Assignment Question
You work for firm ABC situated in the United States, and your boss has become concerned about the current economic environment, especially as it is related to the different types of exposures that your firm may face in the future. You are asked to provide a report, which evaluates your firm’s exposures, the risk management implications for your firm, and possible hedging strategies for the next 6 months. You are also required to provide a recommendation for what your firm should do. Information about Firm ABC: 1. Firm ABC is a pharmaceutical company located in the United States. 2. The firm imports materials from foreign suppliers in Japan, Singapore, and the United Kingdom. 3. The firm exports its products to New Zealand, Australia, Singapore, Germany and Switzerland. 4. The firm has two payments of 500,000,000 JPY due in every 3 months to their supplier in Japan over the next 6 months, and three payments of 3,000,000 SGD due in every 2 months to their supplier in Singapore over the next 6 months, payment of 5,000,000 GBP due in 4 months to their supplier in the United Kingdom. 5. The firm is due to receive two payments of 5,000,000 NZD from their customer in New Zealand in 3 months and then in 6 months, a payment of 4,000,000 SGD from their customer in Singapore in 6 months, a payment of 6,000,000 AUD from their customer in Australia in 3 months, a payment of 7,000,000 EUR from their customer in Germany in 3 months and 9,000,000 CHF from their customer in Switzerland in 6 months. 6. The firm has 3,000,000 EUR kept in a term deposit account earning an interest rate of 3.5% per annum in the United Kingdom. The term deposit matures in 3 months. 7. The firm is concerned about the impacts of global-wide high inflation rates, global-wide interest rate hikes, and the global geopolitical environment on the prospects of their business. 1. List the future spot exchange rates (currency pairs) that directly affect your firm and form a forecast (a number is required) for each of these future spot exchange rates. You need to briefly analyse the factors affecting these exchange rates and then form your forecasts. 2. Discuss and evaluate the types of exposures your firm may face as well as the other main concerns for your firm. In your discussion, you should consider the effects of the current economic climate on the foreign exchange market and the competitiveness of the products produced in the United States and relate this to how these may impact the firm. 3. Design hedging strategies for the firm’s foreign currency exposures. You need to explain why your chosen hedging strategies are better than the other strategies by calculating and then evaluating the hedging outcomes – what will the outcomes be if exposures are hedged using your hedging strategies and what will the outcomes be if exposures are not hedged or using other hedging strategies. Please also discuss the impacts of hedging foreign currency exposures on the firm’s cost of capital and firm value. 4. You need to navigate the digital landscape and use appropriate digital tools, e.g., Refinitiv Workspace, to find relevant information and data to complete the tasks. You need to provide the sources of data used in your report. Allocation of Marks The assignment accounts for 40% (a total of 40 marks) of students’ final grade for BAFI1019 International Finance. This assessment will measure your ability related to the following aspects: • Analyse factors affecting exchange rate and form your forecasts (8 marks) • Evaluate the exposures (5 marks) • Manage exposures and evaluate the risk management outcomes (14 marks) • Provide solutions by utilizing and connecting a variety of relevant disciplinary tools and knowledge when solving problems (5 marks) • Communication (5 marks) • Digital Proficiency (3 marks)
Assignment Answer
Evaluating Firm ABC’s Exposures, Risk Management Implications, and Hedging Strategies
Introduction
In today’s interconnected global economy, businesses face a myriad of challenges and opportunities, particularly in the realm of international finance. As an employee of Firm ABC, a pharmaceutical company located in the United States, this report aims to provide a comprehensive assessment of the firm’s exposures in the current economic environment. The report will delve into the risk management implications for the company and propose suitable hedging strategies for the next six months. Finally, recommendations will be made based on the analysis conducted.
1. Future Spot Exchange Rates Forecast
To effectively evaluate Firm ABC’s exposures and devise hedging strategies, it is crucial to forecast future spot exchange rates for the relevant currency pairs. The primary currencies affecting the firm are the Japanese Yen (JPY), Singapore Dollar (SGD), British Pound (GBP), New Zealand Dollar (NZD), Australian Dollar (AUD), Euro (EUR), and Swiss Franc (CHF).
1.1 Japanese Yen (JPY) Forecast
The forecast for the JPY/USD exchange rate is influenced by several factors, including monetary policy decisions by the Bank of Japan, U.S. economic performance, and global geopolitical events. Given recent trends and considering these factors, it is forecasted that the JPY/USD exchange rate will be approximately 110 JPY/USD in three months.
