International Trade And Finance: Risks Faced By International Banking And Hedging Techniques

Various types of risks faced by international banking

1. Between 2010 and 2014, the price for a superior room at the Grand Hyatt Kuala Lumpur, Malaysia rose from 430 MYR to 550 MYR. At the same time, the exchange rate went from 1 AUD = 4.30 MYR in 2010 to 1 AUD = 2.50 MYR in 2014. (The currency in Malaysia is the Malaysian Ringgit and is referred to as MYR)
2. By how much has the Australian dollar costof a superior room at the Grand Hyatt Kuala Lumpur, Malaysia changed over this period

Answer: Cost in 2010 = 430 MYR

  Rate of Exchange 1 AUD = 4.30 MYR

  Cost in AUD = 430×1/4.30 = 100 AUD

  Now cost in 2014 = 550 MYR

  Rate of Exchange 1 AUD = 2.50 MYR

  Cost in AUD = 550×1/2.50 = 220 AUD

  Therefore, change in cost = 220AUD – 100 AUD = 120 AUD.

1. What has been the percentage (%) change in the value of the Australian dollar against the Malaysian Ringgit during this period?

Please clearly specify whether AUD has appreciated or depreciated against MYR.

Answer: 2010 1 AUD = 4.30 MYR

  2014 1 AUD = 2.50 MYR

  Percentage change = (4.30-2.50)/4.30 X 100 X 1/4 = 10.465%

  Therefore, Australian Dollar has depreciated over the past four years @ 10.465% p.a.

1. You are given the following spot quotations:

1 USD = 1.5485 AUD

1 USD = 1.7935 EUR

1 GBP = 1.6325 USD

1. What is the value of 1 AUD in terms of EUR (1 AUD =? EUR)?

Answer: We will use cross currency rates to establish direct relationship between different rates.

  Now,   1 USD = 1.5485 AUD

  And   1 USD = 1.7935 EUR

  This implies 1.5485 AUD = 1.7935 EUR

  Therefore, 1 AUD = 1.7935/1.5485 = 1.1582 i.e. 1.1575 EUR.

Study Period 2 2016 Final Examination Page 6 of 14

Open Universities Australia (OUA)	FIN30013
Swinburne University of Technology (SUT)	International Trade and Finance

1. What is the value of 1 GBP in terms of EUR (1 GBP =? EUR)

Answer: 1 USD = 1.7935 EUR

   1 GBP = 1.6325 USD or 1 USD = 0.6125 GBP

   This implies 0.6125 GBP = 1.7935 EUR

   Therefore, 1 GBP = 1.7935/0.6125 = 2.9282 i.e. 2.9275 EUR.

1. What is the value of 1 EUR in terms of USD (1EUR =? USD)?

Answer: We have 1 USD = 1.7935 EUR

   Therefore, 1 EUR = 1/1.7935 = 0.5575 USD.

1. Clearly distinguishbetween the activities of hedging and speculating.

Answer: Hedging refers to taking a forward position opposite to your exposure. Hedge ratio is the ratio of one position relative to other where risk is neutralized. It should be noted that hedging does not remove losses; however, the best that can be achieved using hedging is the removal of unwanted exposure, that is, unnecessary risk. However, Forwards can be used to acquire risk, rather than to insure or hedge against risk. Some individuals and institutions enter into a forward contract to speculate on the value of underlying asset, betting that the party seeking hedging will be wrong about the future value of the underlying asset. This is what is called speculation.Period 2 2016 Final Examination Page 7 of 14

Open Universities Australia (OUA)	FIN30013
Swinburne University of Technology (SUT)	International Trade and Finance

1. An Australian treasurer has 1 million Japanese Yen (JPY) payabledue in six months. The spot rate is 1 AUD = 69 JPY. The six-month forward rate is 1 AUD = 67 JPY. The treasurer forecasts that JPY will strengthen to 1 AUD = 65 JPY in the next six months.
2. If the treasurer enters the forward market to gain protection from unanticipated changes in the rate between AUD and JPY, will (s) he buy or sell JPY? Give reasons for your answer.

Answer: The forward rate; 1 AUD = 67 JPY or 1 JPY = 0.0150 AUD

  The spot rate after six months; 1 AUD = 65 JPY or 1 JPY = 0.0175 AUD

  This shows that JPY is undervalued in the six month forward market. Hence, the treasurer   should buy JPY in forward market to get arbitrage gain.

1. Given the forecast rate and the cost of forward cover, should the treasurer hedge in the forward market? Give reasons for your answer.

Market-based hedging techniques available to the company

Answer: Yes, he should hedge in the forward market because JPY is strengthening in future. If he  does not hedges his position then he will have to pay more AUD as the spot market after six months is in favour of JPY and the treasurer will incur losses. To overcome such loss, the hedging with forward market rate is necessary because the forward market rate is lower as compared to actual market rate after six months.

1. Suppose the treasure hedges and the forecast rate proves correct. Will the treasurer gain or lose AND by how much in terms of AUD

Answer: Amount payable in forward market = 1, 00, 00, 00/67 = 14925 AUD

  Amount payable in spot market = 1, 00, 00, 00/65 = 15385 AUD

  The treasurer will save 460 AUD with forward hedging.

