Topic: Hedging against financial risk: Non-derivative techniques

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  • 15 Marks

AFM – Nov 2016 – L3 – Q5a – Hedging against financial risk: Non-derivative techniques

Demonstrate how YSL can hedge currency risk using futures contracts and calculate the result of the hedge.

YSL is a company located in the USA that has a contract to purchase goods from Japan in two months’ time on 1st September. The payment is to be made in yen and will total 140 million yen. The managing director of YSL wishes to protect the contract against adverse movements in foreign exchange rates and is considering the use of currency futures. The following data are available:

  • Spot foreign exchange rate: $1 = 128.15 yen
  • Yen currency futures contracts on SIMEX (Singapore Monetary Exchange)
    • Contract size: 12,500,000 yen
    • Contract prices (US$ per yen):
      • September: 0.007985
      • December: 0.008250

Assume that futures contracts mature at the end of the month.

Required:
i) Illustrate how YSL might hedge its foreign exchange risk using currency futures. (5 marks)
ii) Explain the meaning of basis risk and show what basis risk is involved in the proposed hedge. (5 marks)
iii) Assuming the spot exchange rate is 120 yen/$1 on 1 September and that basis risk decreases steadily in a linear manner, calculate what the result of the hedge is expected to be. Briefly discuss why this result might not occur. (5 marks)
(Margin requirements and taxation may be ignored.)

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  • 10 Marks

AFM – May 2017 – L3 – Q5a – Hedging against financial risk: Non-derivative techniques

Calculation of settlement value, loan amount, interest on loan, and effective interest rate under a Forward Rate Agreement.

The Board of Directors of Aduana Enterprise has approved an expansion project which will require a cash inflow of GH¢10 million. The investment duration will be 6 months, and management is considering taking a fixed interest rate loan from its bankers. The loan will be required in three months from the date of board’s approval.

Management of Aduana is considering hedging its risk exposure using a Forward Rate Agreement (FRA). The 3-9 months’ FRA rate at the transaction date was 5%.

Required:
If the spot rate at the settlement date is 8%, calculate the following:
i) Settlement value (3 marks)
ii) Loan amount required (2 marks)
iii) Interest on the loan (2 marks)
iv) Effective interest rate (3 marks)

 

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  • 5 Marks

AFM – May 2017 – L3 – Q1a – Hedging against financial risk: Non-derivative techniques

Recommendations to mitigate losses on foreign currency transactions due to the depreciation of the Cedi.

In the last couple of years, the Cedi has depreciated substantially against the US Dollar. This has had an adverse effect on the financial performance of most of the multinational companies in Ghana.

Required:
As a Financial Adviser of your organization, a multinational company involved in the export trade, recommend actions to be taken to minimize the loss on foreign currency transactions. (5 marks)

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  • 3 Marks

AFM – Nov 2017 – L3 – Q1d – Hedging against financial risk: Non-derivative techniques

Recommendations on how to minimize the loss on foreign currency transactions for a multinational company involved in export trade.

In the last couple of years, the Cedi has depreciated substantially against the US Dollar. It is also noticed that the Cedi has had volatile movements against the Pounds Sterling since the beginning of year 2017.

Required: As a Finance Director of your organization, a multinational company which is involved in the export trade, recommend THREE actions to be taken to minimize the loss on foreign currency transactions.

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  • 10 Marks

AFM – May 2018 – L3 – Q5b – Hedging against financial risk: Non-derivative techniques

Explaining exchange exposure and methods for minimizing and hedging against both pre- and post-acceptance exposure.

i) Explanation of Exchange Exposure (2 marks):

Exchange exposure refers to the risk that a company’s financial performance or position may be affected by fluctuations in exchange rates between currencies. For an exporter quoting prices in a foreign currency, there is a risk that the value of the foreign currency may change before payment is received, leading to a gain or loss in the value of that payment when converted into the company’s domestic currency.

Exchange exposure is classified into three types:

  • Transaction Exposure: Risk arising from actual transactions involving foreign currency payments or receipts.
  • Translation Exposure: Risk from converting foreign subsidiaries’ financial statements into the parent company’s reporting currency.
  • Economic Exposure: Risk from the overall impact of exchange rate changes on a firm’s future cash flows and market value.

(2 marks)

ii) Methods for Minimizing Pre-Acceptance Exposure (4 marks):

Pre-acceptance exposure arises in the period between the time an exporter quotes a price in a foreign currency and the time the contract is accepted.

