- 14 Marks
FM – L2 – Q87 – Foreign exchange risk and currency risk management
Question
AB Enterprises, a company whose domestic currency is the cedi, has imported a consignment of tomato paste from Spain at a cost of EUR540,000, which is payable in three months’ time. Ama Kofi, the company’s finance director, is concerned about the company’s exposure to currency risk, and she is considering the use of forward contracts or currency futures to hedge the risk.
Required:
(i) Explain to Ama Kofi FOUR differences between a forward contract and a futures contract.
(ii) Currency risk exposure may be transaction risk, economic risk, or translation risk. Which of the three kinds of currency risk exposure is AB Enterprises facing in relation to the EUR540,000 tomato paste consignment?
(iii) Explain to Ama Kofi, THREE disadvantages of hedging the euro exposure with futures hedge.
Answer
(a) differences between forward and futures
The differences between forward and futures are summarised in the
| Point of distinction | Futures | Forward |
|---|---|---|
| Trading platform | Exchange traded instruments (i.e. open market) | Over-the-counter transactions |
| Contract sizes | Standardised contract sizes | Tailored contract sizes |
| Contract maturity dates | Standardised maturity dates | Tailored maturity dates |
| Settlement/close out dates | Flexible close out dates | Fixed date of settlement |
(ii) Type of currency risk AB Enterprises is facing
Explanation of the three types of currency risk exposures:
A firm that engages in international business transactions faces transaction risk when it has contractual cash flows that are fixed in the foreign currency and the exchange rate might change over the contract period. For instance, transaction risk exists when value of imports and exports are fixed in the foreign currency and there is movement in the exchange rate between the invoice date and settlement date.
Translation risk is when an organisation will suffer exchange losses when the results of its foreign branches and subsidiaries are translated into the home currency.
Economic risk refers to the effect of exchange rate movement on the international competitiveness of an organisation. It refers to the present value of longer-term cash flows. It exists when an organisation faces competition from domestic producers/traders in the foreign country or local importers in the home country.
Analysis of AB Enterprises case:
By engaging in the import transaction that will be settled in the future, AB Enterprises faces contractual cash flow (here the obligation to pay EUR540,000). Moreover, the contractual cash flow is fixed in the foreign currency, the euro.
Conclusion on risk type:
With respect to the tomato import from Spain, AB Enterprises is facing transaction exposure to currency risk.
(iii) Disadvantages of hedging with futures hedge
- Contract size cannot be tailored to the exact requirements the investor. This means that the investor’s underlying exposure may not be covered effectively, resulting in hedge inefficiency.
- Contract maturity date cannot be tailored to synchronise with maturity date of underlying exposure. For instance, AB Enterprises’ euro obligation falls due in January 20X9 but the available contract matures in February 20X9. This results in hedge inefficiency.
- Basis risk is inherent in futures hedge. There is the risk that the futures price may move by a different amount from the price of the underlying asset.
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