• Matching: The matching technique is a strategy of working capital financing wherein we finance short term requirements with short-term debts and long-term requirements with long-term debts. The underlying principle is that each asset should be financed with a financial instrument having almost the same maturity. This can help manage transaction and translation risk.
• Netting: Netting is a method of reducing risks in financial contracts by combining or aggregating multiple financial obligations to arrive at a net obligation amount. Netting is used to reduce settlement, credit, and other financial risks between two or more parties.
• Leading and lagging: leading and lagging refer to the expediting or delaying, respectively, of settlement of payments or receipts in a foreign exchange transaction because of an expected change in exchange rates.
• Invoicing in local currency: This technique can give you the advantage in sales price negotiations and the opportunity to increase your margins, because all the foreign exchange risk has been absorbed and is no longer your customer’s concern.

(4 points well explained @ 1.5 marks = 6 marks)

Intrinsic value in an option is explained as the positive value or gain if an option is exercised today. Technically, the option will be so considered to be in the money. An option has an intrinsic value when it is in-the-money.

DUU ltd was in the money for 1 to month 3, at the money in month 4 and out of the money in month 5 and 6.

A foreign currency swap is an agreement to exchange principal and interest payment in one currency for equivalent principal and interest payment in another currency. It is used usually to raise liquidity in one currency by utilizing the surplus liquidity in another currency without converting the currency to create exchange rate risk. It can also be done for trading purposes. Each party is borrowing and paying interest on the currency is short in liquidity by utilizing the liquidity surplus in has in the other currency.                                                                                                                                                  (2 marks)

An interest rate swap is an agreement between two parties to exchange interest payments on an agreed Notional amount in the same currency for a specific maturity. It could be from floating to fix or from fix to floating. One party pays floating and receives or the vice versa The floating rate is referenced to a market benchmark like LIBOR and changes from time to time based on the changes in the benchmark.                                                                                                (2 marks)

Difference (LOSS): 48,400,000 – 45,000,000 = 3,400,000
*By exercising the total cost is GHS 48,400,000 (inclusive of premium paid)
*By Not exercising and buying from the spot market the total cost is GHS 45,000,000
*The LOSS will be 3,400,000 for exercising option A.
Decision:
Universal Plastics should not exercise the option but buy from the spot market. That will be cheaper not withstanding option premium already paid.

Alternatively:
The option is out of the money since the spot rate was lower than the option rate and should not be exercised. The maximum loss is the option premium of 1,400,000 cedis.

Profit/Gain for exercising = Rate Differentials less premium paid in buying protection
.                                          = 51,600,000 – 48,400,000 -1,200,000
.                                          = 2,000,000
OR 50,400,000 – 47,200,000  – 1,200,000
.                  = 2,000,000
OR (6.3 -5.9) X EUR 8m = 3,200,000 – 1,200,000
.                                         = 2,000,000
Decision:
Universal Plastics should exercise option B as it will Profit or gain = GHS 2,000,000

Transaction exposure – This arises from the effect that exchange rate fluctuations have on a company’s obligations to make or receive payments denominated in foreign currency. This type of exposure is short-term to medium-term in nature. Transaction exposure is driven by transactions which have already been contracted for and hence they are of short term nature. For example: if Company A, based in the US has already supplied goods worth $100 Mio to another Company B in the UK and has agreed to receive the payment in GBP, it has already undertaken transaction risk on cash flows.

Economic (or operating) exposure – This is lesser-known than the previous two, but is a significant risk nevertheless. It is caused by the effect of unexpected currency fluctuations on a company’s future cash flows and market value, and is long-term in nature. The impact can be substantial, as unanticipated exchange rate changes can greatly affect a company’s competitive position, even if it does not operate or sell overseas. For example, a Ghanaian furniture manufacturer who only sells locally still has to contend with imports from Asia and Europe, which may get cheaper and thus more competitive if the dollar strengthens markedly.

