a) Components of foreign currency risk – transaction risk, translation risk and

economic risk. Identifying specific foreign currency risk in the transactions below which relate to WCL.

i. WCL products becoming expensive due to exchange rate instability/volatility This is economic risk. Economic risk (also called operating exposure or competitive exposure) is the risk that a company’s long-term cash flows, market value, and competitive position will be affected by unexpected changes in exchange rates. Depreciation of the local currency will make the imported products by WCL more expensive thereby making the company less competitive.

Unlike transaction risk (which focuses on specific committed transactions) and translation risk (which focuses on accounting consolidation), economic risk is concerned with the long-term strategic impact of exchange rate movements on a company’s competitive position and future cash flows. Economic risk, in the context of foreign exchange, is therefore the risk that a company might choose to locate its operations in a country whose currency gains in value over time compared to the currencies of its competitors in world markets. The consequence of an increase in the value of the domestic currency is a loss of competitiveness. Economic risk refers to the long-term movement in exchange rates caused by changes in the competitiveness of a country.

ii. Foreign suppliers granting WCL 90 – 120 days of credit the risk arising from foreign suppliers granting WCL credit is transaction risk. Foreign currency risk is the fluctuation in the exchange rate between the date of a transaction and the date of settlement of the transaction. WCL transacts now and makes payments between 90 to 120 days and in between the dates of transaction and payment date, the local currency amount required initially for payment on the date of transaction may either increase or decrease by the time of settlement. This change in the local currency equivalent is what is referred to as transaction risk.

Transaction risk is the risk that, for any future transaction in a foreign currency, the amount received or paid in domestic currency might be different from the amount originally expected because of movements in the exchange rate between the date of the initial transaction and the date of settlement (payment/receipt). Volatile exchange rates increase transaction risk. Transaction risk can disrupt international trade, and make businesses more reluctant to trade internationally, because losses arising from adverse movements in an exchange rate reduce the profit on sales transactions or increase costs of purchases. The transaction loss might even offset the amount of normal trading profit.

WCL consolidating the financial statements of Kenya subsidiary when it becomes operational. This risk is known as translation risk. Translation risk (also called accounting exposure or balance sheet exposure) is the risk that a company’s financial statements will be adversely affected when the financial results of foreign subsidiaries or operations are converted (translated) from their local currency into the parent company’s reporting currency for consolidation purposes. Translation risk is therefore the risk of losses (or gains) arising on the translation of the financial statements of a foreign subsidiary into the currency of the parent company, for the purpose of preparing consolidated accounts.

In simple terms, the risk that exchange rate changes will affect the reported value of foreign assets, liabilities, revenues, and expenses when consolidated into the parent company’s financial statements.

B)

Debts instruments – straight debt, convertible bonds and bonds with warrants

attached.

i. Explanation of straight debts and bonds with warrants attached o Straight Debts – The term ‘straight debt’ means a fixed amount of redeemable

debt at a fixed rate of interest. Straight debt is a basic debt instrument that represents a loan with fixed terms and no special features or conversion options embedded or warrants attached. Straight debt entitles the holder to interest payment and principal repayment without more. Thus, the debt issuer is only obligated to pay agreed interest and repay the principal amount without any further obligations. A typical bank loan that entitles the bank only to interest and principal repayment is a straight debt. o Bonds with warrants attached – These are debt instruments which gives the

bondholder, a right but not an obligation to subscribe for a specified quantity of new equity shares in the company at a future date, at a fixed purchase price. A share warrant attached to a debt is detachable and can be sold by the bondholder to a third party. Share warrants are a form of option, giving the holder of a warrant in a company the right, but not the obligation, to subscribe for a specified quantity of new shares in the company at a future date, at a fixed purchase price.

Warrants are usually issued as part of a package with bonds as an equity sweetener, a phrase which signifies that attaching warrants to the bond issue can make it more attractive to investors.

 ii. The key difference between convertible bonds and bonds with warrants attached.

The differences between bonds with warrants and convertibles may include the following: o Separability of embedded option and attached warrant. With convertibles,

the right to subscribe for equity shares is included in the bond itself, and if the bonds are converted, the investor gives up the bonds in exchange for the equity shares. With bonds with warrants, the warrants are detachable from the bonds. The bonds are therefore redeemed at maturity, in the same way as straight bonds. The warrants are separated from the bonds, and the warrant holder either exercises the warrants to subscribe for new shares when the time to do so arrives or lets the warrants lapse. o Consequence of exercising the right. With convertible bonds when the

embedded option is exercised; the bondholder exchanges his/her bond for equity. On the contrary, when the holder of the bond with warrants attached exercises his right by paying additional cash to buy shares while keeping or maintaining the bond till maturity. o Bond Status After Exercise. After exercising embedded option in the

convertible bond, the bond extinguishes or ceases to exist because it is converted into equity but in the case of bonds with warrants attached, the bond continues to exist after exercising the right in the warrant. o Fresh injection of capital. Exercising of the option embedded in the

convertible bond does not result in injection of fresh capital while exercising the right in the bonds with warrants attached leads to fresh injection of equity capital.

iii. Key advantage that convertible bonds offer to WCL over straight debt in relation to interest rate costs. The key advantage is that convertible bonds typically carry lower interest rates than straight (non-convertible) debt. This is because they offer investors the option to convert the bond into equity (shares of the company) at a future date, which adds value to the bond. In exchange for this conversion feature, investors are usually willing to accept a reduced coupon rate/reduced interest rate.

Convertible bonds are issued at a lower interest rate compared to straight debt because convertible debt gives the bondholder a call option to acquire equity shares at a future date and make instant capital gains. As there is a prospect of making a capital gain should the share price market perform strongly, convertibles can usually be issued at a lower rate of interest than straight debt.

iv. The concept of “conversion premium” as it applies to convertible bonds. The amount by which the market value of the convertible exceeds the market value of the shares into which the bonds will be convertible is called the conversion premium. Conversion premium is the difference between a convertible bond’s market price and its conversion value. Conversion premium is the amount by which the market price of a convertible bond exceeds the current market value of the shares into which it may be converted.

When convertible bonds are first issued, the market value of the shares into which the bonds will be convertible is always less than the market value of the convertibles. This is because convertibles are issued in the expectation that the share price will rise before the date for conversion. Investors will hope that the market value of the shares will rise by enough to make the market value of the shares into which the bonds will be convertible higher than the value of the convertible as a ‘straight bond’.