Financial management
Foreign Exchange-Rate Risk
Introduction
Foreign exchange risk is the exposure of an institution to the potential impact of movements in foreign exchange rates. The risk is that adverse fluctuations in exchange rates may result in a loss in British pound terms to the institution.
Foreign exchange risk arises from two factors: currency mismatches in an institution’s assets and liabilities both on- and off-balance sheet that are not subject to a fixed exchange rate vis-a-vis the British pound, and currency cash flow mismatches. Such risk continues until the foreign exchange position is covered. This risk may arise from a variety of sources such as foreign currency retail accounts and retail cash transactions and services, foreign exchange trading, investments denominated in foreign currencies and investments in foreign companies. The amount at risk is a function of the magnitude of potential exchange rate changes and the size and duration of the foreign currency exposure.
In-order to critically evaluate and assess the impact that Foreign exchange rates have on firms, 2 listed UK based firms have been nominated be evaluated and assessed by comparing implementation methods and approaches to the management of exchange rates risks.
General Motors Company, one of the world’s largest automakers, traces its roots back to 1908. With its global headquarters in Detroit, GM employs 235,000 people in every major region of the world and does business in some 140 countries. GM and its strategic partners produce cars and trucks in 34 countries, and sell and service these vehicles through the following brands: Buick, Cadillac, Chevrolet, GMC, GM Daewoo, Holden, Opel, Vauxhall and Wuling. GM’s largest national market is the United States. (GM, Corporate information, 2009)
Corus is a steel manufacturing company that mainly exports large quantities of readymade steel to various countries across the world. Corus is Europe’s second largest steel producer behind Tata Steel with annual revenues of around �12 billion and a crude steel production of over 20 million tonnes. Tata Steel has since joint ventures with Corus in 2006 after agreeing a �4.3bn takeover deal. (BBC News, Corus accepts �4.3bn Tata offer, 2006)
Foreign exchange risk Management
Managing foreign exchange risk is a fundamental component in the safe and sound management of all institutions that have exposures in foreign currencies. It involves prudently managing foreign currency positions in order to control, within set parameters, the impact of changes in exchange rates on the financial position of the institution. The frequency and direction of rate changes, the extent of the foreign currency exposure and the ability of counterparts to honour their obligations to the institution are significant factors in foreign exchange risk management.
Due to this economic downturn which is being faced by numerous countries is resulting in the balance of currency being shifted (Forex) resulting in devastating effects on countries which rely on exporting and importing goods and services to aid their economies i.e. China heavily depends on the USA and UK to buy their exports. It is there for vital for firms to accurately manage foreign exchange rates risks as it can impact on various aspects of a firm’s activities such as:
The acceptability, of an overseas investment project – When a firm evaluates its opportunities to make substantial profits on a certain investment, the firm must be aware that future forex’s can impact heavily on the estimated Net Present Value.
Income to be received from abroad – For example Corus exports goods to a German construction firm on six months’ credit terms, payable in Euros, it is variable as to the number of pounds it will actually receive because the pound could forex against the Euro in the intervening period. This actually occurred between 1996 and 2001 the pound rose against most currencies and from the German importers view point UK goods relative to domestic goods rose in price by the order of 30-40 per cent, as a result Corus were forced to cut thousands of jobs in response to sterling’s rise and started losing money at an alarming rate. Corus exacerbated the issue further by informing its 700 UK suppliers to cut prices. (Glen Arnold 3rd 2005)
The valuation of foreign assets and liabilities assets and liabilities – In today’s globalised marketplace numerous firms own assets abroad and incur liabilities in foreign currencies. Meaning the value of the assets in home currency terms are exposed to change as a result of the forex movements.
The long term viability of foreign operations – In future long term subsidiaries invested in other countries can increase their value due to the favourable forex change; however this could also have major negative implications on the firms operating in the wrong currency at the wrong time.
The amount actually paid for imports at some future date – For instance, a Japanese firm importing steel within the UK could have a liability to pay pounds a few months later. The quantity of Yen it will have to use to exchange for the pounds at that point of time will be variable to the time when the deal was agreed.
The need for currency risk management started to arise after the breakdown of the Bretton Woods system and the end of the US dollar peg to gold in 1973 (Papaioannou, 2001), which has resulted in many multinational firms implementing risk committees to oversee the treasury’s strategy in managing the exchange rate and interest rate risk (Lam, 2003). This shows the importance that firms attach to risk management issues and techniques.
Types of foreign exchange rate risks
Corus and GM being Multinational firms they predominately participate in currency markets by virtue of their international transactions. To measure the impact of exchange rate movements on the two organisations involved in foreign currency denominated operations, we need to identify the types of risks that GM & Corus are exposed to and the amount of risk they actually encounter. In the International marketplace there are three main types of exchange rate risks which are: transaction risk, translation risk and economic risk. (Buckley, A, 2000, 4th edition).
