foreign exchange risk management and techniques to reduce risk

Foreign Exchange Risk Management

Many firms are exposed to foreign exchange risk - i.e. their wealth is affected by movements in exchange rates - and will seek to manage their risk exposure. This page looks at the different types of foreign exchange risk and introduces methods for hedging that risk

Types of foreign exchange risk

·        Transaction risk

This is the risk of an exchange rate changing between the transaction date and the subsequent settlement date, i.e. it is the gain or loss arising on conversion.

This type of risk is primarily associated with imports and exports. If a company exports goods on credit then it has a figure for debtors in its accounts. The amount it will finally receive depends on the foreign exchange movement from the transaction date to the settlement date.

As transaction risk has a potential impact on the cash flows of a company, most companies choose to hedge against such exposure. Measuring and monitoring transaction risk is normally an important component of treasury risk management.

The degree of exposure is dependent on:

(a) The size of the transaction, is it material?

(b) The hedge period, the time period before the expected cash flows occurs.

(c) The anticipated volatility of the exchange rates during the hedge period.

The corporate risk management policy should state what degree of exposure is acceptable. This will probably be dependent on whether the Treasury Department is been established as a cost or profit centre.

·        Economic risk

Transaction exposure focuses on relatively short-term cash flows effects; economic exposure encompasses these plus the longer-term affects of changes in exchange rates on the market value of a company. Basically this means a change in the present value of the future after tax cash flows due to changes in exchange rates.

There are two ways in which a company is exposed to economic risk.

Directly: If your firm's home currency strengthens then foreign competitors are able to gain sales at your expense because your products have become more expensive (or you have reduced your margins) in the eyes of customers both abroad and at home.

If your firm's home currency strengthens then foreign competitors are able to gain sales at your expense because your products have become more expensive (or you have reduced your margins) in the eyes of customers both abroad and at home.

Indirectly: Even if your home currency does not move vis-a -vis your customer's currency you may lose competitive position. For example suppose a South African firm is selling into Hong Kong and its main competitor is a New Zealand firm. If the New Zealand dollar weakens against the Hong Kong dollar the South African firm has lost some competitive position.

Even if your home currency does not move vis-a -vis your customer's currency you may lose competitive position. For example suppose a South African firm is selling into Hong Kong and its main competitor is a New Zealand firm. If the New Zealand dollar weakens against the Hong Kong dollar the South African firm has lost some competitive position.

Economic risk is difficult to quantify but a favoured strategy to manage it is to diversify internationally, in terms of sales, location of production facilities, raw materials and financing. Such diversification is likely to significantly reduce the impact of economic exposure relative to a purely domestic company, and provide much greater flexibility to react to real exchange rate changes.

·        Translation risk

The financial statements of overseas subsidiaries are usually translated into the home currency in order that they can be consolidated into the group's financial statements. Note that this is purely a paper-based exercise - it is the translation not the conversion of real money from one currency to another.

The reported performance of an overseas subsidiary in home-based currency terms can be severely distorted if there has been a significant foreign exchange movement.

If initially the exchange rate is given by $/£1.00 and an American subsidiary is worth $500,000, then the UK parent company will anticipate a balance sheet value of £500,000 for the subsidiary. A depreciation of the US dollar to $/£2.00 would result in only £250,000 being translated.

Unless managers believe that the company's share price will fall as a result of showing a translation exposure loss in the company's accounts, translation exposure will not normally be hedged. The company's share price, in an efficient market, should only react to exposure that is likely to have an impact on cash flows.

Hedging transaction risk - the internal techniques

Internal techniques to manage/reduce forex exposure should always be considered before external methods on cost grounds. Internal techniques include the following:

Invoice in home currency

One easy way is to insist that all foreign customers pay in your home currency and that your company pays for all imports in your home currency.

However the exchange-rate risk has not gone away, it has just been passed onto the customer. Your customer may not be too happy with your strategy and simply look for an alternative supplier.

Achievable if you are in a monopoly position, however in a competitive environment this is an unrealistic approach.

Leading and lagging

If an importer (payment) expects that the currency it is due to pay will depreciate, it may attempt to delay payment. This may be achieved by agreement or by exceeding credit terms.