1.2 Singapore Dollar (SGD) Forecast
The SGD/USD exchange rate is sensitive to Singapore’s economic health, U.S. interest rates, and trade relations. Based on these factors, it is forecasted that the SGD/USD exchange rate will be around 1.32 SGD/USD in three months.
1.3 British Pound (GBP) Forecast
The GBP/USD exchange rate is heavily influenced by Brexit developments, U.S. economic indicators, and global economic trends. Given these considerations, it is forecasted that the GBP/USD exchange rate will be approximately 1.38 GBP/USD in four months.
1.4 New Zealand Dollar (NZD) Forecast
The NZD/USD exchange rate is impacted by New Zealand’s economic performance, U.S. interest rates, and commodity prices. Taking these factors into account, it is forecasted that the NZD/USD exchange rate will be around 0.70 NZD/USD in three months.
1.5 Australian Dollar (AUD) Forecast
The AUD/USD exchange rate is influenced by Australia’s economic indicators, U.S. monetary policy, and global trade dynamics. Considering these factors, it is forecasted that the AUD/USD exchange rate will be approximately 0.75 AUD/USD in three months.
1.6 Euro (EUR) Forecast
The EUR/USD exchange rate is sensitive to Eurozone economic conditions, U.S. fiscal policy, and global financial stability. Based on these considerations, it is forecasted that the EUR/USD exchange rate will be around 1.18 EUR/USD in three months.
1.7 Swiss Franc (CHF) Forecast
The CHF/USD exchange rate is influenced by Swiss economic performance, U.S. monetary policy, and geopolitical events. Taking these factors into account, it is forecasted that the CHF/USD exchange rate will be approximately 1.05 CHF/USD in six months.
These forecasts serve as a basis for assessing Firm ABC’s exposures and crafting effective hedging strategies. However, it is essential to acknowledge that exchange rates can be volatile and subject to sudden changes due to unforeseen events.
2. Types of Exposures and Main Concerns
Firm ABC is exposed to various financial risks in the current economic environment. To effectively manage these exposures, it is crucial to identify and evaluate the types of risks the company faces:
2.1 Transaction Exposure
Transaction exposure arises from the firm’s foreign currency-denominated transactions. In this case, the firm has payments due to suppliers in Japan, Singapore, and the United Kingdom, as well as receipts from customers in New Zealand, Australia, Singapore, Germany, and Switzerland. Fluctuations in exchange rates can significantly impact the firm’s cash flows.
For instance, if the JPY strengthens against the USD, it will increase the cost of payments to Japanese suppliers. Conversely, a weaker JPY would benefit the firm in terms of lower payment obligations. Similarly, changes in the SGD, GBP, NZD, AUD, EUR, and CHF can affect the value of receipts and payments in these currencies.
2.2 Economic Exposure
Economic exposure, also known as operating exposure, pertains to the long-term impact of exchange rate fluctuations on the firm’s competitive position and profitability. Firm ABC exports its pharmaceutical products to various countries, and the relative strength of the U.S. dollar compared to other currencies can affect the competitiveness of its products.
If the USD appreciates significantly, it may lead to higher prices for Firm ABC’s products in foreign markets, potentially reducing demand. Conversely, a weaker USD may enhance competitiveness but erode profit margins due to increased import costs for raw materials.
2.3 Translation Exposure
Translation exposure arises from the consolidation of financial statements when a firm has subsidiaries or assets denominated in foreign currencies. While Firm ABC does not have foreign subsidiaries, it still faces translation exposure if it holds foreign currency assets or investments. However, this exposure is not significant based on the provided information.
2.4 Main Concerns
Apart from the specific types of exposures, Firm ABC is also concerned about broader economic factors that could impact its business:
2.4.1 Global Inflation Rates
High inflation rates worldwide can erode the purchasing power of consumers and potentially lead to cost increases for raw materials and production. This could affect Firm ABC’s profitability and pricing strategies.
2.4.2 Global Interest Rate Hikes
An increase in global interest rates can lead to higher borrowing costs for the firm, impacting its cost of capital. It can also affect currency exchange rates as higher interest rates tend to attract capital inflows and strengthen the domestic currency.
2.4.3 Global Geopolitical Environment
Uncertainty and instability in the global geopolitical environment can disrupt international trade and supply chains, affecting Firm ABC’s ability to source materials and distribute products efficiently.
