Example research essay topic: Managing Foreign Currency Risk In Business - 1,682 words

NOTE: Free essay sample provided on this page should be used for references or sample purposes only. The sample essay is available to anyone, so any direct quoting without mentioning the source will be considered plagiarism by schools, colleges and universities that use plagiarism detection software. To get a completely brand-new, plagiarism-free essay, please use our essay writing service.
One click instant price quote

... of inter subsidiary accounts receivable Invoice exports in local currency and imports in foreign currency It should be kept in mind though, that if a devaluation of the dollar is unlikely, such hedging methods are inefficient and costly, but if a devaluation is expected then the cost of using those techniques the cost of hedging rises to reflect the anticipated devaluation. Alternatives, such as pricing decisions, currency collars, risk sharing, or options, are not useful since Universal Circuits revenues are in dollars anyway. Exposure netting, however, is a very efficient hedging tool, and Universal Circuit could offset its position in Ireland against that of Japan, for instance, but this would have to be done by the corporate controller rather than the Irish. If PPP holds, the dollar is bound to depreciate against the punt.

Then buying the punt forward is a feasible solution to protect the companys profits. In the case of the dollar remaining stable or appreciating further, the company will not be able to realise any upside potential, but a hedge is better than no hedge. Longer-term, the controller should also adjust his funds flows, but since the short-term outcome of the dollar weakening is obviously unclear, it makes sense to begin with a forward rather than going to great lengths to change funds flows. 4. General foreign exchange policy Currently, Universal Circuits (UC) has 40 % of its sales made outside the US which means that 2 / 5 of its profits are exposed to currency fluctuations and hence to currency risk.

In order to protect its profits in US$ terms, the company has to implement a strict foreign exchange policy. In order to determine what is the optimal general strategy, we shall look individually at the foreign production facilities (FPF) and at the foreign sales Affiliates (FSA). As discussed above, the FPF consist mainly of the Irish plant, but production is also conducted in the UK, the Philippines and Japan. The main exposures for a FPF will therefore be economic and transaction, assuming that the US$ is the functional currency in all FPF. Transaction exposure arises whenever a company is committed to foreign currency denominated transactions, which is the case of every FPF when ordering for raw materials. Thus some sort of protective measures need to be taken against the risk of the local currency depreciating.

Such measures involve entering into foreign currency transactions whose cash flows exactly offset the cash flows of the transaction exposure. They could include using currency options, borrowing or lending in the foreign currency, forward contracts and price adjustment clauses. But it should be kept in mind that taking such precautionary measures while eliminating transaction exposure will not eliminate all foreign currency risk; currency risk on the present value of the Fpf's future cash flows (economic exposure) will still be present. It is altogether much harder to hedge against economic exposure, thus the firm must adjust its long-term strategy in order to profit or limit losses arising from long lasting currency over or under-valuation. Such strategic changes need to stem from the marketing and the production function of the company. In terms of marketing initiatives this implies changes in marketing selection, product strategy, pricing strategy and promotional strategy.

For the changes in the production initiatives, it will involve product sourcing, input mix, plant location and raising productivity. For example, as UC has FPF in numerous countries, the firm can allocate production among its different plants in line with the changing US$ cost of production. Thus effectively increasing production in a nation whose currency has devalued and decreasing production in a country where there has been a revaluation. With regards to the FSA the question is what exposures are present and what type of currency policy should be implemented to protect their US$ value. In terms of exposure, the FSA are mainly concerned with transaction exposure.

Thus in order to protect the US$ value of their sales, forward or money market hedges should be used. If exchange risk is the element of cash flow variability attributable to unexpected currency fluctuation (Shapiro, 1999), then the main foreign exchange risk policy of UC should be to arrange its financial affairs so that in whatever direction the exchange rates might move in the future, the US$ outcome will remain marginally unaffected. This can be brought into place in three ways: 1. Placing appropriate hedges on all sales whose payment is to be made in more than 10 days and whose value exceeds US$ 150, 000. 2. Placing appropriate hedges to limit translation exposure where present. 3. Allowing FPF to have sufficient flexibility in order to quickly adjust and capitalise on currency appreciations and depreciation's.

But the problem UC faces is who should be held responsible for the hedging strategies and decisions; should the process be centralised or decentralised? The main problem associated with decentralisation is that foreign subsidiaries might undertake hedging actions, either through lack of knowledge or lack of incentives, which increase rather than decrease the overall corporate exposure in a currency. But on the other hand, local managers can take advantage of certain situations that only they may be familiar with in a decentralised firm. There is thus no clear answer to which approach gives better results.