If an exporter (receipt) expects that the currency it is due to receive will depreciate over the next three months it may try to obtain payment immediately. This may be achieved by offering a discount for immediate payment.

The problem lies in guessing which way the exchange rate will move.

Matching

When a company has receipts and payments in the same foreign currency due at the same time, it can simply match them against each other.

It is then only necessary to deal on the forex markets for the unmatched portion of the total transactions.

An extension of the matching idea is setting up a foreign currency bank account.

Decide to do nothing?

The company would "win some, lose some".

Theory suggests that, in the long run, gains and losses net off to leave a similar result to that if hedged.

In the short run, however, losses may be significant.

One additional advantage of this policy is the savings in transaction costs.

Hedging transaction risk - the external techniques

Transaction risk can also be hedged using a range of financial products. These are introduced below with links to more detailed pages.

Forward contracts

The forward market is where you can buy and sell a currency, at a fixed future date for a predetermined rate, i.e. the forward rate of exchange. This effectively fixes the future rate.

Money market hedges

The basic idea is to avoid future exchange rate uncertainty by making the exchange at today's spot rate instead. This is achieved by depositing/borrowing the foreign currency until the actual commercial transaction cash flows occur. This effectively fixes the future rate.

Futures contracts

Futures contracts are standard sized, traded hedging instruments.

The aim of a currency futures contract is to fix an exchange rate at some future date, subject to basis risk.

Options

A currency option is a right, but not an obligation, to buy or sell a currency at an exercise price on a future date. If there is a favourable movement in rates the company will allow the option to lapse, to take advantage of the favourable movement. The right will only be exercised to protect against an adverse movement, i.e. the worst-case scenario.

A call option gives the holder the right to buy the underlying currency.

A put option gives the holder the right to sell the underlying currency.

Options are more expensive than the forward contracts and futures but result in an asymmetric risk exposure.

Forex swaps

In a forex swap, the parties agree to swap equivalent amounts of currency for a period and then re-swap them at the end of the period at an agreed swap rate. The swap rate and amount of currency is agreed between the parties in advance. Thus it is called a fixed rate/fixed rate swap.

The main objectives of a forex swap are:

To hedge against forex risk, possibly for a longer period than is possible on the forward market.

Access to capital markets, in which it may be impossible to borrow directly.

Forex swaps are especially useful when dealing with countries that have exchange controls and/or volatile exchange rates.

Currency swaps

A currency swap allows the two counter parties to swap interest rate commitments on borrowings in different currencies.

In effect a currency swap has two elements:

An exchange of principal in different currencies, which are swapped back at the original spot rate - just like a forex swap.

An exchange of interest rates - the timing of these depends on the individual contract.

The swap of interest rates could be fixed for fixed or fixed for variable.

SWAPS. ITS FEATURES AND TYPES

swaps

swaps are a primary element in the derivatives markets, and one of the most active financial sector (represents 61% of the OTC market in 2001).

swaps are OTC instruments which means they traded in context other than a formal exchanges so it's falls under the forward contracts, in fact we can consider swaps as a series of forward contracts due to the substantial similarity between their characteristics as we will below.

Before we cross to the characteristics, let's take a look to the definition of swaps: swaps are contract between two parties to exchange a series of cash flows  based on notional principles at a specified dates.

Characteristics: 

1- as mentioned the swaps are an OTC instruments.

2- at initiation neither party pays any amount to other, so swap has a zero value at the start. except currency swap which the parties exchange amounts denominated in two different currencies but equal in value.

3- with different titles but same concept, swaps has a two important dates as all derivatives instruments, the first one is a settlement date which refer to each date the parties exchange the payments, the time between two settlement dates call as a settlement period, the second date is the termination period and it's refer to the date of final payment between the parties.

4- the payment between the parties is based on net owed amount, for example if I owes you $10 and you owes me $8, simply I will pay you $2, also this point is excluded from currency swap.

of course as all OTC instruments, swaps subject to the default risk, the risk of the counterparty fault to pay the his obligation, that's why before entering to any contract swap, one must to make a enough analysis to assess the credit quality of the counterparty.

