Protecting a Business From Adverse Currency Movements

I would protect my business against adverse currency by entering into a forward exchange rate contract with my financial provider for the period of making the business deal with the foreign retailers and the stipulated date of the receipt of payment to eliminate any financial risks that may occur as a result of fluctuations in the foreign exchange rates. A forward exchange contract is a particular type of foreign currency transaction which involves an agreement between two parties to exchange a designated currency at a specific time in the future (Cornell, 1977; Eun & Resnick, 1988). The parties involved in the contract are interested in hedging a foreign exchange position to mitigate on the foreign exchange fluctuation risk or taking a speculative position for future financial gain (Adler & Dumas, 1984). The contracts rate of exchange is fixed and specified for a specific date and allows parties involved to better budget for future business operations and provides protection for parties from unexpected or adverse movements in the currencies future spot rates (Hansen & Hodrick, 1980 ). The contract is made between a financial provider and a business and involves two components: the spot component which is the rate of the two currencies at the current date and a forward part which is a reflection of the interest rate differential of the two currencies over that period.

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I would like to use this protection to cushion against economic risks as a result of the change in competitive strength between exports and imports (Brown, 2001; Taylor, 1992 ) which would occur if the euro weakened against the British pound making the commodity more expensive and reducing their competitiveness in the British market. Additionally, I will use this protection to eliminate transaction risks as a result of movement of exchange rates between the date of agreeing on the contract and the date of receipt of payment through a guaranteed future exchange rate (Hodrick & Srivastava, 1984; Stulz, 1984 ) The future exchange rate or the forward exchange rate assures the exporter of a certain amount of cash flow and thus can make business operations like budgeting. Management of cash flow and financial budgeting by negating the risks associated with foreign exchange fluctuations and ensuring a certain amount of cash flow. The variations in the foreign exchange rate of the euro and the British pound will not affect the amount that the exporter will receive (Solnik, 1995).

There are no initial transaction costs like brokerage which makes it a cheaper way of securing a business's cash flow while eliminating the dangers associated with foreign exchange fluctuations (Campbell et al., 2010). The value of the hedge is zero because at the inception of the forward exchange rate contract as no payment is made (Stulz, 1984).Forward exchange contracts provide flexibility; can be tailored regarding dates and amounts to meet specific requirements (Clark, 1973). This feature enables the importer to set up delivery dates to match the period of cash flows. The forward exchange rate is convenient for international traders who conduct business in different currencies and receive payments in future dates (Honsin & Srivastava, 1984).

Calculations

The exchange rates:

EUR To PS spot 1.2028

PS To EUR Spot - 1.2022

One month forward rate EUR/PS 1.2026 - 1.2014

The Italian exporter will make a forward exchange contract arrangement with his bank that will take one month to coincide with the date that he or she expects to receive payments from the British retailer.

The forward exchange rate can be calculated using four variables.

S= the current spot rate of the currency pair

R (d) = the domestic interest rate

R (f) = the foreign currency interest rate

T= time of contract in days

The British domestic interest rates are 0.5 % (Bankofengland-ar.com, 2018)

The euro interest rates are 0.00 % (Bank, 2018)

The spot value of the order is;

1.2028 X 500000 = 601400 euros

The amount the exporter will receive if they get payment the date the deal is made

The formula for the exchange rate is given:

One month Forward rate= S x (1 + r (d) x (t/360))/ (1+ r (f) x (t/360))

=1.2028 x (1+ 0.25) x (30/360))/ (1+0.5) x (30/360))

= 1.2028 x 0.8333328

=1.00233269

The exporter arranges to deliver PS500,000 to their financial provider in a month's time and receive

PS500,000 x 1.2022

= 601100 euros

This cash flow is certain no matter fluctuations in the exchange rates within the one month period.

References

Adler, M. and Dumas, B., 1984. Exposure to currency risk: definition and measurement. Financial management, pp.41-50.

Brown, G.W., 2001. Managing foreign exchange risk with derivatives. Journal of Financial Economics, 60(2), pp.401-448.

Campbell, J.Y., SerfatyDe Medeiros, K. and Viceira, L.M., 2010. Global currency hedging. The Journal of Finance, 65(1), pp.87-121.

Clark, P.B., 1973. Uncertainty, exchange risk, and the level of international trade. Economic Inquiry, 11(3), pp.302-313.

Eun, C.S. and Resnick, B.G., 1988. Exchange rate uncertainty, forward contracts, and international portfolio selection. The Journal of Finance, 43(1), pp.197-215.

Hansen, L.P. and Hodrick, R.J., 1980. Forward exchange rates as optimal predictors of future spot rates: An econometric analysis. Journal of political economy, 88(5), pp.829-853.

Hodrick, R.J., and Srivastava, S., 1984. An investigation of risk and return in forwarding foreign exchange. Journal of International Money and Finance, 3(1), pp.5-29.

Stulz, R.M., 1984. Optimal hedging policies. Journal of Financial and Quantitative analysis, 19(2), pp.127-140.

Taylor, S.J., 1992. Rewards available to currency futures speculators: compensation for risk or evidence of inefficient pricing?. Economic Record, 68(S1), pp.105-116.

Cornell, B. (1977). Spot rates, forward rates, and exchange market efficiency. Journal of Financial Economics, 5(1), 55-65.

Solnik, B. H. (1995). Why not diversify internationally rather than domestically?. Financial analysts journal, 51(1), 89-94.