Background on globalization:
Engaging in business transactions with foreign entities involves an additional layer of complexity, not only because of foreign currency, but also because of factors that influence accounting reporting. The SEC acknowledges the changing landscape of our business community:
“Over the last two decades, the global financial landscape has undergone a significant transformation. These developments have been attributable, in part, to dramatic changes in the business and political climates, increasing global competition, the development of more market-based economies, and rapid technological improvements. At the same time, the world’s financial centers have grown increasingly interconnected.” https://www.sec.gov/rules/concept/34-42430.htm
The Case:
Students must be able to make sound business decisions that are well supported. This project represents decision making in a global context.
Porter Products Inc. purchases vitamins from a supplier abroad. The invoices received by Porter are denominated in the foreign currency. Porter understands that fluctuations in foreign currency exchange rates may adversely affect the company’s earnings. The CFO of Porter wants you to investigate derivative instruments and determine whether or not the use of a foreign currency forward contract or foreign currency option contract is best to hedge the company’s exposure to foreign currency exchange risk.
REQUIRED:
- Examine the foreign currency exchange rate for the country during the most recent twelvemonth period. Create a graph of the exchange rate.
- NOTE: do not copy a graph; you should use Excel to create the graph.
- Draft a memo to explain to the CFO the advantages and disadvantages of using a foreign currency forward contract and foreign currency option contract for hedging. Based on the history of the exchange rates (from above), how might the choice between the derivatives instruments impact Porter?
- Make a recommendation on the hedging instrument that you believe the company should use. Justify/support your recommendation.
- The busy CFO appreciates the documentation of your analysis, but also wants you to discuss your findings and recommendations. Assume you are called to his/her office and asked to explain your findings and recommendations. Prepare a 5-minute video of the discussion that you would have with the CFO.
Note: Porter’s foreign supplier is from one of the following countries. Select one for your analysis
China, Mexico, India, Ukraine, Colombia, Japan, Egypt, South Korea, Canada, Switzerland, Ethiopia
Solution
1-US/INR Exchange Rate from 2 August 2017 to 26 July 2018
Figure 1: US/INR Exchange Rate from 2 August 2017 to 26 July 2018 (PoundSterlingLive.com, 2018)
2-MEMO
Subject: Analysis of Derivatives to Hedge the foreign exchange risk
Porter Products, Inc has purchased vitamins from its supplier who is abroad, and the transaction of the Porter Products, Inc and its invoices are going to be denominated in the foreign currency of India. It means that the vitamins are supplied from the Indian market. The fluctuations in the foreign exchange rate of the Indian Rupees will affect adversely on the earnings of the company. It leaves out the question that which of the derivative instrument should be adopted and preferred to hedge the company from any potential foreign currency exposure.
There are various ways through which exchange rate risk can be hedged for a company. Forward contracts and currency options are one of these options which can be used for hedging against any fluctuations in the exchange rates of Indian Rupees which if not hedged can affect the profitability of the company. For this reason, let’s get into the advantages and disadvantages of these two alternatives in detail.
Currency Options:
Currency option is a type of contract in which the buyer is provided with the right, however not an obligation to sell or buy any specific currency at a specific exchange rate before or one a pre-specified date. Using this for the Porter Products, Inc, the holder would have the right to fix the price at the desired exchange rate, and it has the right to use or not use the option price on or before its exercise date as depending on the currency exchange rate on that day (Janakiramanan, 2014).
Advantages:
Options are traded in the stock exchange market, and for this reason, options are more liquid. Options are also relatively cheaper as compared to other hedging instruments. The options are regulated by the central banks. The risk of the option is limited to the premium of the option in case you are the buyer. The option also offers potentially higher returns against its risks. It also offers various strategies for speculation on the price movement and volatility.
Disadvantages:
The writer of the option is exposed to unlimited risk. Moreover, the holder of the option is usually at a disadvantage because of the expiring nature of the option. Furthermore, the option holder also has to pay a margin or premium amount for entering into an option contract which gets forfeited it, if the option is not exercised. Options also quickly become illiquid and worthless, as the risk is unlimited as well; if worthless it can pose a severe problem (Subramani, 2011).
Forward Contract:
Forward contracts are the type of contracts in which a certain exchange price is settled on a future date, and the buyer must use it on or before that date.
Advantages:
The advantage of the forward contract is pretty clear. One can stop the currency exchange rate where desired and stop the things which are costing more and make sure that one is not losing out on the foreign currency rate which is to be due in some point of time in future. It helps in hedging the exposure of the risk. It is also inexpensive to maintain and very simple to set up. The company can draw down to have the currency early as well. The company can buy now and then pay later as well. It can also rollover if it does not need the funds until the original settlement. These can be customized as per individual needs and are traded over the counter. There is no requirement of paying any extra margin or premium on the contract.
Disadvantages:
There can be some disadvantages of the forward contract as well. However, the main con is that hedging can also work against the company. Even though, as compared to the protection that it offers, there is the possibility of it going against the company as well. If the currency moves in favor of the company, then it can turn out as missing the gains. Moreover, small deposits also need to tie up the capital. Furthermore, these are not regulated and are not traded on the stock exchange making it less liquid. They are not widely in demand as these are not widely traded. There can be the possibility of default as it is more of a private agreement.
3-Recommendation
It can be recommended that due to the reasons mentioned above, the importer, i.e., Porter Products Ins can safely involve in foreign exchange transactions with its Indian Supplier by hedging its risk through the use forward contract. It will ensure that any changes in the exchange rate do not affect the profitability of the company.
4-Discussion
As shown in the analysis above, it can be safely suggested that the current scenario asks for the use of a forward contract for Porter Products Inc. It can be for the following reasons.
The forward contracts offer the freedom of customization, using this we can customize the contract as per the transaction exposure. Furthermore, the forward contract not only aids in reducing the risk, but it also eradicates the risk. It ensures that using forward contracts, our profitability will be ensured as safe from exchange rate risk. Options would be more feasible if the company considers the situation as highly risky, which is when huge currency movements are expected. It is not the case in the US/Indian Exchange Rate as the rate has not been changing drastically in the past twelve months and for last three it remained within 67 to 68 Indian Rupees range.
References
Janakiramanan, S. (2014). Derivatives and Risk Management. Pearson Education India.
PoundSterlingLive.com. (2018, July 29). U.S. Dollar to Indian Rupee Spot Exchange Rates for 2017 from the Bank of England. Retrieved from PoundSterlingLive.com: https://www.poundsterlinglive.com/bank-of-england-spot/historical-spot-exchange-rates/usd/USD-to-INR-2017
Subramani, R. V. (2011). Accounting for Investments, Equities, Futures and Options. John Wiley & Sons.
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