Types of Swap:

there are various types of swap, but the most important are

1-currency swap

2-interest rates swap

3-equity swap

Currency Swap:

remember the two swap characteristics which are excluded from the currency swap 1- no notional principle exchange at initiation, 2- the payment make based on netting.

the general definition of the swap currency is: exchange of interest payments between two parties in different currencies.

for example if Apple corporation seeks to expands it's operations in Europe and need a € 1 million, Apple has a three choices as follows:

1- issue a fixed-rate euro denominated bond: which is required a well knowledge in a European bonds market (suppose Apple lacks this feature)

2-borrowing a €1 million from a bank at floating rate which subject apple to the risk of interest rates increases. for sure Apple will not prefer this type of finance.

3- is to issue a fixed-rate dollar denominated bond and swap it with a fixed-rate euro denominated bond, which represents a perfect solution for Apple in this scenario, please remember that even the both bonds denominated in the different currencies, but the bonds value are equal

to progress in the third solution, simply apple send to the best credit quality  European financial brokers or investment banks, ask them to quote such bond, suppose that Apple chose ABC investment bank for their good offer  to make the transaction with. 

suppose Apple issues a 3 years $1.5 million bond at rate of 5.5% semiannually, then enters into a swap with ABC which issues a €1 million at a rate of  4.9% semiannually (note that the $1.5 million and €1 million are equal in value if the exchange rate $1=€0.667).

now Apple will exchanges it's dollar denominated bond at rate 5.5% with the ABC's euro denominated bond at rate of 4.9%, so apple will pay the principle amount of it's bond to the ABC, and receive the principle amount of the ABC's bond, practically this operation equal to Apple has issued euro denominated bond at 4.9% interest rate and this bond purchased by ABC which will receive semiannually interest payments in euro, and the same for ABC prospective.

now lets continue our example to discover how this transaction will running during the life of transaction and how it will be terminated.

suppose the settlements dates (the dates of payments occurrence) are 1st of June and 1st of December of each 3 years. 

at the initiation (1st June 2012), Apple will pay $1.5 million to the ABC, and ABC will pay €1 million to the Apple.

at the 2nd settlement date (1st Dec 2012), apple will pay interest payment =

€1 million *0.049*0.49315068= €24,164.68

and ABC will pay interest payment =

$1.5 million * 0.055*0.9315068= $40,684.931

this interest payments will be the same, until the 5th  settlement date 

 (1st June 2014), in the final interest payments (termination date 1st Dec 2014) both parties are pays the interest payment plus the bond's amount, that means the final payment of Apple = €24,164.68 + €1 million= €1,024,164.68 and for ABC= 40,684.931+ $1.5 million= $1,50,684.931.

I used the bonds here for simplicity, but actually neither Apple or ABC issued any bond, simply they exchange the amounts they need at a different denominated currencies and the interest payments at a rates and dates they agreed in advanced.

Interest Rate Swaps:

the definition of interest rate swaps are: the exchange a series of cash flows in the same currency between two parties based on a notional principle amount, one party pay at a fixed interest rate, and the other at a floating interest rate (most often LIBOR), this  called as plain vanilla swap.

Characteristics:

1- as mentioned in the swaps characteristics the interest rate swaps no exchange of any payment between the parties at initiation(except the fools), because the both side will pay the same amounts in the same currency.

2- the interest payments always netted ( I owes you $10 you owes me $8, I pay you only $2).

3- interest rate swaps one party pay fixed rate, while the other party pay floating, or both pay floating (different rates)m but never both pays fixed rates.

4-the floating rate always determined at the beginning of the settlement period, which means the floating payer know the amount will pay only if the new settlement period has started.

note: always remember that the floating interest rates  will be made based on 30 days in month and 360 days in year, and for the fixed interest rates 30 days in month 365 days in year.

let's take an example on interest rate swaps

suppose that on 1st Jan 2012 Apple borrowed $1 million from ABC bank, at a LIBOR + 25 points on a quarterly basis on the 1st March, 1st June,                           1st September and 1st December at the end of the year Apple will return the principle amount they borrowed.