Two methods to minimize pre-acceptance exposure:

  1. Time-Limited Quotes:
    • The exporter can limit the validity period of the quote to a short timeframe, ensuring that the exchange rate does not fluctuate significantly before the contract is accepted.
    • Advantage: This method reduces the period during which the exchange rate risk exists, thus minimizing potential exposure to currency fluctuations.
  2. Forward Contracts:
    • The exporter can lock in a forward contract to sell the foreign currency at a predetermined rate when the quote is accepted. This ensures that the company knows exactly what exchange rate will apply, regardless of fluctuations.
    • Advantage: A forward contract provides certainty about the future exchange rate, allowing the exporter to avoid potential losses due to unfavorable exchange rate movements.

(2 marks for each method, 4 marks total)

iii) Hedging Methods for Post-Acceptance Exposure (4 marks):

Post-acceptance exposure arises after the contract has been accepted but before the payment has been received. There are several methods for hedging this exposure:

  1. Borrowing in the Foreign Currency:
    • The exporter can borrow the foreign currency equivalent of the receivable immediately and repay the loan once the foreign customer pays. This hedges the risk of adverse currency movements.
    • Advantage: This method is relatively simple and cheap. It also provides immediate cash flow in the foreign currency and eliminates exchange rate risk.
  2. Forward Contracts:
    • The exporter can enter into a forward contract to sell the expected foreign currency receipt at a specified rate on the date payment is due. This locks in the exchange rate and eliminates the uncertainty associated with currency fluctuations.
    • Advantage: Forward contracts offer certainty about the amount of the domestic currency that will be received, providing security and allowing for better financial planning without committing cash resources upfront.

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  • 3 Marks

AFM – May 2016 – L3 – Q4a – Hedging against financial risk: Non-derivative techniques, Economic environment for multinational

Outline three risk mitigation strategies that a company can adopt to reduce risks affecting profitability.

a) Booms and Bumps Limited has recently been registered as a multinational company dealing in the production and drilling of crude oil in the Oil and Gas industry. Due to uncertainties surrounding the future prospects of the industry, management has hired you as a financial consultant to conduct a risk assessment about the viability of the firm. In the course of the assessment, you constructed a risk register containing various risks that have the potential to affect negatively the profitability of the company.

Required:
Outline THREE basic strategies the management of the company can adopt to mitigate the impact of the risks. (3 marks)

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  • 5 Marks

AFM – May 2016 – L3 – Q2b – Hedging against financial risk: Non-derivative techniques, Hedging against financial risk: Derivatives

Describe four approaches that a company can use to hedge against foreign exchange risk.

b) As a trading company, Joewoka exports and imports merchandise in many countries for which it receives and makes payment in foreign currency. This exposes the company to foreign exchange risk.

As a Financial Consultant to the company, suggest FOUR approaches that the company can use to hedge against foreign exchange exposure. (5 marks)

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  • 10 Marks

AFM – May 2016 – L3 – Q1b – Hedging against financial risk: Non-derivative techniques, Hedging against financial risk: Derivatives, The use of financial derivatives to hedge against interest rate risk

Explain how to hedge a foreign exchange risk exposure using forward and money markets with calculations.

b) A Ghanaian Food and Beverage company has recently imported raw materials from China with an invoice value of US$264,000 payable in three months’ time. Due to the company’s efficient production capacity, it has finished production and exported finished products to Germany. Consequently, the German customer has been invoiced for US$75,900 payable in three months’ time. Below is the current spot and forward rates for the transactions:

  • USD/GHS Spot: 0.9850 – 0.9870
  • 3 Months Forward: 0.9545 – 0.9570

Current Money Market rates per annum are as follows:

  • US$ (USD): 11% – 13.2%
  • Gh¢ (GHS): 12.7% – 14.3%

Required:
i) Demonstrate with relevant calculations how the Ghanaian company can hedge its exposure to foreign exchange risk using the Forward Markets. (3 marks)
ii) Demonstrate with relevant calculations how the Ghanaian company can hedge its exposure using the Money Markets. (4 marks)
iii) Determine which of the above markets is the best hedging technique. (3 marks)

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  • 15 Marks

AFM – Nov 2016 – L3 – Q5a – Hedging against financial risk: Non-derivative techniques

Demonstrate how YSL can hedge currency risk using futures contracts and calculate the result of the hedge.

