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BFW2341 INTERNATIONAL FINANCIAL MANAGEMENT

SEMESTER 2 2017, ASSIGNMENT TASK 1
ASSESSMENT WEIGHTAGE: 30%
DUE DATE: FRIDAY 22rd SEPTEMBER 2017 by 12.00 noon
Part A: Managing Transaction Exposure (20%)
American Fast Track Inc. (AFT) operates high speed rail services in the U.S. AFT has placed an order
to purchase rail cars from the Xinjiang Locomotives of China in June 2017. AFT has ordered 20 units
of Multi-speed rail cars at the quoted price of USD2.5 million each, which totals to a payment of
USD50 million. All the 20 units of this rail cars will be delivered to AFT in December 2017. AFT has
agreed to pay 50% of its payable when the order is delivered and another 50% to be settled in June
2018. Xinjiang has invoiced this order in USD and will receive its receivables in USD. As the
receivable amount is substantially large in USD, Xinjiang will face the exchange rate risk if USD
continue to depreciate against the Chinese Yuan.
Background
Since the beginning of 2017, the U.S. dollar had been steadily depreciating against the Chinese Yuan
(CNY). In January 2017, the dollar was trading around CNY7.22573/$ and by June 2017, it softened
to 6.72475/$. This represented a 8% depreciation of the dollar against the CNY.
Although many analysts had concluded that the U.S. dollar was undervalued during this period, it
continued to show signs of weakening. Government interventions to strengthen the dollar was not
being discussed at this time.
Issue
While many forecasters were predicting an eventual appreciation of the U.S. dollar, for Xinjiang, the
size
of this contract which was denominated in U.S. dollars was seen as too large a transaction to be left
uncovered.
Therefore, you have been contacted by Xinjiang to analyze and recommend alternatives as to how this
locomotive company can hedge its U.S. dollar transaction exposure.
Data
Having collected the CNY/US$ exchange rates from various financial institutions that have a
dedicated
foreign exchange department, you are provided with the following quotes:
Spot Exchange rate 180-day Forward 360-day Forward
CNY 6.72475/$ CNY 6.62335/$ CNY 6.22755/$

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Not satisfied with the lack of risk management opportunities, you decided to contact a few banks to
obtain
the latest interest rates:
U.S. 180-day interest rates : 4.000 4.345% p.a.
U.S. One year interest rates : 4.255 4.500% p.a.
China 180-day interest rates : 2.323 2.452% p.a.
China One year interest
: 2.001 2.225% p.a.
rates

The risk management executives at the banks you contacted also provided you with another
alternative,
which is to manage the exposure via currency options contracts. The available derivatives are as
follows:
Option Contract On USD On CNY
Strike Premium Strike Premium
180-day Call Option CNY 6.500/$ CNY 0.03/$ CNY 6.700/$
180-day Put Option CNY 6.650/$ CNY 0.05/$ CNY 6.600/$
 360-day Call Option CNY 6.300/$ CNY 0.02/$ CNY 6.520/$
360-day Put Option CNY 6.250/$ CNY 0.04/$ CNY 6.500/$

(a) Based on the information provided, analyze all possible alternatives for managing the foreign
exchange risk exposure in the scenario above, and make a recommendation for the best alternative.
(15%)
(b) Justify your recommendation(s). (5%)
Part B (continuation of the above scenario, 10%)
On December 2017 and in June 2018, if the actual exchange rates between the U.S. Dollar and the
Chinese

Yuan is CNY6.8255/$ and CNY6.950/$ respectively:

1. How much unrealized gain / loss did Xinjiang face through your recommendation(s) from Part
A during both the settlement periods? (3%)

2. In not more than 1,500 words: (7%)

i. Explain how the unrealized gain / loss happen in each period of settlement.

ii. Explain whether managing foreign exchange risk is worth the amount of effort required.

iii. Explain whether a company like Xinjiang should just choose to remain unhedged.

Please note that this is an essay. Therefore, all essay requirements, as can be found in your Q-
manual applies. Students who do not abide by the guidelines will be penalized. Your marks
will depend upon accurate calculations of the hedge alternatives and logical decisions made as the
outcome of the analysis in part A. As for part B, marks will be awarded for clear explanation on
issues raised and logical explanation backed by appropriate choice of theories articulated based on
the units teaching.