Apple fears from the increasing in LIBOR rate, and prefer to pay a fixed rate, so the management call for their broker XYZ ask him to make an interest rate swap, the broker  quote the transaction and give Apple a fixed rate of  5.8% on the same settlement dates of the loan payment.

suppose the current LIBOR is 6.1% , so the first payment which apple make to the XYZ = $1 million * 0.058* 0.24657s= $14,301.35 and this amount is constant during the swap's life, and the amount will pay to the Apple = $1 million*0.061*0.25= $15,250 and this amount is flactuates in respones to the LIBOR, we can note that XYZ is owes the greater amount, and the difference between the two amounts = $948.65 this amount will pay by the XYZ to the Apple.

we cant determine the next payments of the XYZ before we reach to the end of the next settlement period.

now apple is pay a fixed rate of 5.8% and receive the LIBOR rate, also Apple pay a 0.25 of LIBOR to the ABC bank, so the total interest rate Apple pays = 5.8% + 0.25%= 6.5%.

Equity Swaps

equity swaps are same the other types there's a party pay at a fixed rate while the other party pays at floating rate, but instead of a interest rates, the floating payer pays based on the return on stock or stock index (S&P500, NASDAQ indices).

There's a two points distinguishes equity swap than the currency and interest rate swaps.

First one is the fixed payer could also pay a variable amount, when the equity return of the index declined, suppose Apple enters into equity swap with XYZ broker, Apple promised to pay the return on the NASDAQ while XYZ promised to pay a fixed rate of 8% and the specified notional principle amount is $1 million, if the current return on the NASDAQ is 1287.23, after few days it became 1280.00, payments make on a quarterly basis.

It's obvious that the return is negative by 3197/3287.23-1= -0.02744, now the XYZ must to pay the fixed payment which = $1 million*0.08*0.24657= $19,725.6 + $1 million (-0.02744)= $47,165.6.

If the current return on NASDAQ is 3237 and became 3350, the return is positive and apple must to pay 3350.23/3237-1* $1 million = $34,908.86 (this payment will be paid by Apple to XYZ).

XYZ will pay $1 million *0.08*0.24657= $19,724.6, so Apple owes the great amount, so apple must pay $34,908.86 - $19,724.6.

Yasser Almansoor

https://www.linkedin.com/pulse/swaps-definition-types-characteristics-calculations-yasser-almansoor

Methods of Valuation of Shares

Methods of Valuation of Shares (5 Methods) 

Let us make in-depth study of the five methods of valuation of shares, i.e., (1) Asset Backing Method, (2) Yield-Basis Method, (3) Fair Value Method, (4) Return on Capital Employed Method, and (5) Price-Earning Ratio Method.

A. Asset-Backing Method:

Since the valuation is made on the basis of the assets of the company, it is known as Asset-Basis or Asset- Backing Method. At the same time, the shares are valued on the basis of real internal value of the assets of the company and that is why the method is also termed Intrinsic Value Method or Real Value Basis Method.

This method may be made either:

(i) On a going/continuing concern basis; and

(ii) Break-up value basis.

In the case of former, the utility of the assets is to be considered for the purpose of arriving at the value of the assets, but, in the case of the latter, the realizable value of the assets is to be taken. Under this method, value of the net assets of the company is to be determined first.

Thereafter, the net assets are to be divided by the number of shares in order to rind out the value of each share. At the same time, value of goodwill (at its market value), investment (non-trading assets) are to be added to net assets. Similarly, if there are any preference shares, those are also to be deducted with their arrear dividends from the net assets.

However, this following step should carefully be followed while calculating Net Assets or the Funds Available for Equity Shareholders:

(a) Ascertain the total market value of fixed assets and current assets;

(b) Compute the value of goodwill (as per the required method);

(c) Ascertain the total market value of non-trading assets (like investment) which are to be added;

(d) All fictitious assets (viz, Preliminary Expenses, Discount on issue of Shares/Debentures, Debit-Balance of P&L A/c etc.) must be excluded;

(e) Deduct the total amount of Current Liabilities, Amount of Debentures with arrear interest,” if any, Preference Share Capital with arrear dividend, if any.

(f) The balance left is called the Net Assets or Funds Available for Equity Shareholders.