YSL is a company located in the USA that has a contract to purchase goods from Japan in two months’ time on 1st September. The payment is to be made in yen and will total 140 million yen. The managing director of YSL wishes to protect the contract against adverse movements in foreign exchange rates and is considering the use of currency futures. The following data are available:

  • Spot foreign exchange rate: $1 = 128.15 yen
  • Yen currency futures contracts on SIMEX (Singapore Monetary Exchange)
    • Contract size: 12,500,000 yen
    • Contract prices (US$ per yen):
      • September: 0.007985
      • December: 0.008250

Assume that futures contracts mature at the end of the month.

Required:
i) Illustrate how YSL might hedge its foreign exchange risk using currency futures. (5 marks)
ii) Explain the meaning of basis risk and show what basis risk is involved in the proposed hedge. (5 marks)
iii) Assuming the spot exchange rate is 120 yen/$1 on 1 September and that basis risk decreases steadily in a linear manner, calculate what the result of the hedge is expected to be. Briefly discuss why this result might not occur. (5 marks)
(Margin requirements and taxation may be ignored.)

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  • 10 Marks

AFM – May 2017 – L3 – Q5a – Hedging against financial risk: Non-derivative techniques

Calculation of settlement value, loan amount, interest on loan, and effective interest rate under a Forward Rate Agreement.

The Board of Directors of Aduana Enterprise has approved an expansion project which will require a cash inflow of GH¢10 million. The investment duration will be 6 months, and management is considering taking a fixed interest rate loan from its bankers. The loan will be required in three months from the date of board’s approval.

Management of Aduana is considering hedging its risk exposure using a Forward Rate Agreement (FRA). The 3-9 months’ FRA rate at the transaction date was 5%.

Required:
If the spot rate at the settlement date is 8%, calculate the following:
i) Settlement value (3 marks)
ii) Loan amount required (2 marks)
iii) Interest on the loan (2 marks)
iv) Effective interest rate (3 marks)

 

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  • 5 Marks

AFM – May 2017 – L3 – Q1a – Hedging against financial risk: Non-derivative techniques

Recommendations to mitigate losses on foreign currency transactions due to the depreciation of the Cedi.

In the last couple of years, the Cedi has depreciated substantially against the US Dollar. This has had an adverse effect on the financial performance of most of the multinational companies in Ghana.

Required:
As a Financial Adviser of your organization, a multinational company involved in the export trade, recommend actions to be taken to minimize the loss on foreign currency transactions. (5 marks)

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  • 3 Marks

AFM – Nov 2017 – L3 – Q1d – Hedging against financial risk: Non-derivative techniques

Recommendations on how to minimize the loss on foreign currency transactions for a multinational company involved in export trade.

In the last couple of years, the Cedi has depreciated substantially against the US Dollar. It is also noticed that the Cedi has had volatile movements against the Pounds Sterling since the beginning of year 2017.

Required: As a Finance Director of your organization, a multinational company which is involved in the export trade, recommend THREE actions to be taken to minimize the loss on foreign currency transactions.

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  • 10 Marks

AFM – May 2018 – L3 – Q5b – Hedging against financial risk: Non-derivative techniques

Explaining exchange exposure and methods for minimizing and hedging against both pre- and post-acceptance exposure.

i) Explanation of Exchange Exposure (2 marks):

Exchange exposure refers to the risk that a company’s financial performance or position may be affected by fluctuations in exchange rates between currencies. For an exporter quoting prices in a foreign currency, there is a risk that the value of the foreign currency may change before payment is received, leading to a gain or loss in the value of that payment when converted into the company’s domestic currency.

Exchange exposure is classified into three types:

  • Transaction Exposure: Risk arising from actual transactions involving foreign currency payments or receipts.
  • Translation Exposure: Risk from converting foreign subsidiaries’ financial statements into the parent company’s reporting currency.
  • Economic Exposure: Risk from the overall impact of exchange rate changes on a firm’s future cash flows and market value.

(2 marks)

ii) Methods for Minimizing Pre-Acceptance Exposure (4 marks):

Pre-acceptance exposure arises in the period between the time an exporter quotes a price in a foreign currency and the time the contract is accepted.

