FINANCIAL DECISION MAKING

This scenario contains 5 short questions each worth 2 marks (a total of 10 marks)

Maple Machinery (MM), a business based on the outskirts of Toronto, whose home currency is the Canadian Dollar (C$), trades regularly with customers and suppliers in a number of different countries and currencies. Among many other transactions, MM expects to receive C$ 275,000 from a US customer in one months' time and to pay ? 500,000 to a Spanish supplier in three months' time.

Current exchange rates between the C$ and the ? are as follows:

Spot exchange rate: C$1 = ? 0.7655 - ? 0.7699

3-month forward exchange rate: C$ 1 = ? 0.6987 - ? 0.7010

Annual interest rates in Canada and Spain for the next year are expected to be as follows:

Canada 1.7% - 2.0%

Spain 0.4% - 0.6%

In addition to the use of money market products and derivatives to hedge any foreign exchange risk exposure, the CFO of MM is considering 'internal' methods such as invoicing all customers in C$, insisting that suppliers invoice MM in C$ and 'leading' or 'lagging' payments.

Required:

1) What type of foreign exchange risk exposure is MM exposed to in relation to the receipt in one months' time from a US customer?

A. Transaction risk

B. Translation risk

C. No risk

2) What is the gain or loss in C$ compared to its current C$ value which MM will incur by taking out a forward exchange contract for the future ? payment to the Spanish supplier? Show all workings.

3) What is the payment in C$ if MM uses a money market hedge to hedge the payment to the Spanish supplier in three months' time? Show all workings.

4) With reference to MM making foreign currency purchases, if the C$ is expected to weaken against the ? should MM 'lead' or 'lag' in its management of the anticipated payment? Explain your answer

5) If MM decided to invoice all its customers in C$, which of the following statements is/are false?

A. Invoicing customers in C$ will eliminate all foreign exchange risk that MM is exposed to

B. Invoicing customers in C$ will pass translation risk to the customer

C. Insisting on being invoiced in C$ is a cost-free way of reducing risk exposure related to foreign suppliers

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MAKE USE OF THE FOLLOWING NOTES IN ORDER TO ANSWER THE QUESTIONS ABOVE:

