Assignment – International Financial Management Essay Example

of foreign exchange exposures: Transaction exposure, Economic exposure, and Translation exposure. Transaction exposure measures the impact on the value of financial liabilities that were obtained prior to a change in exchange rates but are to be repaid after the change. Economic exposure measures the effect on the present value of a company caused by unpredictable changes in expected future operating cash flows due to fluctuations in exchange rates. Translation exposure assesses the potential gains or losses that will be reflected in consolidated financial statements due to varying exchange rates.

The use of options as a hedging method is explored in the text. Currency options are agreements between two parties that give the option buyer the right (but not obligation) to buy or sell currency at a predetermined exchange rate, on or before a specified date, from the option seller. There are two types of options: call options allow the buyer to acquire currency at a designated rate and date, while put options enable the buyer to sell currency at a specific rate and date. The option buyer compensates the seller with a premium in exchange for exercising their rights.

Currency futures in the futures market are used as a hedge against currency value fluctuations. Selling futures protects against a decrease in currency value, while buying futures safeguards against an increase in currency value. A futures contract is a legally binding agreement that involves exchanging a specified amount of one currency for another at a predetermined exchange rate and within a set timeframe. Changes in the futures market impact changes in exchange rates. For example, if a buyer purchases a contract to buy wheat

in September and adverse weather conditions destroy the crops, the price of wheat will increase due to supply and demand factors in the futures market. In this situation, the contract buyer can choose to trade within a specific period or hold it until the contract expires.

The idea of hedging with a swap involves using a currency swap agreement between two parties to exchange currencies at a predetermined rate on a specific future date. This helps mitigate the risk of fluctuating exchange rates. For example, if Company A needs dollars in the future and Company B needs pounds, they can arrange to trade currencies at an agreed-upon rate on a specified date. This arrangement benefits both parties by reducing the risk caused by currency fluctuations. Currency swaps involve exchanging principal and interest in one currency for another, also known as a foreign exchange transaction.

Companies can use forward contracts to protect against exchange rate fluctuations by securing rates up to a year in advance. This is particularly advantageous for importers, as it enables them to establish a selling price well ahead of shipment and ensure they have knowledge of the precise cost of goods, regardless of potential changes in the exchange rate. These contracts safeguard against unfavorable shifts in the exchange rate and typically require only a small deposit, ranging from 5% to 15%, with the remaining balance due on the agreed-upon future payment date. To illustrate this concept, let's consider an example involving a farmer who annually produces 2 million pounds of apples.

The price of apples varies, ranging from 30pence per lbs after the harvest to 10pence per lbs. This fluctuation can

either lead the farmer to make a good profit or struggle to cover costs. On the other hand, an Apple Pie Chain buys apples from the farmer annually and earns significant profits when purchasing at 10pence per lbs but minimal profits when buying at 30pence per lbs. To address this uncertainty, the farmer and the apple pie chain can establish a contract before harvesting. They agree on purchasing 2 million lbs of apples for 20pence per lbs. This arrangement helps mitigate market fluctuations and benefits both parties.

The money market hedge is a strategy used by companies to reduce the risk of currency fluctuations. It involves borrowing and lending in different currencies, allowing the company to secure the value of a foreign currency transaction in their own country's currency. For instance, let's consider company XYZ, which anticipates receiving $10 million in 3 months. The spot rates for converting dollars to pounds range from 1.5384 to 1.5426, while interest rates are between 5.2% and 5.8% in the US and between 3.6% and 3.9% in the UK.

To hedge its position, XYZ borrows $10 million at an interest rate of 1.45%, resulting in a present value of $9.86 million ($10 million * (1 + (0 .0145/4))^4). Then XYZ converts this borrowed amount into British pounds at the current spot rate of 1 .5426, obtaining ?6 .392 million.

Next, XYZ deposits the ?6 .392 million for 3 months at an interest rate of 0 .9%, achieving a total amount of ?6 .97 million (?6 .392 million * (1 + (0 .009/12))^3).

Finally, XYZ converts this sum back into dollars at the spot rate of 1 .5384, receiving $10 .7 million (?6 .97m

* 1 .5384).

Consequently, not only did XYZ receive the expected $10 million but also gained a profit surpassing $700 ,000 ($10 .7m - $10m).