1. Suppose the treasurer hedges but instead of the forecast rate of 1 AUD = 65 JPY, the future spot rate moves to 1 AUD = 75 JPY. Under this new scenario, will the treasurer gain or lose AND by how much in terms of AUD?

Answer: Amount payable in forward market = 14925 AUD

  Amount payable in spot market = 1, 00, 00, 00/75 = 13333 AUD

  Therefore, the treasurer will lose by 1592 AUD.

Study Period 2 2016 Final Examination Page 8 of 14

Open Universities Australia (OUA)	FIN30013
Swinburne University of Technology (SUT)	International Trade and Finance

1. Identify AND describe three internal basedtechniques a company’s treasurer could use to hedge against foreign exchange risk.

• Leads and Lags: Leading refers to advancing a payment due in foreign currency whereas lagging refers to delaying the payment, to safeguard from likely risk from fluctuation of foreign exchange. Leading is beneficial if foreign currency payable is at premium on the other hand lagging is beneficial if foreign currency payable is at discount, vice versa is true in case of receipt in foreign exchange.

(ii) Netting: In case of MNC’s a parent company and its subsidiaries periodically settle up the net amounts. It is called as netting. Similarly, foreign currency cash flows receivable from the one party or in one currency and payable to the other party or in other currency may be net off to avoid Foreign Exchange difference.

(iii) Currency Rollover: The currency rollover contracts are entered into to cover the exchange rate risk on long-term liabilities. This cover is initially taken for a maximum of one year. After the expiry of the tenure of a year contract is further extended to another one year and so on.

1. Swindale Co. exports 80 percent of its total production of goods in Victoria to variouscountries in Asia.

Swinthorn Co. sells all goods it produces in Australia, but it has a subsidiary in Malaysia that usually generates about 30 percent of its total earnings.Compare the translation exposure of these two Australian firms.

Answer: Translation exposure is the likely increase or decrease in the net worth of a company caused because of changes in exchange rate used for valuation of assets and liabilities denominated in foreign currencies. Swindale Co. has the translation exposure of 80 percent of its goods because it will translate the goods exported to other countries in domestic currency at the closing date for the financial period. However, Swinthorn Co. has the exposure of only 30 percent of its earnings which comes from the Malaysian wing. This earning will also be recognised at the end of the financial period during consolidation of the statements of the group. Thus, both companies are facing the translation exposure but for Swindale Co. it is 50% (80-30) more as compare to the other company.

Costs and benefits of hedging

Study Period 2 2016 Final Examination Page 9 of 14

Open Universities Australia (OUA)	FIN30013
Swinburne University of Technology (SUT)	International Trade and Finance

1. Yarra Valley Clothing is a major children’s clothing company in Australia. All the inputs for clothing are sourced domestically and the company sells the final products throughout Australia. Does Yarra Valley Clothing face a foreign exchange exposure? Clearly explain.

Answer: Foreign Exchange Exposure refers to the risk, which is due to the relative devaluation and appreciation in the value of currency of a country in relation to the currency of some other country. Hence, it is very much important that the business transaction should relate to two or more different countries. In the given case, Yarra Valley Clothing is acquiring it inputs from Australia and does all its selling operations in the same country. Therefore, there are no transactions in two or more different currencies which could lead to fluctuation risk. Thus, the company does not face any risk of foreign exchange.

Study Period 2 2016 Final Examination Page 10 of

Open Universities Australia (OUA)	FIN30013
Swinburne University of Technology (SUT)	International Trade and Finance

This section consists of FIVE questions.

Each question is worth 10 marks.

You ONLY have to answer TWO questions from this section.

“Many factors have contributed to the growth and development of international banking since World War II. While the operations of an international bank can take various forms, international banking faces a diverse range of risks.”Elaborate on this statement. In your answer, make sure you will clearly discuss every sentence in the statement

Answer: After the World War II, the banking sector has seen enormous development which made it possible for countries all over the world to get easy finance for the developmental aspects. However, the banks face numerous risks which can impact the countries enormously. Thus, a continuous assessment is required to find out these risks and find measures to diversify or mitigate them. For any financial system, it is very much essential to determine the international banking risks.

