Intragroup currency netting
Conversion of indebtedness to netting currency (GH¢):

Transfer plan:
Gil (Nigeria) receives GH¢2.091 million from Edi (Ghana) and GH¢7.5675 million from Zep (South Africa)

Advantages of hedging currency risk with options rather than futures

• The main advantage of hedging with currency options over currency futures is that options present relatively lower risk. This is because with options hedge comes with the flexibility of enjoying gains in the upside whilst avoiding losses in the downside. In the case of futures, however, trading is obligatory even in the downside.
• Besides, several strike prices are available to choose from. This thus present an opportunity to use varied strategies in hedging the currency option.                           (2 points for 2 marks)

Disadvantages of hedging currency risk with options rather than futures

• The main disadvantage of hedging with an option the requirement to pay a nonrefundable premium upfront. In the case of futures, the margin deposit is refundable once losses are covered.
• Another disadvantage of options is that premiums vary as volatility changes. Futures, however, comes with fixed upfront margin requirements which have be same for many years.                     (2 points for 2 marks)
  

Convert all the cash flows into Ghana Cedis (GH¢)

So overall, Nsawam Limited needs to pay amounts equivalent to GH¢11m to Paakro, Receive GH¢4.5m from Mangoase and pay GH¢5m to Asaman Limited.

OR

So overall, Nsawam Limited needs to pay amounts equivalent to GH¢11m to Paakro, Receive GH¢4.5m from Mangoase and pay GH¢5m to Asaman Limited.

• The usage of a forward exchange contract: This is a contract, usually between a bank and its customers, for the purchase/sale of a specified amount of a stated foreign currency at an exchange rate fixed at the time the contract is made for performance at a future date agreed upon at the time of the contract.
• To borrow foreign currency: A Ghanaian company that has recognized the need to pay a certain amount of US dollars in two months’ time, can borrow that amount of US dollars now, thereby avoiding and reducing translation/conversion risks.
• To insert protection clauses: The exporter can incorporate a clause in the contract of sale, to adjust the selling price, if the exchange rate moves outside an agreed range. Also additional charges may be made as a result of conversion or translation changes which may be agreed to be borne by the importer.
• Export factoring: where the exporter raises foreign finance through the usage of an international factor.
• To operate a domiciliary account: The company in this case maintains an account in a Ghanaian bank, but denominated in the desired foreign currency. Proceeds of export sales can then be used through this account to settle future commitments.
• To match currencies: The idea here is to match receipts and payments in the foreign currency. In this case related amounts are offset in foreign currency if they fall due to within the same time period.
• Incorporating a clause in the export contract which will specifically allow or disallow fluctuations in exchange rates: This is slightly different from protection clauses, since the adjustment is done on the exchange rate for payment especially in local currency.
• Discounting export bills or invoices with foreign finance houses.
• Negotiating of bills of exchange payable or discountable abroad.                      (Any 3 points)
  

𝐿𝑜𝑎𝑛 𝑎𝑚𝑜𝑢𝑛𝑡 𝑟𝑒𝑞𝑢𝑖𝑟𝑒𝑑 = 10,000,000−144,230.77 = 9,855,769.23

• The usage of a forward exchange contract. This is a contract, usually between a bank and its customer, for the purchase/sale of a specified amount of a stated foreign currency at an exchange rate fixed at the time the contract is made for performance at a future date agreed upon at the time of the contract.
• To borrow foreign currency. A Ghanaian company that has recognized the need to pay a certain amount in US dollars in two months’ time, can borrow that amount of US dollars now, thereby avoiding and reducing translation/conversion risks.
• To insert protection clauses. The exporter can incorporate a clause in the contract of sale, to adjust the selling price, if the exchange rate moves outside an agreed range. Also additional charges may be made as a result of conversion or translation changes which may be agreed to be borne by the importer.
• Export factoring. Where the exporter raises foreign finance through the usage of an international factor.
• To operate a domiciliary account. The company in this case maintains an account in a Ghanaian bank, but denominated in the desired foreign currency. Proceeds of export sales can then be used through this account to settle future commitments.
• Matching and Netting currencies. The idea here is to match receipts and payments in the foreign currency. In this case related amounts are offset in foreign currency if they fall due within the same time period.
• Incorporating a clause in the export contract which will specifically allow or disallow fluctuations in exchange rates. This is slightly different from protection clauses, since the adjustment is done on the exchange rate for payment especially in local currency.
• Foreign Currency Options.
• Foreign Currency Swaps.
• Foreign Currency Futures
• Discounting export bills or invoices with foreign finance houses.
• Negotiation of bills of exchange payable or discountable abroad.                                 (Any 5 points)
  