The following chart will make the above principle clear:

Alternatively:

Net Assets = Share Capital + Reserves and Surplus Revaluation – Loss on Revaluation

Applicability of the Method:

(i) The permanent investors determine the value of shares under this method at the time of purchasing the shares;

(ii) The method is particularly applicable when the shares are valued at the time of Amalgamation, Absorption and Liquidation of companies; and

(iii) This method is also applicable when shares are acquired for control motives.

Illustration 1:

From the following Balance Sheet of Sweetex Ltd. you are asked to-ascertain the value of each Equity Share of the company:

For the purpose of valuing the shares of the company, the assets were revalued as: Goodwill Rs. 50,000; Land and Building at cost plus 50%, Plant and Machinery Rs. 1, 00,000; Investments at book values; Stock Rs. 80,000 and Debtors at book value, less 10%.

Intrinsic Value of each share = Funds available for Equity Shares/Total Number of Shares

Intrinsic Value of shares = Rs. 3, 30,000/20,000

= Rs. 16.50.

Intrinsic Value of Shares on the Basis of Valuation of Goodwill

Illustration 2:

X Ltd. presented the following Balance Sheet as on 31st March 2010:

Additional Information:

(a) Land and Building and Plant and Machinery were revalued at Rs. 15, 00,000 and Rs. 2, 28,000, respectively.

(b) Investments were valued at market value.

(c) Stock to be taken at Rs. 80,000 and Debtors subject to a deduction @ 10% for bad debts.

(d) Net profit (before Tax) for the last five years were: Rs. 50,000; Rs. 70,000; Rs. 80,000; Rs. 1, 00,000 and Rs. 1, 25,000.

(e) Managerial Remuneration Rs. 8,000 to be charged against profit for every year.

(f) Normal Rates of Return 10%.

(g) Goodwill to be valued at 5 years’ purchase of Super-Profit.

(h) Rate of tax 50%.

Ascertain the Intrinsic Value of Shares.

Intrinsic Value of Share and Ratio of Exchange of Shares:

Illustration 3:

The following Balance Sheets were presented by X Ltd. and Y Ltd. as on 31st Dec. 2008:

Solution:

(a) Calculation of Intrinsic Value of Shares:

(b) Calculation of Ratio of Exchange:

It can be calculated by two ways:

(i) Ascertain the L.C.M. of the intrinsic value of shares and the same is divided by the intrinsic values in order to get the ratio of exchange.

We know, L.C.M. of 20 and 10 is 20.

Thus, one share of X Ltd. is equal to two shares of Y Ltd. since value of X Ltd.’s share is Rs. 20 and that of Y Ltd.’s is Rs. 10.

So, we can say, the ratio of exchange is 1 share of X Ltd. is equal to 2 shares of Y Ltd.

(ii) Alternatively:

Net assets of Y Ltd. should be divided by the intrinsic value of X Ltd. in order to calculate the number of shares to be issued on the basis of which they said ratio can be ascertained.

Thus, the ratio of exchange is 5,000 shares of X Ltd. for 10,000 shares of Y Ltd. i.e., the ratio is 1 : 2 or 1 share of X Ltd. is equal to 2 shares of Y Ltd.

B. Yield-Basis Method:

Yield is the effective rate of return on investments which is invested by the investors. It is always expressed in terms of percentage. Since the valuation of shares is made on the basis of Yield, it is called Yield-Basis Method. For example, an investor purchases one share of Rs. 100 (face value and paid-up value) at Rs. 150 from a Stock Exchange on which he receives a return (dividend) @ 20%.

Under Yield-Basis method, valuation of shares is made on;

(i) Profit Basis;

(ii) Dividend Basis.

(i) Profit Basis:

Under this method, at first, profit should be ascertained on the basis of past average profit; thereafter, capitalized value of profit is to be determined on the basis of normal rate of return, and, the same (capitalized value of profit) is divided by the number of shares in order to find out the value of each share.

The following procedure may be adopted:

Illustration 4:

Two companies, A Ltd. and B. Ltd., are found to be exactly similar as to their assets, reserves and liabilities except that their share capital structures are different:

The share capital of A. Ltd. is Rs. 11,00,000, divided into 1,000, 6% Preference Shares of Rs. 100 each and 1,00,000 Equity Shares of Rs. 10 each.

