer a complete hedge.

The Disadvantages of the Forward Contract:

If the company has abided with the forward contract it cannot take the advantage of the preferential exchange rate movements.

The company can face financial loss if an order is cancelled or there is any surplus amount outstanding on a forward exchange.

Early deliveries, extensions, surrenders and cancellations during the fixed term of the forward exchange contract cause additional administration.

MONEY MARKET HEDGE: it is a process of borrowing and lending in multiple currencies. This method relies upon borrowing and investing funds via the money markets and using the spot rate to lock-in the amount that would be received from the receivables. If there is an inflow of the foreign currency than this technique involves borrowing present value of the foreign currency at a fixed interest rate and converting it into home currency and depositing the home currency at a fixed interest rate. When the foreign currency is received it is used to pay off loan. If there is an outflow of the foreign currency than we determine the present value of the foreign currency to be paid, we borrow equivalent amount of home currency and then convert home currency into present value which is equivalent of the foreign currency and make the foreign currency deposit. On the day of the payment we can withdraw the foreign currency deposit and make the payment.

The advantages of the money market hedge are that they are a great medium for investment because they have low liability and competitive interest rates. Losing money in this case is rare because we invest in non-volatile safe securities and also they are backed by the FDIC (Federal Deposit Insurance Corporation). These are also regulated by the SEC (Securities and Exchange Commission).

The disadvantage of money market hedge is that it is a relatively expensive hedge and sometimes it is not feasible to have transactions if there are constraints on borrowing and lending. Also, the returns are not so good.

BILLING IN U.S DOLLAR: when we are dealing in the international markets we deal with foreign exchange risk which is known as transaction exposure. This risk comes into existence when a company has payables or receivables denominated n a foreign currency. This risk lies in the fluctuation of the foreign currency exchange rate. As this risk has an impact on the cash flow the transaction exposures and the requirements of the Financial Accounting Standards Board (FABS) which consists of independent members who have created and interpret Generally Accepted Accounting Principles (GAAP), statement no. 52 which includes Foreign Currency Translations to include foreign exchange transactions gains and losses in the determination of net income and today most companies are hedging these exposures. The strategy here to control risk is pricing or controlling the billing currency. The exchange risk is waved off if the company bills its customers in its reporting currency. By invoicing in our own currency the company does not suffer the risk of exchange rate movement. The risk does not disappear but it is transferred to the other party, but whether the party is ready to take the risk or not is the question. Furthermore the risk is reduced if the customers are billed in the same currency in which the company is billing its suppliers.

If the company is unable to bill in its reporting currency than it can use the settlement strategy to help minimise the foreign exchange risk. This requires the management of the company to negotiate or offer discounts for the settlement of the payables or receivables denominated in the foreign currency. But this strategy does not benefit the company on the time value of money in order to forgo the risk of foreign exchange fluctuations. This is the reason that most of the international trade takes place in the "VEHICLE CURRENCY" i.e. the currency which is not of either of the parties. Vehicle currencies are chosen in respect to the currencies stability, liquidity and low transaction cost and this is the reason that most of the international trade takes place in the single vehicle currency which is the "US DOLLAR."

CALCULATIONS

BILLING IN U.S DOLLARS

The exports made to Mexico will receive 500 million Mexico Pesos. The given Spot Rate of Peso/USD is 15.3555-15.3561. The bid price is 15.3555 at which the trader will buy and 15.3561 is the price at which we will sell. We need to consider the spot exchange ask rate 15.3561, which means the 500 million Mexican Pesos will come to 500/15.3561 = $ 32.5604 million.

We will receive a definite sum of $ 32.5604 million after the end of 6 months contract which would not be affected by the fluctuation of exchange rate by the end of 6 months.

The company has to pay an equivalent of $ 32.5604 which will be $ 32.5604 M * 15.3555 = 499.9812 million Pesos. This is due to depreciation of Pesos with respect to US Dollars.

FORWARD CONTRACT

Entering into a forward contract we sign an agreement with the importer that the delivery of the amount will be made after 6 months time at the forecasted forward rate which is Peso/USD 15.0123 – 15.0134. We will be entitled to a sum of 500/15.0134 = $ 33.3035, therefore we enter into a future contract which gives us $33.3036 million at the end of 6 months.

We will be receiving $ 33.3036 million which is equivalent to 500 million Mexican Pesos, therefore the importer needs to make a payment of $ 33.3036 * 15.0123 = 499.9636 million Pesos to the trader. If the future rate increases than the importer is obliged to pay the 500 million Pesos at the prevailing Spot rate but if the spot rate goes down then the importer has to meet the previously agreed rate for the payment.

MONEY MARKET HEDGE

We are expected to receive 500 million Pesos therefore we borrow the same amount from a Mexican bank at the borrowing rate of 2.6% per annum and we convert them to US Dollars and invest the same amount at 3.1% per annum.

We borrow 500 million Mexican Pesos at 2.6% 500/ 1+0.013 which equals 493.5834 million and convert them into Dollars at the prevailing Spot rate of 15.3561 which equals 493.5834/ 15.3561 = $ 32.1425 million and invest them in the US market at 3.1% which equals $32.1425 * 1.016 + $32.6568. Once the payment of 500 million Pesos will be received than the loan has to be repaid and we will have $36.6568 * 15.0123 = 506.3029 million Pesos. This states that there will be a profit of 550.3029 million – 506.5 million Pesos = 43.8029 million pesos which equals 43.8029/15.3561 = $2.9176 million.

The recommended hedging technique in this case would be FUTURE CONTRACT METHOD which is the most beneficial out of the three. The 3 methods earn the following amounts:

Billing in US Dollars - $32.5604 million

Forward contract - $33.3036 million

Money market hedge - $32.6568 million

FORWARD EXCHANGE FIXED CONTRACT AND FORWARD EXCHANGE OPTION CONTRACT

Forward exchange contracts help us to manage the risk of foreign currency denominated payables or receivables. It is a contract to conduct the foreign exchange transaction at a fixed rate of exchange on a fixed future date which is also known as closed contract or during a fixed period of time known as open contract.

Fixed forward contract: this protects the profitability and improves the bottom line by minimising foreign currency risk. It must be settled and utilised on a specific date and is useful only when we have a invoice to pay or we know that a payment will be received on a fixed date. Under this type of contract the delivery of the foreign exchange takes place on a specified future date. The delivery of foreign exchange in any circumstances can take place prior to or later than the determined date. In case of fixed forward contract the forward margin added will include the forward period as well as the transit and usance period. This alleviates a lot of stress from a clients perspective as the client knows that his profit is secure for the course of the forward contract. The fixed forward contract is:

OPENING DATE---------------------------------------------------------------MATURITY DATE

_________Non-optional period_________

Option forward contract: it sets a time during which any contract can be settled as long as the all of it paid by the final date. It is designed for people who know that they have a number of bills to pay in a certain currency and it gives them the flexibility on the date on which they wish to make use of the currency. In the case where there is a difficulty in fixing the exact date for delivery of foreign exchange, the customer is given a choice of making the delivery within a given period of days. This kind of arrangement when people have a choice of buying or selling on any day during the given period of time at a predetermined rate is option forward contract. The period during which the option takes place is known as the "Option Period." In this case the option rate quoted on behalf of the customer is based on the interbank option forward rate. For the purchase transactions we quote premium for the earliest delivery and for sale transactions we quote premium for the latest delivery.

OPENING DATE------------------------------------------------------------MATURITY DATE

__________Fully optional period_______