YSL can hedge using futures as follows.
• Use September futures, since these expire soon after 1 September, price of 1/0.007985 = 125.23 ¥/$.
• Buy futures, since it wishes to acquire yen to pay the supplier, and the futures are in Yen.
• Number of contracts 140m/12.5m = 11.2 contracts   (11 contracts)
• Tick size:  0.000001 x 12.5m = $12.50

Basis risk arises from the fact the price of a futures contract may not move as expected in relation to the value of the instrument being hedged. Basis changes do occur and thus represent potential profits/losses to investors. Typically, this risk is much smaller than the risk of remaining unhedged.

Basis risk is the difference between the spot and futures prices.
Spot price = 1/128.15
.                  = 0.007803
Basis = 0.007803 – 0.007985 = 182 ticks with 3 months to expiry
Basis with one month to expiry, assuming uniform reduction = 1/3 X 182 = 61 ticks
Spot price on 1 Sept = 1/120 = 0.008333
Therefore predicted futures price = 0.008333+0.000061= 0.008394

Outcome:
Futures market
Opening futures price      0.007985
Closing futures price       0.008394
Movement in ticks           409 ticks
Page 22 of 23
Futures market profit 409 x 11 x $12.50 = $56,238

Net outcome
.                                                                               $
Spot market payment (¥140m. 120)             1,166,667
Futures market profit                                       56,238
.                                                                           1,110,429
Hedge efficiency
56,238/74,197  = 76%

This hedge is not perfect because there is not an exact match between the exposure and the number of contracts, and because the spot price has moved more than the futures price due to the reduction in basis. The actual outcome is likely to differ since basis risk does not decline uniformly in the real world.

Foreign Exchange risk is the probability that a company will be unable to adjust its prices and cost to offset changes in exchange rates. It also means the risk that the domestic currency value of cash flows denominated in foreign currency may vary due to changes in the foreign exchange rate.

Ways of heading against Foreign Exchange Risk
1. Forward Contract
This involves a contract, which is tailor-made (taken out for the exact amount of currency required. The future exchange rate is fixed at the time the contract is entered in to with the bank. The cost is then determined by the forward rate quoted by the bank.
2. Future Contract
This offers the opportunity to buy/sell currency in standard amount of a limited number of currencies at a specified time and rate.
3. Lead/Lag Payment
In the case of paying for goods in a foreign currency, it is possible to pay for the goods in advance and thereby fix the exchange rate at the spot rate.
4. Currency Options
Here, the firm has the possibility of buying (call) or selling (put) currency at an agreed rate usually at any time within a specified period.

Since the Ghanaian Company has an asset of USD$75,000 and a liability of USD$264,000, maturing at the same time (3 months) they can be used to offset each other to leave a net liability of USD189,000.

Forward Market Hedge
Offset $254,000 – $75,000 = USD$189,000
Buy USD$189,000 3 months forward
Cost = $189,000 ÷ 0.9545 = GH¢198,009 payable in 3 months

* Since the company has a US$ liability it needs to create a matching US$ assets
* Place US Dollar on deposit for 3 months at an interest rate of 2.7%
* Accumulate capital at the end of 3 months to the US$189,000 required
* Pay off the net liability as follows

Deposit US$ (1 + 0.025) = USA$189,000 required in 3 months
Amount to deposit now:
US$189,000 ÷ 1.025 = 184,390

The Ghanaian company will have to buy these US$184,390 on the spot market.
Cost = US$184,390 ÷ 0.9850 = GH¢187,198 payable now

.                                                      Now                           3 months Time
Forward Market                                                                 (GH¢198,009)
Money Market:                        (GH187,198)

Compound cost of the Money Market Hedge = 187,198 (1+0.0325)
.                                                                              = GH¢193,282
As this is lesser amount than the Forward Market Hedge, it can be concluded that the money market hedge is the least cost method of hedging the company’s net liability.