The most common methods for hedging transaction exposures are −

• Forward Contracts − If a firm has to pay (receive) some fixed amount of foreign currency in the future (a date), it can obtain a contract now that denotes a price by which it can buy (sell) the foreign currency in the future (the date). This removes the uncertainty of future home currency value of the liability (asset) into a certain value.
• Futures Contracts − These are similar to forward contracts in function. Futures contracts are usually exchange traded and they have standardized and limited contract sizes, maturity dates, initial collateral, and several other features. In general, it is not possible to exactly offset the position to fully eliminate the exposure.
• Money Market Hedge − Also called as synthetic forward contract, this method uses the fact that the forward price must be equal to the current spot exchange rate multiplied by the ratio of the given currencies’ riskless returns. It is also a form of financing the foreign currency transaction. It converts the obligation to a domestic-currency payable and removes all exchange risks.
• Options − A foreign currency option is a contract that has an upfront fee, and offers the owner the right, but not an obligation, to trade currencies in a specified quantity, price, and time period.
• Risk Shifting − The most obvious way is to not have any exposure. By invoicing all parts of the transactions in the home currency, the firm can avoid transaction exposure completely. However, it is not possible in all cases.
• Currency risk sharing − The two parties can share the transaction risk. As the short-term transaction exposure is nearly a zero sum game, one party loses and the other party gains.
• Leading and Lagging − It involves playing with the time of the foreign currency cash flows. When the foreign currency (in which the nominal contract is denominated) is appreciating, pay off the liabilities early and collect the receivables later. The first is known as leading and the latter is called lagging.
• Reinvoicing Centers − A reinvoicing center is a third-party corporate subsidiary that uses to manage one location for all transaction exposure from intra-company trade. In a reinvoicing center, the transactions are carried out in the domestic currency, and hence, the reinvoicing center suffers from all the transaction exposure.
• Netting

The original expectation would have been that the amount to payback would be $280,000 x GH¢4.2 = GH¢1,176,000. However, during the time that it was exposed to the currency risk, the exchange rate has moved in an adverse direction, and the actual payments are $280,000 x GH¢4.6 = GH¢1,288,000. The ‘FX loss’ has been GH¢112,000.

Currency risk arises from exposure to the consequences of a rise or fall in an exchange rate. Here, the Ghanaian company was exposed to the risk of a fall in the value of the cedi.
Currency risk is a two-way risk, and exposure to risk can lead to either losses or gain from movements in an exchange rate. In this example, the exchange rate could have moved the other way. For example, if the exchange rate after three months had been $1= GH¢4.0, the Ghanaian company would have paid GH¢1,120,000 instead of GH¢1,288,000.

Transaction risk arises only when the settlement of the transaction (and receipt/payment) will occur at a future date. An exposure lasts for a period of time. Here, the exposure lasts from when the goods were sold on credit until the time that the customer eventually pays.

Trading profits for companies engaged in foreign trade can be significantly affected by currency movements. When exchange rates are volatile and unpredictable, the gain or loss on currency exchange could possibly be even bigger than the expected gross profit from the transaction.

Foreign exchange risk is the risk of changes in the foreign exchange rate or the value of a currency. The level of change or movement cannot be determined with certainty making any counterparty with exposure in that be exposed to the market volatility or uncertainty.

Transaction exposure refers to the gains or losses made on foreign exchange transactions due to the changes in the exchange rate between the transaction date and the payment or settlement date if the exposure or transaction is unhedged.

Translation risk refers to the movement in values either gains or losses of the balance sheet due to the consolidation of the assets and liabilities into a reporting currency from various currencies.

Economic exposure refers to the long term changes in the value of a foreign firm due to the unexpected changes in the exchange rate movements.

• Translation risk is best managed by using matching. For example, in purchasing an asset in a foreign country, a company should raise the funds for the purchase in the foreign currency so both the asset and liability are in the same currency. There are a number of ways to hedge transaction risk internally. Matching, for example, could mean paying for imports in the same currency that a company invoices its exports in.
• Alternatively, a company could invoice customers in the domestic currency and find a supplier which does the same. The problem with this method, though, is that the company may lose foreign sales and also restrict the potential suppliers it can purchase from.
• Companies can also manage transaction risk by leading and lagging payments according to their expectations of exchange rate movements.