Currency risk management options for PPP Group

¶ … currency risk to which the PPP Group was exposed. The paper also considers their options for currency risk management, in particular evaluating how PPP Group can manage their translation exposure risk.

Types of Currency Risk

The PPP Group's international transactions subject the firm to currency risk or exchange rate risk which arises with the potential change in the exchange rate of EUR against USD. The PPP Group is exposed to three kinds of currency risk that must be managed: transaction risk, translational rick and economic risk. Transaction risk is associated with the time delay that occurs between PPP Group's entering into contracts to purchase paper supplies and the actual contract settlement. PPP Group is also exposed to translation risk which the is the risk of adverse effects on their financial statements, possibly affecting the company's assets, liabilities, equities or income, due to changes in currency exchange rates. PPP Group is exposed to economic risk, which is the danger that the company may be at a disadvantage and unable to sell the paper bags at a profit if exchange rates move against the company.

Pros and Cons of the Hedging Proposal

The local Chief Executive's proposal to hedge 80% of paper purchases one year in advance is one means of hedging against currency risk. Without hedging, a significant amount of the company's accounts payable remains an unmanaged risk. There are academic studies of currency risk that suggest investors who bear currency risk are not compensated with higher returns, which in effect means that it is essentially needless to bear currency risk. The Chief Executive is well advised to develop some kind of hedging strategy to manage their exposure.

The benefit to PPP Group, or pros, of currency hedging is that it potentially reduces their losses. Hedging protects the company against currency exchange rate fluctuations. The disadvantage or cons of hedging is that it also reduces potential profits. If exchange rates were to move in their favor, the PPP Group will not realize those profits. Given that their intent is to reduce exposure as opposed to profit from trading, this is an acceptable tradeoff. Another disadvantage of the Chief Executive's proposed hedging strategy is the associated expenses of hedging which can be significant.

Factors in Evaluating PPP's Translation Exposure Risk

The PPP Group's translation exposure risk is another result of their currency risk. Because the PPP Group's accounting exposure can affect their assets and liabilities denominated in a foreign currency, as happens with their accounts payable and their accounts receivable, they also need to manage this additional risk. When the parent company prepares its financial statements, it has to report the assets and liabilities that it has in other currencies. The process of valuing foreign assets and liabilities requires that the values be translated into the home currency as specified by FASB 52. As a result, exchange rate fluctuations will impact the value of the PPP Group's assets and liabilities. These are factors that must be taken into account in evaluating PPP's translation exposure risk.

The factors that the PPP Group should also take into account when evaluating their translation exposure risk include determining the degree of their exposure and considering the tradeoffs involved in managing their translation exposure risk. These considerations would influence my response to managing that risk, looking at the following alternatives. One option for managing translation exposure would be adjusting the fund flows between the parent and the subsidiary to reduce the firm's local currency accounting exposure. Given that accounts payable and accounts receivable are a function of sales, the PPP Group has little ability to alter the related flows because an increase in sales is the only desirable adjustment; one assumes the company is in business to make a profit and would not choose to decrease sales. Nor can they alter the respective currencies, with the EUR and USD currencies determined by the subsidiary from which they source and the markets in which they sell.

Other considerations that would influence my response include reviewing the following options. Another means by which PPP Group can manage their translation exposure risk is by the use of forward contracts, which can be used to create an offsetting asset or liability in the foreign currency. Exposure netting is another option, wherein exposures in one currency offset with exposures in the same or another currency; PPP Group gains and losses on the two currency positions will offset each other.

Additional hedging strategies for PPP to consider for managing their translation exposure risk would be:

Increasing hard currency assets, that is, assets that are likely to appreciate

Decreasing soft currency assets, that is assets that are likely to depreciate

Decreasing hard currency liabilities

Increasing soft currency liabilities

A primary consideration in evaluating these strategies is their feasibility; another is their impact on PPP Group's operations which would be affected by a strategy that reduced the level of cash, for example. Similarly, they may not be able to tighten credit terms to decrease accounts receivable if the market for their paper products is highly competitive. Or delaying accounts payable might impair PPP Group's credit rating. These are all factors that influence the decision on managing translation exposure.