The various types of risks which are being faced by International Banking are:-

1. Interest Rate Risk – Interest Rate Risk is the risk of adverse movements in interest rates which affect the bank’s financial condition. Interest Rate Risks can potentially increase the unexpected cost to international banks. The banks are required to find a solution in order to manage this risk and effectively manage its impacts.
2. Credit Risk – The credit risk can be defined as the risk of non payment or inability or unwillingness to pay or meet a bank’s financial obligation by any counterpart. The reason could be insolvency or bankruptcy of the person or it could be a default. Insolvency is a situation where the borrower’s value of assets is below that of its liabilities. Default relates the borrower’s failure to honour contractual obligations when they fell due. Bankruptcy occurs when a borrower recognized the dying financial situation and files to the court for protection under existing law. Credit risk is therefore the primary cause of bank’s failure. Thus, a banks capacity for credit risk management will significantly contribute to the quality of risk management policies.
3. Liquidity Risk – Liquidity risk is the potential loss to a bank arising from either increase in fund without incurring unacceptable losses or cost or its inability to meet its obligations as they fall due. Liquidity risk may arise due to unplanned changes in funding sources. It may arise due to numerous factors and is difficult to assess. Its prudent management is very much required for the effective management as the failure may lead to inability of bank to meet its obligations. Bank’s liquidity risk management critically requires determination of cumulative net funds flow and formulation of effective strategies.
4. Market Risk – Market risk is the risk of losses due to unfavourable movements in market prices. This risk may arise due to changes in interest rates, foreign exchange rates, stock prices and similar market indicators. Management of market risk is also a key feature as it may lead to capital loss and lower future income. To mitigate this risk, the banks are advised many times to create a Reserve fund to meet these unanticipated risks of Investment Fluctuations.
5. Operational Risk – Operational risk is the risk due to failure of inadequate internal processes, people and systems or from external events. The major reasons could be categorized as the Internal Fraud which may be the misappropriation of assets, tax evasion, bribery etc., External Fraud like theft of information, third party theft, forgery etc., Employment practices and workplace safety which may be discrimination, employee health and safety etc., Clients products, and business practice which may be market manipulation, improper trade etc., Damage to physical assets like natural disasters, terrorism and vandalism etc., Business disruption and systems failure which includes hardware and software failures and execution, delivery and process management which includes data entry errors, accounting errors etc. Good operational risk management results in quality improvement and reduction in cost.

Hence, the banks that loses the vision for existence of these risks and does not put effective strategies for their mitigation stand in a vulnerable position in a competitive banking sector. The ability to manage various risks determines the survival in the market place.

An Australian company carries 35 million NZD in its account receivable which is due in 180 days.

1. Identify AND explain four market-basedhedging techniques available to the company in order to meet this obligation
2. Identify AND discuss the issues or factors a company should consider when deciding which hedging technique to employ

Answer (a): The four market-based hedging techniques available to the company in order to meet this obligation are:-

1. Money Market Hedge– A firm can also hedge the exchange risk in the money market by borrowing or lending in the foreign currency. With the help of money market hedge, exchange risk is completely taken care at spot at the cost of interest. In this process, the required foreign currency to be purchased at the spot is calculated on the basis of the required foreign currency payable or receivable in future period. The required currency is then borrowed in domestic currency in payable situation and in foreign currency in receivable situation. Then the borrowed amount in converted into other currency and invested in foreign market in payable situation and domestic market in receivable situation. At the end of the period, the liabilities are settled on due date.
2. Forward Contracts– Where buyers and sellers contract to buy and sell currencies for delivery at a future date. The parties agree the forward rate at the time of making contract, which remains fixed irrespective of future exchange rate fluctuations. Forward contracts are most usual method, used for hedging purpose. The different types of Forward Contracts can be Fixed Forward Contract, Option Forward Contract and Forward Exchange Rates. Fixed Forward Contracts take place on a specified future date however it can be cancelled, or extended or settled at an earlier date. Option Forward Contracts where the customer can buy or sell from the bank foreign exchange on any day during a given period of time at predetermined rate of exchange. Forward Exchange Rate is a spot rate adjusted for forward premium or forward discount as the case may be.
3. Currency Futures– The concept of future contract is closely related to the concept of forward contract. A future contract is standardized agreement that calls for delivery of a currency at some specified future date at agreed price. The currency future market exists only for the major currencies. These are traded on an exchange and are valued at closing price.
4. Options– The option contract provides to buyer of the option, a claim without any liability to buy or sell a sum of foreign currency at agreed rate called as strike price on or before the maturity date. The difference between the forward contract and the option contract is that under the forward contract, the customer has right and obligation both, while in case of option contract, customer has right to execute contract or not to execute contract as may be beneficial to him. The cost of buying an option is called as option premium.

Answer (b): After an assessment of all the risks which a firm or company is exposed to the next important step is to categorize these risks and analysing that which risks are required to be hedged and which are to be passed to the investors or exploit. This judgement is purely based on the costs and benefits which flow from various hedging techniques available and choosing to hedge those risks whose benefits are greater than the associated costs.

The various costs related to hedging could be:-

1. Explicit costs– Businesses which predict their risks can in some manner hedge the possibility of those risks by using insurance options. The insurance premium is the total cost of this hedging which increases with the likelihood and expected impact of a specified risk.
2. Implicit costs– The firms that use other ways of hedging against risk may be able to reduce some default risk. Such ways depend on the financial choices made by the hedger. Thus implicit costs are the cost of the risk which actually occurs and not the overall anticipated cost for covering the risk.

The benefits flowing from hedging could be the tax benefits which may arise from effective hedging which enhances the flow of revenues as the hedged revenues will be clearer and actual. Other benefits may arise in the form of better investment decisions, distress costs, capital structure and informational benefits.