Executive Summary Our company is currently confronted to operating and profitability concerns resulting from its foreign supplies and their unpredictable cost. The main reason for the unpredictability is the fluctuation of the USD vs. GBP, which resulted to an increase in the cost of our supplies and hence a slide in our profitability. To protect against the increase in our cost resulting from the unstable rates of the USD vs.
the GBP Dollar, there are various options available in the financial markets which can be used to maintain our supplies cost relatively stable and hence improve our profitability, these are mainly financial instruments in the form of derivatives such as the forward, the futures, the options. After the analysis we have performed, we recommend the use of options derivatives to hedge against the foreign currency risks faced by QN Plc. Introduction Foreign exchange has always been a subject of concern for many players in the trading and financial world, often leading unprepared companies to bankruptcy or to major losses.
It exposes a company depending for its survival on foreign inputs of raw materials or services or on sales to foreign customers in a currency other than the one of its supplies and its cost to currency risks. A country currency value on the foreign exchange market is generally influenced by factors such as inflation, interest rates differential, current account deficits, public debt, terms of trade and political stability and economic performance. 1(Jason Van Bergen, 2010).
These factors contribute to creating some predictability in the rates of the currencies; however, currencies value can still vary irrespective of these influencing factors and in an unpredictable manner due to speculation on the foreign exchange market or to change in governmental monetary policy. Through time, many strategies have been studied and made available to the business world in order to help them protect against the risks associated with foreign exchange fluctuation and unpredictability. This is the same for the countries, due to the impact of foreign exchange on the economic indicators.
Also researches exist to indicate which course of action, which hedging methods exist to cover every type of risks, although those researches do not provide for detailed solutions for each risk faced by a company which in the normal course of its operations is affected by foreign currency risks. In the next chapters, we will discuss how the value of the currency is determined; discuss how the 6 factors influence its value on the international market, how monetary policy changes affect the value of the country’s currency.
We will continue discussing how the changes on foreign exchange rates affects trading companies in general and QN in particular, and finally discover measures to mitigate and protect against the risks associated with foreign exchange such as futures, forward rate contract, as well as options. In today’s global world, companies dealing on international terms, face many various risks stemming from the nature of their business which often involves either operating in many countries, with affiliates all other the world, or sourcing supplies from vendors in other countries or exporting finished products or services to clients in other countries.
Those risks are essentially import/export duties risks, interest rates risks, commodity price risk, wage rates risks, political or economic climates risks, and exchange rates risks. These risks affect the earnings, the cash flow, and fair value of assets and liabilities of companies. To mitigate those risks companies often resort to hedging. QN is mostly affected by the exchange rate risks.
Before discussing and assessing the ways for us to mitigate this risk, it is important we have a detailed look at what generate this risk, how international institutions like the International Monetary Fund (IMF) and governments contribute to minimizing the exchange rate risk. 1. Exchange rate fluctuations As it is generally agreed in the finance world by both academics, economists and professional, the value of the currency is determined as any other good by the law of demand and supply. If demand is higher than supply, the value of the currency soars, if supply is more than demand, then the value of the currency dwindles.
Said this way, it looks very simplistic; however the reality is a bit more complex, and other factors than the demand and supply, come as well into the picture in determining the value of a currency. Let’s have a look at those factors as well as how they affect in details the value of a currency. a) Demand and supply Just as explained earlier, the principles of supply and demand apply to determining the value of a currency: Supply > Demand? Lower value (price) of a currency, Demand> Supply? Higher value of a currency Supply and demands of a country currency result from its foreign operations.
An example would be for the UK GBP for instance and considering QN Plc, when we import goods from our foreign suppliers in the US, we need to purchase USD to settle our obligations with the US vendors. Then we (or our bankers) will need to go on the fx market to purchase US dollars to pay our vendors, resulting in a demand for USD. If the US companies export to UK more than they import from the UK, then the demand for US dollars will increase vs. GBP and due to the low import therefore low supply of USD, the demand for USD will not be matched by an equivalent supply of USD vs.