Advantages:

• Leveraging on relative borrowing advantage: Swaps allow companies to mutually benefit from their relative borrowing advantage by each borrowing in markets they can get the best deal and then swapping for the loan type they actually prefer.
• Flexibility and convenience: Swaps are more flexible than other derivatives, particularly futures and options, as they can be arranged in any size, and can be reversed if necessary.
• Lower transaction cost: Cost of arranging a swap is relatively lower, particularly when no intermediary is involved. Besides, it is cheaper to arrange a swap to manage interest rate swap than having to cancel existing loan contract and arranging a new one.
• Suitability for long-term exposures: Unlike other derivatives such as futures and options, swaps a typically designed for managing long-term exposures. Most of the interest rate risks that firms face are long-term in nature and swaps are well-suited for managing exposures of such maturity.

Disadvantages:

• Counterparty risk: Effectiveness of hedging interest rate risk with interest rate swap is limited by the risk that one party will default leaving the other to bear its obligations. This problem can be solved by using an intermediary to enforce compliance with the swap terms. However, this will imply higher transaction cost.
• Inability to take advantage of upside risk: Under interest rate swaps, parties have the obligation and not the right to swap. This means that a party that takes up a fixed rate commitment, will not be able to take advantage of favourable movement in interest rates. This problem can be solved using a swaption instead.
• Lack of liquidity: Swaps are typically not traded in open secondary markets, and that reduces ability and convenience of liquidating a swap contract when the need arises.
  

The recommended hedging strategy is the one that presents the lowest net borrowing cost.

Restructure the existing loan
Under this option, the existing fixed rate dollar loan is structured into a floating rate dollar loan at LIBOR + 200 basis point
Borrowing cost = LIBOR + 2%

Hedging alternative 1: Engage in interest rate swap with a swap bank
Under this arrangement, JB will get the opportunity to pay floating rate (what it prefers) at LIBOR + 100 basis points to UT bank (the swap bank) in exchange for a fixed rate payment (what it does not prefer) at the bid fixed rate, 3-year TN rate + 35 basis points. The fixed rate payments from the swap bank will be at the bid rate as in this case the swap bank will be buying a fixed rate from JB.
JB will still honour its fixed rate obligations to the loan syndicate. With the fixed rate payments received from the swap bank however, much of this fixed rate obligation is effectively shifted to the swap bank.

Note: Though the diagram above aids analysis of interest payments amongst the parties involved, it is not a requirement to answering the question. Full credit should be given to a narrative that explains interest flows even without a diagram.

That is if JB hedges the interest rate risk with an interest rate swap with UT bank, its net borrowing cost would be LIBOR + 125 basis points.

Hedging alternative 2: Engage in interest rate swap with another company
Under this arrangement, the entities will swap currency coupons for the type they prefer. That is, JB would pay to McEwen the floating rate coupons it prefers and then receive fixed rate coupons from McEwen. Thus, either entity ends up paying the interest rate type they prefer.

Comment on swap arrangement:
JB would maintain its fixed rate debt, which is at 6.5%; and McEwen keeps its floating rate debt, which is at LIBOR + 1.5%. And under the swap arrangement, JB pays floating rate (LIBOR + 1.5%) to McEwen in exchange for a fixed rate (7%). JB then pays 6.5% out of the fixed interest payment from McEwen to its creditors, and saves 0.5% on the fixed rate side. On the floating rate side, JB pays LIBOR + 1.5% to McEwen instead of LIBOR + 2% to creditors if the loan is restructured, and thus saves another 0.5%.
JB effectively ends up paying a floating rate; gains 1%, which reduces its borrowing cost to LIBOR + 1%

Working:
Take the floating rate that is swapped to be what McEwen could pay under swap (i.e. LIBOR + 1.5%).
Given that the swap gains are shared equally, the fixed rate that would be swapped is calculated as under:

Summary:
Option                                                                                                Net borrowing cost
Restructure existing loan                                                                          LIBOR + 2%
Interest rate swap with a bank                                                                LIBOR + 1.25%
Interest rate swap with another multinational company                    LIBOR + 1%

Recommended hedging strategy
Hedging with interest rate swap with McEwen Ltd is recommended as it present the lowest net borrowing cost.
JB maintains its fixed rate debt contract with loan syndicate, and engages in a fixed-for-floating interest rate swap with McEwen. Under the swap arrangement, JB pays floating rate coupons at LIBOR + 1.5% to McEwen in exchange for fixed rate coupons at 7%.
JB then pays 6.5% out of the fixed rate coupons it receives from McEwen to the loan syndicate. Thus, JB effectively shifts the risk associated with the fixed interest rate obligation to the counterparty, McEwen.