The share capital of B. Ltd. is also Rs. 11,00,000, divided into 1,000, 6% Preference Shares of Rs. 100 each and 1,00,000 Equity Shares of Rs. 10 each. .

The fair yield in respect of the Equity Shares of this type of companies is ascertained at 8%.

The profits of the two companies for 2009 are found to be Rs. 1, 10,000 and Rs. 1, 50,000, respectively.

Calculate the value of the Equity Shares of each of these two companies on 31.12.2009 on the basis of this information only. Ignore taxation.

Illustration 5:

From the following information of J. Adams Co. Ltd. compute the value of its equity share by capitalisation of earning method:

It is the usual practice of the company to transfer Rs. 30,000 every year to General Reserve. Assume rate of Taxation is at 50% and the rate of normal earnings at 12.5%.

Show workings also.

(ii) Dividend Basis:

Valuation of shares may be made either (a) on the basis of total amount of dividend, or (b) on the basis of percentage or rate of dividend:

Whether Profit Basis or Dividend Basis method is followed for ascertaining the value of shares depends on the shares that are held by the respective shareholders. In other words, the shareholders holding minimum number of shares (i.e., minority holding) may determine the value of his shares on dividend basis since he has to satisfy himself having the rate of dividend which is recommended by the Board of Directors, i.e., he has no such power to control the affairs of the company.

On the contrary, the shareholders holding maximum number of shares (i.e., majority holding) has got more controlling rights over the affairs of the company including the recommendation for the rate of divided among others. Under the circumstances, valuation of shares should be made on profit basis. In short, Profit Basis should be followed in the case of Majority Holding, and Dividend Basis should be followed in the case of Minority Holding.

The same principle may be represented in the following form:

Note:

Yield-Basis Method may also be termed as:

Market Value Method; Profit Basis/Income Basis Method;

Earning Capacity Method etc.

Value of share under yield basis:

Illustration 6:

On December 31, 2009 the Balance Sheet of MA KALI Ltd. disclosed the following position:

Of which 20% was placed to Reserve, this proportion being considered reasonable in the industry in which the company is engaged and where a fair investment return may be taken at 10%. Compute the value of the company’s share under yield-basis method.

Illustration 7:

Calculate the value of each Equity Share from the following information:

C. Fair Value Method:

There are some accountants who do not prefer to use Intrinsic Value or Yield Value for ascertaining the correct value of shares. They, however, prescribe the Fair Value Method which is the mean of Intrinsic Value Method end Yield Value Method. The same provides a better indication about the value of shares than the earlier two methods.

Illustration 8:

The following is the Balance Sheet of X Co. Ltd. as on 31.12.2009:

Ascertain the value of each equity share under Fair Value Method on the basis of the information given:

Assets are revalued as:

Building Rs. 3, 20,000, Plant Rs. 1, 80,000, Stock Rs. 45,000 and Debtors Rs. 36,000. Average Profit of the company is Rs. 1, 20,000 and 12½% of profit is transferred to General Reserve, Rate of taxation being 50%. Normal dividend expected on equity shares is 8% whereas fair return on capital employed is 10%. Goodwill may be valued at 3 years’ purchase of super-profit.

D. Return on Capital Employed Method:

Under this method, valuation of share is made on the basis of rate of a return (after tax) on capital employed. Rates of return are taken on the basis of predetermined/expected rates of return which an investor may expect on the investments. After ascertaining this expected earnings, we are to determine the capital sum for such a return.

Thus, we are to follow the following procedure one by one:

(a) Ascertain the expected (maintainable) profit (after adjustments, if any);

(b) Ascertain the normal rate of return on capital employed for a similar business;

(c) At last, on the basis of expected rate of return, capitalize the (maintainable) profit.

Illustration 9:

Ascertain the value of each equity share under Return on Capital Employed Method from the following particulars:

E. Price-Earnings Ratio Method:

We know that it is the ratio which relates the market price of the share to earning per equity share.

It is calculated as:

Illustration 10:

Compute the value per share and valuation of the business from the following particulars: