Finance Managing Exchange Rate Risk Can Be

Finance

Managing exchange rate risk can be a daunting task for many international firms attempting to expand overseas, acquire new companies, or simply manage its cash flows. Globalization has created a dynamic environment in which competition can arise to disrupt entire industries. Aspects such as technology, pharmaceuticals, banking, and automobiles have all experienced rapid change as a result of globalization and the competitive forces that underline it. As a result, companies, particularly smaller firms, have a higher propensity to experience volatile earnings overtime. Aspects that impact one sector of the globe can have a residual impact on other areas of the individual firm or industry. Managing exchange rates is therefore a viable option for firms to reduce volatility in earnings while subsequently managing its cash flows from operations. Below, is a 5 step program which could be implemented by a firm attempting to manage its exchange rate risk after an acquisition.

The first step in the process of managing exchange rate risk is to forecast exchange rate movements. Proper forecasting will require analysis of various macro and micro economic conditions that could adversely impact exchange rates. For example, as evident in the global financial crisis in 2008, central bank tendencies to expand its monetary base could have an adverse impact on exchange rates. This is particularly true for countries who have traditionally had a very weak currency relative to other countries. For example, the expansion of the monetary base within the United States made the Yen, a relatively weak currency, stronger. As a result, Japanese exports were more expensive. This resulted in Japanese companies being less competitive in the global markets. If these companies properly hedged their risks however, the impact of monetary expansion would have been minimal.

Therefore, in regards to our acquisition, it will be necessary to forecast what percentage of revenues comes from particular portions of the world. Within this context, we can then be in a better position to hedge the exposure of certain currencies that are believes to depreciate relative to others. An analysis of the political, economic, monetary policies of the country will also be warranted. As mentioned briefly above, political unrest and activity can have a significant impact on the exchange rate.

The second step will be to identify the level of complexity that will be used in hedging exchange rate risks. In many instances, hedging exchange rates can be very complex if used improperly. The organization should therefore have an understanding of the risks associated with using various options such as currency derivatives to hedge its cash flows of the acquisition. Companies often use options, forwards, futures, and swaps to hedge their foreign currency exposure. A currency swap for example, is a viable option utilized by many companies around the world to hedge its currency exposure by making payments to each other in different currencies (Jorion, 1999).

In regards to the acquisition, once the political, interest rate, governmental, and economic risk have been adequately ascertained, it will be necessary to understand what the hedge intends to accomplish. Complex solutions are not necessary the most rewarding in regards to reducing currency risk.

The third step is to simulate results using financial techniques. This step will require a detailed understanding of the hedging strategies goal, outlined in step two. Depending on the complexity of the acquisition, and the Below is sample calculation for a currency swap, which is one of the more simply transactions that can be used to hedge foreign exchange risk of the acquisition.

Undoubtedly, the acquired company will have sales in geographic regions outside its home country. However, let's assume that prior to the acquisition, the company decided to expand operations in Europe, in which it doesn't have a presence. The company as a result will need 9 million Euros to fund construction. The acquired company may have difficulty obtaining funding in Europe as it is not well-known. As such it can engage in a currency swap to hedge its exposure, lower its risk, and lower its borrowing costs at the same time. It can do this by issuing a 5-year $10 million bond at 6% and then entering a 5-year swap, in which a bank will make payments to the acquisition at a fixed rate of 5.5%. The acquired company will make payments to the bank in euros at a rate of 4.9%. The payments will be based on notional principle of $10 million (from the initial loan) and 9 million euros (The funding of the project to expand). Payments will occur on Feb. 15, and August 15 respectively. Notional principles will be exchanged at the start and end of the swap. Below are the transactions

August 15

Bank pays acquisition 9 million euros

Acquisition pays bank $10 million

Each Feb 15 and August 15 for the next five years

Bank pays acquisition 0.055 (180/360)($10 million)= $275,000

Acquition pays bank .049 (180/360) (9 million euros)= 220,500 euros

August 15 (5 years after the initiation)

Bank pays $10 million

Acquisition pays 9 million euros

This transaction although it may sound complicated is merely an exchange of interest payments between the two parties. However the acquisition has effectively gained the 9 million Euros needed to expand its operations, in a cost effective and low risk manner. Techniques similar to the one above will be needed to evaluate the effectiveness of different hedging strategies as it relates to the overall goal of the acquisition. For example, a Monte Carlo simulation could be used to simulate results under different interest rate scenarios or economic circumstances. Through these techniques a range of values can be derived that allow management to make better informed decisions.