Question

Question 6
Wesfarmers is one of Australia's largest companies. On its website, it states the following in
reference to FX risk management:
The Group’s policy is to protect the Group from currency fluctuations together with
maintaining the integrity of business decisions and protecting the competitive position of the
Group’s activities. The Group’s primary currency exposures are in US Dollars and arise

from sales or purchases by an operating unit in currencies other than the unit’s functional
currency.
The Group requires all of its operating units to hedge foreign exchange exposures for firm
commitments relating to sales or purchases or when highly probable forecast transactions
have been identified. Before hedging, the operating units are also required to take into
account their competitive position. Operating units are not permitted to speculate on future
currency movements.
What type of FX risk has Wesfarmers identified and what aspects of its FX risk policy formulation
can be identified? [10 marks]
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Answer 1

Foreign exchange risk (also known as FX risk, exchange rate risk or currency risk) is a financial risk that exists when a financial transaction is denominated in a currency other than the domestic currency of the company. The exchange risk arises when there is a risk of an unfavourable change in exchange rate between the domestic currency and the denominated currency before the date when the transaction is completed

Companies that have exposure to foreign markets can often hedge their risk with currency swap forward contracts. Many funds and ETFs also hedge currency risk using forward contracts. A currency forward contract, or currency forward, allows the purchaser to lock in the price they pay for a currency

Types of risks :

1. Transaction risk: This is the risk that a company faces when it's buying a product from a company located in another country. The price of the product will be denominated in the selling company's currency. If the selling company's currency were to appreciate versus the buying company's currency then the company doing the buying will have to make a larger payment in its base currency to meet the contracted price.
2. Translation risk: A parent company owning a subsidiary in another country could face losses when the subsidiary's financial statements, which will be denominated in that country's currency, have to be translated back to the parent company's currency.

Aspects of its FX risk policy formulation

Hedging

Companies will engage in hedging arrangements to reduce the level of potential risk that comes from the price movement of various assets. Hedging provides companies with protection against adverse changes to asset prices that can negatively affect investment. Within the context of transactions, companies will often complete hedging arrangements to reduce the effects of Foreign Exchange and Commodity Risk associated with the deal.

Firms with exposure to foreign-exchange risk may use a number of hedging strategies to reduce that risk. Transaction exposure can be reduced either with the use of money markets, foreign exchange derivatives—such as forward contracts, options, futures contracts, and swaps—or with operational techniques such as currency invoicing, leading and lagging of receipts and payments, and exposure netting.^[17] Each hedging strategy comes with its own benefits that may make it more suitable than another, based on the nature of the business and risks it may encounter

Two popular and inexpensive methods companies can use to minimize potential losses is hedging with options and forward contracts. If a company decides to purchase an option, it is able to set a rate that is "at-worst" for the transaction. If the option expires and it's out-of-the-money, the company is able to execute the transaction in the open market at a favorable rate. If a company decides to take out a forward contract, it will set a specific currency rate for a set date in the future