GBP, and the value of the USD vs. GBP will increase. In general terms, when there is a high domestic or foreign demand for a country’s currency, the currency appreciates in value. This is reflected in the below diagram: In summary demand of a country currency is driven by exports of its goods, or in the case of the USD, the fact that it represents an international currency of reference, used for most international transactions in the world.
b) Differentials in inflation and interest rates In general, low inflation in a country result in a stronger currency value, driven by higher purchasing power in comparison to other currencies. Typical example is that countries with low inflation such as Japan, Germany and Switzerland have stronger currencies in comparison to their trading partners. Another example is following the hyperinflation suffered by Russia in 2008-2009; the value of the Russian Ruble declined by 35% vs. the US Dollar and this lead the Russian government and Central Bank to taking measure to counter inflation (through interest rate manipulation), eventually resulting in a stronger Ruble2 (Padma Desai, 2010).
Interest rates, inflation and exchange rates are highly correlated. By tweaking interest rates, central banks influence inflation and exchange rates. c) Market dynamics/speculation As posit by the economist Paul Krugman, speculation plays an important role on fluctuating value of currencies on the market which confirm earlier analysis and conclusions reached by economist such as Ragnar Nurkse, who claimed that “destabilizing speculation created pointless and economically damaging fluctuations”.
3 The only solution against the possible devastating impacts of currency speculation is through properly articulated and applied monetary policy. d) Monetary policy The value of a country’s currency is also influenced by the country’s government monetary policy. A palpable example is the Chinese Yuan which is kept low by the Chinese authorities to ensure competitive pricing of Chinese products abroad. e) Balance and terms of trade The balance of payments accounts of a country record the payments and receipts of the residents of the country in their transactions with residents of other countries.
If all transactions are included, the payments and receipts of each country are, and must be, equal. 4 A deficit in the balance of payments or current account deficit indicate that the country requires more foreign currency than it receives through sales of exports, and it supplies more of its own currency than foreigners demand for its products. 5 The higher demand for foreign currency negatively affects the value of the country currency.
However in the case of the US, although the US is registering continuous trade deficits, this does not have a huge impact on the value of the USD, because of the international currency status of the USD and because of the monetary policy of the US major trading partners such as China, who for competitive trade pricing reasons, maintain the value of their currency lower vs. the US dollar (Kimberly Amadeo, 2013)
6. f) Other factors Foreign investors always look for stable countries with strong economic performance to invest their capital. As such a country with political stability and economic performance will be preferred for investment to countries with political and economic risk.
Wars, dictatorships, civil unrest, etc…are often causes of loss of confidence in a country’s currency and the resulting outflow of capital to the currencies which weaken the country’s currency. 7 This was the case in Russia on Monday March 03, 2014 following the announcement of Russia invasion of Ukraine; the Ruble plunged after many investors began rushing their capital out of the country. 2. Role of international institutions and governments.
The International Monetary Fund (IMF) was implemented to encourage and support international monetary cooperation, stability of exchange rates, smooth the progress and growth of international trade and avail resources to assist its members in improving their balance of payments deficits or to reduce poverty. IMF member countries accepted to put their economies and monetary policies under the scrutiny of the international community and adhere to policies which favor balanced economic growth across the world, price stability, and the avoidance of exchange rate manipulation.
While states have the right to control their own currency, the chief objective of IMF is that they do not over manipulate currency values and generate high volatility. The IMF rules clearly institute that restriction of currency payments in order to improve its balance of payments are not allowed. In essence it implies that IMF members have accepted voluntarily some constraints on their monetary sovereignty. However, as is the case with China it is almost impossible for the IMF to totally prevent a country from manipulating its currency in order to achieve higher competitiveness over its partners.
In conclusion although IMF supervises the exchange rate policies of members, it is very difficult for the IMF to strictly enforce its rules and totally prevent members from inappropriate currency manipulations. The real benefit from the IMF is the fact that the supervision operated by the IMF is a deterrent against the open manipulation of exchange rates and although the IMF does not determine exchange rates in the floating system, it provides some relative stability and security in the foreign exchange markets.
8 3. Analysis of the impact of the foreign currency risks on our business a) Higher cost of supplies, same revenues Currently with the fluctuating values and the appreciating dollar vs. the GBP and the Euro, the cost of our supplies is largely volatile and unpredictable. Comparing last month ? /$ rates, our supplies cost have increased ultimately by 5% causing a 5% decrease in our net profit. In case we maintain our prices at current level, and with the volatility of the dollar, we will suffer substantial losses.