8.4.1 Exchange rate risk management: the basics There is no textbook reference for this topic. Instead, please read the following sections. Some definitions will be useful. Definitions Forex: This is simply an abbreviation of foreign exchange. Exchange rate: This is the price of one currency expressed in terms of the currency of another country. For example, a rate of (1.10/US$1.00 means that you have to sell 61.10 to buy US$1.00 or alternatively sell US$1.00 to buy 61.10. Spot rate: The exchange rate quoted on any given day for immediate delivery of currency is known as the spot rate. Two prices are quoted: a buying price and a selling price. In this course, and in the examination, exchange rates are always quoted so that the amount of the first-mentioned currency is equal to one unit of the second-mentioned currency. An exchange rate direct quote is written as, for example, US$/GBP 1.2125-1.2277.In this quote, the first number {1.2125} is the exchange rate if you are buying the rst mentioned currency (US dollars], and the second number {1 312??) is the rate if you are selling the rst-mentioned currency {US dollars}. In other words, the rst number is the rate at which the bank will sell you US dollars and the second number is the rate at which the bank will buy US dollars from you. The difference between the two quoted rates is known as the spread and represents the banlcs or forex dealer's prot margin. In this quote. the spread is {1.01 52. Forward rate: It is possible to buy and sell currency for delivery and settlement at a specied future date. This future rate is known as the forward exchange rate or, simply, forward rate. The forward may be at a discount. at a premium or at par. I- Forward at par means that the forward rate of a currency is equal to its spot rate. - Forward at a premium means that the forward rate of a currency is higher than its spot rate. It Forward at a discount means that the forward rate of a currency is lower than its spot rate. If a currency is trading at a premium, it means that the market believes the currency is currently overvalued against another. If a currency is trading at a discount, it means that the market believes the currency is currently undervalued against another. 8.4.2 Types of forex risk Translation risk Translation risk is the possibility that an accounting gain or loss could occur as a result of the exchange rate conversion of assets and liabilities denominated in a foreign currency. It arises because of movements in exchange rate between accounting reporting periods. 'Translation' refers to the conversion of foreign currency assets or liabilities into the domestic reporting currency. Translation risk is a function of the accounting treatment of foreign assets and liabilities at the year-end and does not result in any cash gain or loss for the company. It simply ends up in an account called rexchange gain or loss on translation' tie. it is a 'paper' gain or loss, not a cash gain or loss). Transaction risk Transaction risk involves a gain or loss arising out of transactions that require settlement in a foreign currency. It is the risk that, in the time period between entering into a transaction and it being nally settled, there is a favourable or adverse movement in the exchange rate. In other words, this risk arises from the fact that the exchange rate on the date of transaction could be different from the exchange rate on the date of settlement of the transaction. Economic risk Economic risk is encountered because of changes in the world economy. It is a measure of the change in prots of a company resulting from economic uctuations taking place all over the world. Longterm movement in the rate of exchange that puts the company at some competitive disadvantage is known as economic risk. Economic risk is general in nature. It can impact a company's performance even if the company does not have any foreign currency transactions. It mayr affect a company's performance even if the company has foreign currency transactions and the exchange rate remains unchanged. Companies not exposed to either transaction or translation risk may be affected by economic risk. Translation risk and transaction risk can be reduced or eliminated by avoiding foreign currency transactions and overseas operations, whereas economic risk cannot be avoided. 8.4.3 Causes of exchange rate differences In international trade, payment for goods and services is made in either the seller's or buyer's domestic currency or in a mutually agreed foreign currency. Rates of exchange are mainly determined by changes in demand and supply for different currencies but are also influenced by the economic environment of the specific countries. As consumption patterns change and different countries are subject to different economic and political conditions, exchange rates fluctuate over time. For a company involved in international trade, exchange rate fluctuations, coupled with delayed payment periods, create risk and uncertainty related to foreign payments and receipts. Exchange rates can be floating or fixed. . A floating exchange rate is allowed to fluctuate according to demand and supply conditions in the foreign exchange markets, with very little interference from the government. . A fixed exchange rate is set at a fixed level by the government and maintained by buying or selling its own currency. Balance of payments A country's balance of payments is commonly defined as the record of all its import and export transactions over a specified period. If the level of imports exceeds the level of exports, there is said tobe a deficit on the balance of payments. This equates to a net payment in a foreign currency. Alternatively, a surplus on the balance of payments would lead to an appreciation of a country's currency relative to another. For example, assume that the UK has a balance of payments decit that must be funded through US dollars. In this instancer the demand for US dollars would rise and the supply of British pounds would increase as attempts are made to acquire US currency. Basic laws of supply and demand dictate that when the demand for a commodity increases its price increases as well, and when the supply goes up the price goes down. As a result of the balance of payments decit, British pounds would depreciate relative to US dollars. Purchasing power parity theory Purchasing power parity {PPP} theory states that two currencies are in equilibrium, or at par. when their purchasing power is the same in both countries. This means that the exchange rate between two countries should equal the ratio of the two countries' price level of a xed basket of goods and services. When a country's domestic price level is increasing (Le. a country experiences ination], that country's exchange rate depreciates in order to return to PPP. The process of equilibrium continues until prices of goods in the two countries reach the same level. Thus PPP theory is based on the law of one price. Competitive markets will equalise the price of an identical good in two countries when the prices are expressed in the same currency. PPP suggests that the purchasing power of a consumer will be similar when purchasing goods in a foreign country or in the home country. If ination in the foreign country differs from ination in the home country, the exchange rate will adjust itself to maintain equal purchasing power. PPP theory is based on the following assumptions. . The law of one price assumes that there are no transportation costs and no differential taxes applied between the two markets. There are competitive markets for the goods and services in both countries. The law of one price applies only to tradable goods. In practice it would take a long time to reach price equilibrium, according to PPP. In the short term, exchange rates are driven by many different events: announcements about interest rate changes, changes in perception of the growth prospects of economies, etc. In effect, the difference between the inflation rate in the foreign country and the inflation rate in the home country is the expected percentage change in the spot rate of the foreign currency. A country that experiences high inflation is likely to depreciate its currency against the currency of a country that has a lower rate of inflation. Thus PPP also influences exchange rates.As you can see from the video, the basic principle behind PPP theory is that goods in different countries that have the same value can be compared through an exchange rate. This can be set out as: S1 = SO TItih) where: S1 = Expected spot rate (country f : country h) So = Current spot rate (country f : country h) if = Expected inflation rate in country f in = Expected inflation rate in country h This indicates that, in countries that have high inflation rates, currency values decline more compared to the currencies of countries with lower inflation rates. Interest rate parity theory Interest rates can be used as a tool for demand management in monetary policy, so interest rates in different countries will vary depending on the condition of the economy. Interest rates also influence exchange rates. If interest rates are high in one country compared to another, this will attract capital inflows as investors try to take advantage of the higher rate of interest. Asa result. demand for the domestic currency increases, pushing up its price. The ultimate effect is a depreciation of the domestic country's currency as it becomes more expensive. Interest rate parity [IRP] theory examines the impact of nominal interest rate differentials between two countries on the forward exchange rate of the foreign currency. IRP theory states that the premium or discount of one currency in relation to another should reect the interest rate differentials between the two currencies. The basic principle is that changes in the spot and forward rates are mainly driven by differences in interest rates. If the interest rate is known, the forward rate can be calculated as: El 2 Ste-Egg- WhEFE? E] = Expected spot rate {country f : country h] So = Current spot rate (country I : country h} if = Interest rate in country 1\" if; = Interest rate in country h