Advanced financial management revision question and answer

Advanced Financial Management Block Revision Mock Exams

(a) A company operating in a country having the dollar as its unit of currency has today invoiced sales to the United Kingdom in sterling, payment being due three months from the date of invoice. The invoice amount is £3,000,000 which, at today‟s spot rate of 1.5985 is equivalent to $4,795,500.

It is expected that the exchange rate will decline about 5% over the three month period and in order to protect the dollar proceeds from the sale, the company proposes taking appropriate action through either the foreign exchange market or the money market.

The $/£ three-months forward exchange rate is quoted as 1.5858-1.5873. the three-months borrowing rate for Euro sterling is 15.0% and the deposit rate quoted the company‟s own bankers is currently 9.5%.

You are required to
Explain the alternative courses of action available to the company, with relevant calculations to four decimal places, and to advise which course of action should be adopted.

(b) You are required to discuss whether a multinational company should hedge translation exposure incurring transaction exposure.

(c) Explain briefly what is meant foreign currency options and give examples of the advantages and disadvantages of exchange traded foreign currency options to the financial manager.
ANSWER
(a) There are two courses of action available to the company: forward market cover or money market cover. These are considered in turn below.

Forward market cover
The company is to receive £3,000,000 in 3 months‟ time. Therefore in order to fix the exchange rate at that point in time (and the resultant dollar proceeds) the company could arrange to sell the sterling forward setting up a forward contract.

The forward exchange rate is quoted as $1.5858 – $1.5873/£. The relevant rate for selling forward £ would be $1.5858/£ (which yields the smaller figure for $).

Therefore the forward sale of £3,000,000 would yield

£3,000,000 x $1.5858/£ = $4,757,400.

Exchange rate risk has been eliminated since the dollar receipt of $4,757,400 is guaranteed. In addition, even if the future spot rate of $1.5186/£($1.5985 x 95%) were certain, forward market cover would be preferable, since the latter 3 month spot rate would yield only

£3,000,000 x $1.5186/£ = $4,555,800

However, with the forward market cover there remains a shortfall over the $ proceeds which would be expected on the basis of the current spot rate. This shortfall amounts to:

$4,795,500 – $4,757,400 = $38,100 (given in
question) Money market cover
Again exchange rate risk may be effectively eliminated borrowing sterling which will amount to £3,000,000 with accrued interest in 3 months‟ time and converting this sterling at the current spot rate into $ for investment. The amount of dollars accrued in the deposit account after 3 months represents the effective dollar receipt, as shown below. The £ loan will be repaid when the invoice amount of £3,000,000 is received.

Borrow sterling @ 15% interest for 3 months (3.75%)

As with forward market cover, this represents a shortfall over the $ receipt using the current spot rate, which amounts to
$4,795,500 – $4,731,945 = $63,555

Advice on course of action

Based on the initial computations, the forward market cover will convert the £3,000,000 receipt into
$4,757,400 in 3 months‟ time, whereas the money market cover would yield $4,731,945. On this basis the forward market cover would be preferable as it gives the higher $ receipt. In addition it is completely riskless, whereas the money market cover relies on interest rates remaining constant over the 3-month period in order to eliminate exchange rate risk.

(b) Translation exposure relates to the consolidation of a foreign subsidiary‟s accounts into the group accounts. The group financial statements will be denominated in the currency of the parent company and any balances in the subsidiary‟s accounts denominated in its own currency will be subject to translation exposure. Such balances will usually be translated at the exchange rate prevailing at the balance sheet date. However, if exchange rates between the parent company‟scurrency and the subsidiary‟s currency vary, then the parent company‟s valuation of such foreign currency items will vary over time, giving rise to translation risk or uncertainty. This will, however, only be converted into transactions risk, with a related cash-flow effect, if it is necessary for such foreign currency balances to be exchanged into the parent company currency, or if a foreign currency loan is required to be repaid use of parent company funds. Therefore, translation exposure does not impose a major foreign exchange risk on a company, but merely impacts the accuracy of balance sheet items valued use of an historic exchange rate.

The major link with transaction exposure relates to the method which translation exposure may be hedged. The parent company may effectively finance the foreign subsidiary using its own funds or home currency funds, but such an action would give rise to potential transaction losses on exchange. In certain circumstances it is practical to provide a foreign subsidiary with capital from the parent company, as this may be cheaper than finance obtained from the country in which the subsidiary operates. However, there is little benefit to be derived from incurring such transaction exposure in order to hedge translation exposure.

(c) A foreign currency option gives the buyer of the option the right, but not the obligation, to buy or sell a currency at a specified rate of exchange at a specified time.

Advantages
(i) Foreign currency options limit downside risk whilst allowing companies to take advantage of favourable foreign exchange rate movements.

They are a useful hedge against risk when a company is unsure whether a future foreign exchange risk will occur, for example when tendering for a contract which it might not get, or issuing a price list in foreign currencies.

They provide an effective currency hedge, especially when foreign exchange markets are volatile.

Disadvantages
(i) Cost. A premium is payable when the option is arranged, no matter whether or not the option is exercised.

(ii) Exchange traded options are only available in a small number of currencies with specific expiry dates (OTC options are much more flexible).

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