We also cannot buy huge quantities of products in advance knowing that our products have a maximum shelf life of 7 days. b) Impacting the cost of supplies on the price of our products – volatility of our prices to the consumers Another option available to QN is to reflect the impact of the currency gains and losses in the pricing to the customers. The main issue with that is that we will have prices changing everytime, which will be very difficult to manage, result in major errors in pricing, risks of fraud, and loss of competitiveness with other supermarket chains.
c) Hedge Although the dollar may reverse its current course and slide again to its initial values or even better, we should take measures to protect against currency risk. To protect against the risk of currency, the best option available to QN to maintain profitability, stability of pricing to customers, and minimize operating risks and fraud risks in its operations is to use hedging. Hedging can be defined as the action of protecting against unpredictable, predictable or anticipated changes in exchange rates, interest rates, commodities prices etc…
It is performed through the use of financial instruments called derivatives such as Forward rates, futures, options and swaps. We will discuss these derivatives as well as determine the one that is most appropriate to QN business. 4. Available solutions to protect “hedge” against foreign currency risks a. Forward contracts A forward contract is a financial instrument between a company and a bank, which is not traded on a financial market and offers the buyer of the contract the possibility to buy or sell a certain amount of currency at a predetermined rate and at some specific.
Its main advantage is to offer predictability in the amount of local currency required to make a payment in foreign currency at a later date. Its only cost is inherent to its advantage in that on the day of settlement if the spot rate is better than your contracted rate, you still have to honor your contract at the contracted rate, thereby virtually making a loss against the spot rate. There is no possible defaulting on the forward contract. b. Futures Futures are one of the main derivatives used to hedge risks.
A futures contract is an arrangement between two parties to buy or sell an asset at a given time in the future and at a specified agreed rate or price. Futures are used to fully offset prices or rates risks, and are very similar to forward contract, except that forward are not traded on the financial market as opposed to the futures. c. Options Options are used for two purposes, for hedging or protecting against changes in prices or rates, or for speculating. When used for hedging, they give the purchaser the option to sell or buy a foreign currency contract at a specific price on a specific date.
They are traded on the market and offer a lot of flexibility, in that if at the end of the period the purchaser of the contract can exercise the option at the agreed price (known as the strike price), if currency fluctuations have made it profitable for them otherwise, they let the option lapse, when it is not profitable to them. Conclusion and Recommendation We have reviewed how the foreign exchange system is structure and how exchange rates are determined and what influences them. We have also briefly discussed the role of the IMF in the exchange rate valuation system.
We have finally discussed the issues faced by QN in terms of foreign currency risks and the various possibilities available to QN to improve its position. Our recommendation to manage the foreign currency risks posed by the appreciation of the USD is to use options for the following reasons: Predictability of the rates at which supplies will be purchased Predictability of cost of supplies will enable a more stable pricing of our product to our customers and guarantee our profit margins In case the USD reverses its course i.e. depreciates vs. the GBP, we may let the option lapse and benefit from even further transaction gains. No cost for taking the options.
References 1) Jason Van Bergen (2010), 6 Factors That Influence Exchange Rates. Retrieved from http://www. investopediacom/articles/basics/04/050704. asp 2) Definitions and Basics, Retrieved from http://www. econlib. org/library/Topics/HighSchool/BalanceofTradeandBalanceofPayments. html 3) Kimberly Amadeo (2013), U. S. Trade Deficit with China. Retrieved from http://useconomy.
about. com/od/tradepolicy/p/us-china-trade. htm 4) The IMF’s Role in Determining Exchange Rates. Retrieved from http://www. etoro. com/education/imf-role-determining-exchange-rates. aspx 5) Rethinking Russia : Russia’s Financial Crisis: Economic Setbacks and Policy Responses Padma Desai Retrieved from http://jia. sipa. columbia. edu/russia%E2%80%99s-financial-crisis-economic-setbacks-and-policy-responses 6) Exchange Rates, Paul Krugman. Retrieved from http://www. econlib. org/library/Enc1/ExchangeRates. html