Question

Trendsetter has just purchased a consignment of skins from Amulta Limited for 100
million Indian Rupees and the payment is due in 6 months time. The currency risk
of this purchase is of particular concern to Trendsetter plc.. The following data has
been compiled:
Spot exchange rate Rupees 90/£ Forward rate (6 months) Rupees 95/£
UK borrowing rate 5.00% p.a UK investment rate 4.00% p.a.
Indian borrowing rate 7.5% p.a Indian investment rate 6.5% p.a
Call option exercise price Rupees 92/£ Option Premium 1 million Rupees
Required:
a) Identify and calculate the costs of the alternative strategies available for hedging
this risk and advise which strategy would have produced the best outcome for
Trendsetter plc, assuming the actual spot rate in 6 months’ time is Rupees
89.00/£.
b) Explain why economic (operating) exposure might be of concern to Trendsetter
plc even though they do not, at the moment, have any foreign direct investment
(FDI).
c) Describe the additional operating exposures Trendsetter plc would be exposed
to if they were to engage in FDI and describe the strategies the company might
undertake to reduce its level of economic exposure.
d) Explain why translation exposure might be of concern to multinational
organisations and briefly describe how a multinational organisation might reduce
its exposure to translation risk.

Answer 1

(a)

Sr.No.	Particular	Amount	Amount
	Without Hedge
	Payable	INR         100,000,000
	Spot Rate after 6-Months	INR 89 / 1 £
	Paybale without hedge		£    1,123,595.51
1	Hedge via Forward
	Payable	INR         100,000,000
	Forward Rate	INR 95 / 1 £
	Payable in Forward Contract		£    1,052,631.58
2	Hedge via Money Market Hedge
	Payable	INR         100,000,000
	(A) Today Borrow Money from Uk equivelent to Rs. 100,000,000 after 6-Months including interest (Invest in India)	£             1,076,136.67
	(INR 100,000,000 /1.0325)/90
	Interest on above borrowing @5% for 6-Months	£                   26,903.42
	Payable in Money Market Hedge		£    1,103,040.09
3	Hedge via Call Option
	Payable	INR         100,000,000
	Option exercised so buy at INR 92 /£ 1	INR 92 / 1 £
	Total		£    1,086,956.52
	Add :
	Call Premium Paid	INR              1,000,000
	Conversion Rate (Spot)	INR 90 / £ 1
	Outflow in £	£                   11,111.11
	Add : Interest cost	£                         277.78
	(£ 11,111.11 x 5% x 6/12)
	Total Cost on Call Option		£          11,388.89
	Payble in call option hedge		£    1,098,345.41

Hedge via forward contract have produced the best outcome for
Trendsetter plc because in that lowest outflow £ 1,052,631.58.

(b) Economic (operating) exposure might be of concern to Trendsetter plc even though they do not, at the moment, have any foreign direct investment (FDI) because Trendsetter plc have the foreign currency risk as they have payable in other currency instead of home currency, Appreciation or depreciation may change the outflow of the company which leads to profit or loss to company.

Here Trendsetter plc have not any FDI but they have risk of payment to INR may concern if pound depreciate aganist the INR which may leads to more outflow to the company.

The degree of economic exposure is directly proportional to currency volatility.

Normally Pound is Stronger currency than INR so for payble risk is negligible as per past trend but it is always advisable to hedge risk fixed the risk.

(c)

As mention in above (b) Pound is stronger than INR so if Trendsetter plc. have FDI then company have also exposure of receivalbe as if Pound appreciate than it reduce the inflow in pound and also depreciate the investement.

There are two main strategies to mitigate economic exposure: operational and currency risk mitigation.

(1) Operational strategy

Operational strategy is aiming to adjust or change the current company’s operations to prevent possible risks associated with future currency fluctuations. The operational mitigation strategy may involve the following steps:

(I) The expansion of operating facilities and sales to a mixture of markets.

(II) A company considers the acquisition of its key inputs from different regions.

(III) A company may seek financing from capital markets in different regions.

(2) Currency risk mitigation strategy

The main goal of the currency risk mitigation strategy is to minimize or eliminate economic exposure through hedging. Some of the currency risk mitigation strategies are:

(I) Strensetter plc matches the foreign currency outflows with foreign currency inflows.

(II) Strensetter plc enters into a currency risk-sharing agreement with its supplier. According to this agreement, the sale contract is executed at a predetermined price. Thus, both parties share the potential currency risk.

(III) Strensetter plc can use currency swaps to obtain the required cash flows in foreign currency at the desired exchange rate. The counterparties will exchange the interest and principal in one currency for the same in another currency at fixed dates until the maturity of the swap.

(d)

Translation exposure (also known as translation risk) is the risk that a company's equities, assets, liabilities, or income will change in value as a result of exchange rate changes.Translation risk occurs when a firm denominates a portion of its equities, assets, liabilities, or income in a foreign currency.Translation risk can lead to what appears to be a financial gain or loss that is not a result of a change in assets, but in the current value of the assets based on exchange rate fluctuations. Therefore, companies seek to hedge this risk as best as possible.

Translation exposure is most evident in multinational organizations since a portion of their operations and assets will be based in a foreign currency. It can also affect companies that produce goods or services that are sold in foreign markets even if they have no other business dealings within that country.

In order to properly report the organization's financial situation, the assets and liabilities for the whole company need to be adjusted into the home currency. Since an exchange rate can vary dramatically in a short period of time, this unknown, or risk, creates translation exposure. This risk is present whether the change in the exchange rate results in an increase or decrease of an asset's value.

Translation risk can lead to what appears to be a financial gain or loss that is not a result of a change in assets, but in the current value of the assets based on exchange rate fluctuations.

Hedging Translation Risk

Use hedging to lower the risk created by translation exposure. like Currency swap or hedging through future contracts or request the foreign party to billing in home currency.