Transaction risk – The exchange rate risk associated with the time delay between entering into a contract and settling it. The greater the time differential between theentrance andsettlement of the contract, the greater the transaction risk, becausethere is more time for the two exchange rates to fluctuate. Transaction risk creates difficulties not only for Corus & GM but for numerous corporations in dealing with different currencies, as exchange rates can fluctuate significantly over a short period of time. This volatility is usually reduced, or hedged,by entering into currency swaps and other similar securities. (Taylor, F, 2000 2nd edition)
In addition when GM & Corus borrow in foreign currency, committing themselves to regular interest and principal payments in that currency, they are exposed to forex risk. This predicament beset a number of Brazilian companies in 2002, as they had committed themselves to paying off borrowings in hard currency (e.g. US Dollars, sterling). This became an issue when debt rose by 40% simply because of the decline in their currency against the hard currency. (Wheatley, J, Financial times, 2002) Exhibit A
Translation risk – The exchange rate risk associated with companies that deal in foreign currencies or list foreign assets on their balance sheets. The greater the proportion of asset, liability and equity classes denominated in a foreign currency, the greater the translation risk. This poses a serious threat for Corus & GM in conducting business in foreign markets. Exchange rates usually change between quarterly financial statements, causing significant variances between the reportedfigures. Companies attempt to minimize these transaction risks by purchasing currency swaps or hedging through futures contracts. (Taylor, F, 2000, 2nd edition)
For example, Courts, the furniture and electrical retailer, which had 60% of its turnover overseas found that even though overseas sales rose 8% in local currency terms, when the figures were translated into sterling a fall of 4% was reported. This was the result of sterling rising against the dollar and later in 2004 Courts went into administration as profits collapsed and it failed to pay creditors. (Buckley, S, Financial Times, 2004) Exhibit B
Economic Risk – The possibility that an economic downturn will negatively impact an investment. For example, launching a luxury product immediately before or during a recession carries a great deal of economic risk. Economic risk is closely related to political risk as government decisions impacting the economy may also affect an investment. For example, a central bank may raise interest rates or the legislature may raise taxes, and this may result in economic conditions impacting an investment.
Risk management techniques
Futures contracts, forward contracts, options and swapsare the most common types of derivatives. Derivatives are contracts and canbe used as an underlying asset.
Derivatives are generally used as an instrument to hedgerisk, but can also be used forspeculative purposes. For example, a European investor purchasing shares of an American companyoffof an American exchange (using U.S. dollars to do so) would be exposed to exchange rate risk while holding that stock. To hedge this risk, the investor could purchase currency futures to lock in a specified exchange rate forthe future stock sale and currency conversion back into Euros.
Corus
Corus has a separate department that deals with foreign exchange rate risks and exposures. The Group’s policy is to minimise currency translation, transaction and economic exposure by hedging a proportion of most material overseas investments through forward contracts or cross currency swaps pending on the type of customers being dealt with. Through forward contracts and cross currency swaps “Corus generate on average a combined total of �766m a year and all the foreign exchange contracts agreed do not extend beyond twelve months.” With 83% of British steel’s turnover accounted for by sales to Europe effective risk management is crucial for Corus. Referencing from the annual report the substantial strengthening of sterling adversely affects Corus’s results in three ways. First, it directly reduces export revenues. To manage this exposure Corus initiates forward contact sales to the extent of the Company’s contractual commitments, but such hedge is effective for only that defined time. Second, it improves the relative competitiveness of steel producers in countries with weaker currencies enabling them to discount prices in British Steel’s domestic market. For Corus it is not practicable to constantly hedge this competitive exposure due to the unpredictability of the economy, so the exposure still remains but is closely monitored by their designated department. Third, it exposes British Steel’s UK customers to similar pressures leading to a reduction in demand for steel in the UK.
Through the use of Forward contracts Corus can create certainty through locked it specific rates, no margins or premiums payables, occasionally Corus will ask for performance margins to act as reassurance that the other party will be able to pay for the goods on the agreed date or impose credit limits mitigating the risk. However forward contracts also carry burdens that could seriously affect Corus as a business for instance it becomes more difficult to liquidate position than with exchange traded instruments by creating an offsetting transaction that cancels position, also in a hedge position if the underlying transaction does not materialise Corus can experience a switch from a covered to an uncovered position, the potential loss is unlimited. Also Corus will have no right to let the contract lapse resulting in benefits from favourable movements in underlying forgone.
Hedging through the use of Cross currency swaps is beneficial for Corus because it allows them to switch their loans from one currency to another. They also gain the flexibility to choose whether the loans have fixed or floating rate interest. The swap allows Corus to borrow in the currency which generates the best outcome. Corus’s foreign currency exposure is reduced through the use of swaps and they can use money received in foreign currency to pay off its loans when switched. The only down side being unlimited loss potential.
General Motors
GM is actually a major customer of Corus as they are supplied with finished courted metal, steel, iron est. Like Corus GM has also got a separate department that deals with FOREX movements, interestingly enough they both use the same hedging techniques as Corus. Meaning they are exposed to various risks and benefits as Corus, but according to the 2008 Foreign exchange Hedge article addressed to GM concludes that “GM can also hedge more by way of options. Since options have a 50% delta (in the way in which GM chooses it trades), they may allocate a bigger percentage to options. Hedging by the way of options results only in premiums whereas hedging by way of forwards may call for a bigger notional amount in the transaction.” Since reviewing the recommendations from the article GM have since decided to adopt the options technique into their policy, through options GM’s downside risk is limited but the buyer is able to participate in favourable movements in the underlying. For many options there are highly liquid markets resulting in keen option premium pricing and the ability to reverse a position quickly at low cost further benefiting GM. Compared to the other two techniques used by GM options is by far the least risky technique/method with only minor issues such as GM’s premium payables returns are reduced and that when writing the options GM will require margins.
To summarise GM and Corus both have the required knowledge and experience in handling Forex exposures as research has indicated, the only difference being the scale of operations overseas with GM being the most affected regardless to their risk management policy due to economic risk exposure, as evident with this year’s recession, as GM nearly sold part of their business to the German car manufacturer Magna and that also included job cuts and a $6.7bn from the US government. BBC article compare that to Corus who didn’t close or forced to sell their plants but instead job cuts were initiated across the whole establishment, cutting 3,500 jobs worldwide including 2,500 in the UK.