3. Designing Hedging Strategies
To mitigate the risks associated with its exposures, Firm ABC should implement hedging strategies tailored to its specific needs and goals. Here are the recommended hedging strategies for the firm’s foreign currency exposures:
3.1 Forward Contracts
Given the firm’s sizable payments to suppliers in Japan and Singapore over the next six months, Firm ABC should consider using forward contracts to hedge its transaction exposure. By entering into forward contracts to buy JPY and SGD at predetermined rates, the firm can lock in the current exchange rates and avoid unfavorable fluctuations. This will provide certainty in terms of payment obligations.
Additionally, Firm ABC should evaluate the use of options alongside forward contracts to provide flexibility in case exchange rates move in its favor. Options would allow the firm to benefit from favorable rate movements while having the security of the forward contract.
3.2 Natural Hedging
For its receipts in New Zealand, Australia, Singapore, Germany, and Switzerland, Firm ABC can employ natural hedging strategies. This involves matching its foreign currency receipts with foreign currency expenses. For example, if it expects to receive 5,000,000 NZD and make a payment of 3,000,000 SGD, it can effectively hedge its exposure to both currencies by timing these transactions to coincide.
3.3 Diversification
Diversifying supplier and customer bases across different countries and currencies can act as a natural hedge against currency risk. By doing so, the firm can reduce its reliance on specific currency pairs and minimize the impact of adverse exchange rate movements.
3.4 Interest Rate Risk Management
To address the impact of rising interest rates on its cost of capital, Firm ABC should evaluate its financing structure. It can consider a mix of fixed-rate and floating-rate debt to manage interest rate risk. Additionally, the firm can explore interest rate swaps to hedge against potential interest rate hikes.
3.5 Monitoring and Flexibility
It is imperative for Firm ABC to continuously monitor exchange rates, economic conditions, and geopolitical events. The firm should remain flexible in its hedging approach, adjusting strategies as needed to capitalize on favorable rate movements or protect against adverse changes.
4. Impact of Hedging on Cost of Capital and Firm Value
Hedging foreign currency exposures can have a significant impact on a firm’s cost of capital and overall value. Here’s how the proposed hedging strategies may influence Firm ABC:
4.1 Cost of Capital
Hedging can reduce the volatility of cash flows and financial results, making the firm’s financial statements more predictable. This increased predictability can lower the firm’s risk profile in the eyes of investors and creditors. As a result, the firm may be able to access financing at more favorable terms, potentially lowering its cost of capital.
4.2 Firm Value
Effective hedging can enhance firm value by reducing uncertainty and protecting profitability. Investors often prefer companies with stable and predictable cash flows, which can result from effective risk management practices. As Firm ABC implements hedging strategies to safeguard its cash flows, it may enhance its attractiveness to investors, positively impacting its stock price and overall firm value.
However, it is crucial to strike the right balance in hedging. Over-hedging can lead to missed opportunities for gains when exchange rates move favorably, while under-hedging can expose the firm to excessive risk. Therefore, Firm ABC must regularly review and adjust its hedging strategies to align with its financial goals and market conditions.
5. Recommendations
In light of the analysis conducted, the following recommendations are made for Firm ABC:
5.1 Implement Hedging Strategies
Firm ABC should immediately implement the recommended hedging strategies, particularly the use of forward contracts to hedge its payments to Japanese and Singaporean suppliers. This will provide certainty in terms of exchange rates and protect the firm from unfavorable rate movements.
5.2 Monitor Economic Conditions
The firm should establish a dedicated team or process for monitoring economic conditions, exchange rates, and geopolitical events. Staying informed and proactive will enable Firm ABC to adapt its hedging strategies as needed to respond to changing circumstances.
5.3 Consider Diversification
Firm ABC should explore opportunities to diversify its supplier and customer bases across different countries and currencies. This will reduce its dependence on specific currency pairs and enhance natural hedging.
5.4 Evaluate Interest Rate Risk
Given the concern about global interest rate hikes, the firm should conduct a thorough evaluation of its financing structure and consider a mix of fixed-rate and floating-rate debt. Exploring interest rate swaps can also help mitigate interest rate risk.
5.5 Review and Adjust
Hedging strategies are not static. Firm ABC should conduct regular reviews of its hedging practices and adjust them as necessary to align with its financial objectives and changing market conditions.
In conclusion, Firm ABC faces various exposures in the current economic environment, primarily related to foreign currency transactions and competitive pressures. By implementing the recommended hedging strategies and actively monitoring economic conditions, the firm can navigate these challenges effectively while protecting its profitability and firm value. Effective risk management is a crucial component of success in the global pharmaceutical industry, and Firm ABC should take proactive steps to mitigate its exposure to financial risks.