Two methods to minimize pre-acceptance exposure:

  1. Time-Limited Quotes:
    • The exporter can limit the validity period of the quote to a short timeframe, ensuring that the exchange rate does not fluctuate significantly before the contract is accepted.
    • Advantage: This method reduces the period during which the exchange rate risk exists, thus minimizing potential exposure to currency fluctuations.
  2. Forward Contracts:
    • The exporter can lock in a forward contract to sell the foreign currency at a predetermined rate when the quote is accepted. This ensures that the company knows exactly what exchange rate will apply, regardless of fluctuations.
    • Advantage: A forward contract provides certainty about the future exchange rate, allowing the exporter to avoid potential losses due to unfavorable exchange rate movements.

(2 marks for each method, 4 marks total)

iii) Hedging Methods for Post-Acceptance Exposure (4 marks):

Post-acceptance exposure arises after the contract has been accepted but before the payment has been received. There are several methods for hedging this exposure:

  1. Borrowing in the Foreign Currency:
    • The exporter can borrow the foreign currency equivalent of the receivable immediately and repay the loan once the foreign customer pays. This hedges the risk of adverse currency movements.
    • Advantage: This method is relatively simple and cheap. It also provides immediate cash flow in the foreign currency and eliminates exchange rate risk.
  2. Forward Contracts:
    • The exporter can enter into a forward contract to sell the expected foreign currency receipt at a specified rate on the date payment is due. This locks in the exchange rate and eliminates the uncertainty associated with currency fluctuations.
    • Advantage: Forward contracts offer certainty about the amount of the domestic currency that will be received, providing security and allowing for better financial planning without committing cash resources upfront.

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  • 3 Marks

AFM – May 2016 – L3 – Q4a – Hedging against financial risk: Non-derivative techniques, Economic environment for multinational

Outline three risk mitigation strategies that a company can adopt to reduce risks affecting profitability.

a) Booms and Bumps Limited has recently been registered as a multinational company dealing in the production and drilling of crude oil in the Oil and Gas industry. Due to uncertainties surrounding the future prospects of the industry, management has hired you as a financial consultant to conduct a risk assessment about the viability of the firm. In the course of the assessment, you constructed a risk register containing various risks that have the potential to affect negatively the profitability of the company.

Required:
Outline THREE basic strategies the management of the company can adopt to mitigate the impact of the risks. (3 marks)

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  • 5 Marks

AFM – May 2016 – L3 – Q2b – Hedging against financial risk: Non-derivative techniques, Hedging against financial risk: Derivatives

Describe four approaches that a company can use to hedge against foreign exchange risk.

b) As a trading company, Joewoka exports and imports merchandise in many countries for which it receives and makes payment in foreign currency. This exposes the company to foreign exchange risk.

As a Financial Consultant to the company, suggest FOUR approaches that the company can use to hedge against foreign exchange exposure. (5 marks)

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You're reporting an error for "AFM – May 2016 – L3 – Q2b – Hedging against financial risk: Non-derivative techniques, Hedging against financial risk: Derivatives"

  • 10 Marks

AFM – May 2016 – L3 – Q1b – Hedging against financial risk: Non-derivative techniques, Hedging against financial risk: Derivatives, The use of financial derivatives to hedge against interest rate risk

Explain how to hedge a foreign exchange risk exposure using forward and money markets with calculations.

b) A Ghanaian Food and Beverage company has recently imported raw materials from China with an invoice value of US$264,000 payable in three months’ time. Due to the company’s efficient production capacity, it has finished production and exported finished products to Germany. Consequently, the German customer has been invoiced for US$75,900 payable in three months’ time. Below is the current spot and forward rates for the transactions:

  • USD/GHS Spot: 0.9850 – 0.9870
  • 3 Months Forward: 0.9545 – 0.9570

Current Money Market rates per annum are as follows:

  • US$ (USD): 11% – 13.2%
  • Gh¢ (GHS): 12.7% – 14.3%

Required:
i) Demonstrate with relevant calculations how the Ghanaian company can hedge its exposure to foreign exchange risk using the Forward Markets. (3 marks)
ii) Demonstrate with relevant calculations how the Ghanaian company can hedge its exposure using the Money Markets. (4 marks)
iii) Determine which of the above markets is the best hedging technique. (3 marks)

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You're reporting an error for "AFM – May 2016 – L3 – Q1b – Hedging against financial risk: Non-derivative techniques, Hedging against financial risk: Derivatives, The use of financial derivatives to hedge against interest rate risk"

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