But perhaps UC could go the middle way: allowing local managers to hedge their own exposure by engaging in forward contract with the prior notification and agreement of the central treasury. 5. Universal Circuits foreign exchange strategy today Changes since 1985 There are three main changes since 1985 affecting Universal Circuits: 1. Introduction of the Euro 2. Innovation in financial products use of swaps, options, futures 3. Increased foreign investment in Ireland (American new economy) Looking at the exchange rate movements, one can see that the dollar has actually depreciated and that PPP did hold in 1991 and 1993. Universal Circuits exchange risk in 2001 Following the introduction of the Euro, Universal Circuits is facing slightly less translation exposure, since it can be assumed that fluctuations are flattened due to the size of the Euro zone and due to the diversity of currencies, which have joined the Euro.

However, translation exposure is still present: what was Irish Punt / dollar is now simply Euro / dollar and if the Euro strengthens costs will increase in dollar terms. Within Europe, Universal Circuits is no longer facing transaction exposure relating to costs (if inputs are purchased within Europe), and supposing customers are still invoiced in dollars no transaction exposure regarding revenues. Cash flows however are still exposed to economic exposure and especially in Ireland strong economic growth due to tax incentives is a trigger for inflation. When the euro was launched in January 1999, Ireland had a growth rate of 8 % for the sixth year in a row. Attracting massive mainly American foreign investment in software and other new products, the prices of its traded goods and services were going to rise faster than those of its mature competitors in the rest of the euro zone (Minford, Daily Telegraph, 21 August, 2000). Therefore, European interest rates are too low to limit inflation.

As to the current Euro / dollar exchange rate, the economic outlook suggests that the Euro should appreciate against the dollar. In other words, Universal Circuits is now likely to face the same situation as in 1985 and might consider buying forward the Euro. Recommendations Because the Euro is expected to strengthen, Universal has to protect itself against a weakening dollar long-term more than short-term. Its exposure is less due to the Euro but it still has to be managed (translation for $, transaction for $, yen, etc. ). Across the organisation, it should be attempted to employ exposure netting. Universal Circuits might also include hedging tools such as futures, swaps or options in its transaction exposure management.

Controls and limitations should be put in place and clearly communicated, though. Overall, since customers pay in $ and if the dollar weakens, Universal Circuits will become more competitive inside Europe. Economic exposure can only be managed through long-term strategic initiatives, such as marketing or production. In terms of market selection, it is advisable to stay in Europe and maintain flexible production facilities to diversify risk: whenever the dollar is weak, primary inputs should be purchased in US, and abroad when the dollar is strong. Efficient production and product innovation with the view to shorten life cycles also helps to protect profit margins and minimise substitution possibilities for customers (hence distracting them from contemplations about transaction costs and dollar payments). Alternatively or additionally, Universal Circuits might decide to build its product range around standardised inputs: standardised procurement facilitates supplier shifting and bulk buying (too little orders too frequently are costly).

More importantly, in order for foreign currency exposure to be managed in the most efficient way, it has to be done so across the organisation and in line with the companys strategy. The corporate controller at Universal Circuit should work closely with the Irish operations: while local initiative should be encouraged, clear strategies regarding the management of foreign currency exposure have to be communicated. The organisation chart suggests that the corporate controllers link to the Irish subsidiary is not sufficiently close. Senior management and top marketing and production managers should all be aware of the risks, which currency fluctuations entail when making decisions.

It is the role of the CFO to: Provide management with economic forecasts Identify risks of competitive exposure Structure evaluation criteria to avoid managers being penalised or rewarded Finally, the financial centre of the organisation should always be informed about the economic outlook and political risks where its operations abroad are. Bibliography Alan Shapiro, 1999, Multinational Financial Management, John Wiley Patrick Minford, 21 / 8 / 2000, Irelands race against inflation cant be won with the Euro, URL: euro-know. org / telegraph URL: oz forex. com Michael Park and Patricia Pollard, 1996, For here or to go?

Purchasing Power Parity and the Big Mac, Review, Federal Reserve Bank of St. Louis, see URL: stl's. frb. org / docs /publications / review / 96 / 01

Research essay sample on Managing Foreign Currency Risk In Business