Question

Suppose you are a Chief Financial Officer (CFO) of a UK based listed Part A - company. The company is currently trading at £10 per share and 10 million shares in issue. The total market value of the issued share capital of the company is £100 million. You have been requested to write a report to the board of directors with respect to raising an additional funding of £50 million to enable the next stage of development of international projects to be carried out. Note 2: For the report in Part A, it should critically review the advantages and disadvantages of the main funding options and have many appropriate academic references to strengthen your discussion. Further, your report should form the basis for a discussion at the next board meeting. In particular, you are required to include the different financing choices available through the equity and debt markets.

Part B - This additional funding will allow the business to become more global with the opportunity to develop a market in numerous countries with payment being made in the local currency. The directors are conservative in their attitude to risk. You have been requested to provide a report to the directors critically evaluating alternative derivatives including forwards, futures, options and swaps that are available in the market in order to minimize the risk with respect to payment in international currencies. : For the report in Part B. it should critically discuss and compare the use of derivatives including forwards, futures, options and swaps to hedge Foreign Exchange (FX) Risk. With reference to appropriate academic references, discussions must include: • how it works in mitigating FX risk. advantages and disadvantages of each type of derivative in managing FX risk.  

Can you please assist in answering Part B in bold. thank you

Answer 1

Report on Risk Hedging Options

If the Board decides for additional funding, which will allow the business to become more global, there will be FX risk for the company, as we will be making payments in local currency of various countries. Hence i have prepared a comparative analysis and evaluation of various options of FX risk hedging through use of derivative products. List of hedging products is as below:

While expanding our business, we will need to pay in local currency, for which will have to buy currency of that country. If we decide to pay certain amount today, there may be risk of price increase in currency of that country. in this case we can buy forward contract to buy the currency at the rate available today. so that our risk can be covered. Benefit of forward is that they can be tailor made for our requirements, with respect to currency amount, time. but they are difficult o cancel or can cost more when canceled. whereas in case of futures, which are traded on stock exchange, cost of buying and selling them is lower. But futures are always in standard forms. It cannot be made as per company requirements, with respect to value and term. Value and term of futures is always fixed, which may not suit for our requirements. In case of forwards and futures,no intermittent flow of funds will be available, moreover there is requirement to deposit some margin money for futures. Risk quantum can be high in case of futures & forwards, whereas in case of options risk is limited to premium paid. Moreover there is no restriction on time of option contract, it can be executed at any time.Another option available with the company is swaps, where we can enter into an agreement for exchanging currencies. Swaps gives chance to have gain to both parties from the contract.There can be credit risk as other party could default on interest and principal payments, but this can be covered by paying commission for credit default risk.