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Introduction

Exchange rate risk management is an integral part in every firms decisions about foreign
currency exposure (Allayannis, Ihrig, and Weston, 2001). Currency risk hedging strategies
entail eliminating or reducing this risk, and require understanding of both the ways that the
exchange rate risk could affect the operations of economic agents and techniques to deal with
the consequent risk implications (Barton, Shenkir, and Walker, 2002). The issue of currency risk
management for non-financial firms is independent from their core
business and is usually dealt by their corporate treasuries. Most multinational firms have also
risk committees to oversee the treasurys strategy in managing the exchange rate (and interest
rate) risk (Lam, 2003).

A common definition of exchange rate risk relates to the effect of unexpected exchange rate changes
on the value of the firm (Madura, 2006). This essay will analyze the alternatives of how Xinjiang
Locomotive of China can hedge its U.S. dollar transaction exposure as the exchange rate risk of USD
continue to depreciate against Chinese Yuan, as Xinjiang is involved in receivable transaction
exposure.This is an important matter for Xinjiang to hedge its exchange risk as the transaction involved
a huge amount of money, USD50 million with American Fast Track Inc, (AFT) from United States.
The issue regarding this situation is although many forecasters were predicting an eventual appreciation
of the U.S. dollar, for Xinjiang,the seize of the contract which was denominated in U.S. dollar was seen
as too large a transaction to be left uncovered. Therefore, this essay will suggest the best alternatives on
how Xinjiang company can hedge its U.S. dollar transaction exposure.

Transaction exposure is a degree to which the value of future cash transactions can be affected by
exchange rate fluctuations (Madura, 2006). In this essay, there are four hedging alternative techniques
that will be discussed. These are to remain unhedged (remain exposed), hedging with currency forward
contracts, hedging with money market hedge (MMH) and hedging with options contract (Part A). It
also will discuss relating to the how much unrealized gain or loss did Xinjiang face through the
alternative that will be chosen as well as whether managing foreign exchange risk is worth the effort
required followed by a question whether a company like Xinjiang should just choose to remain
unhedged (Part B).

The first technique is by remain unhedged. Suppose that Xinjiang decides to accept the
transaction risk by not entering any hedging propositions.According to IRP if calculate the
future spot rate of receivable at 180-day and 360-day, the future spot rate would be
CNY6.66596/$ and CNY6.57885/$. Therefore the expected value of cash to be received by
Xinjiang is CNY 166,649,000 which is uncertain, receivable in December 2017 and
CNY164,471,250 receivable in June 2018. If we add the two periods of the receivable amount
above, the total expected value of cash to be received is CNY331,120,250 for Xinjiang as a
result of the foreign exchange transaction with American Fast Track Inc, (AFT) from United
States. However, if the future spot rate is CNY6.72475/$, Xinjiang will receive only
CNY168,118,750, which is CNY1,469,750 lower in December 2017 and CNY3,647,500 lower
receivable in June 2018.

Receivable Expected Future Expected Value from Remain

time Spot Rate Unhedged
December CNY6.66596/$ CNY166,649,000 ($25,000,000
2017 (uncertain) CNY6.66596/$)
June 2018 CNY6.57885/$ CNY164,471,250 ($25,000,000
(uncertain) CNY6.57885/$)
Total CNY331,120,250

The second technique is by using Forward Market Hedge. Forward contracts allow a
company to set the exchange rate at which it will buy or sell a given quantity of foreign currency
in the future (on either a fixed date or during a fixed period of time). They are flexible
instruments that can easily match future transaction exposures (generally up to one year).
Hedging in forward market here means selling $25,000,000 forward at the 6-month (180-day
Forward) rate of CNY6.62335/$. And selling the othe $25,000,000 forward at the 12-month
(360-day Forward) rate of CNY6.22755/$. In 6-month (December 2017), Xinjiang will receive
$25,000,000 and exchange them at a rate of CNY6.62335/$, receiving CNY165,583,750 with
certainty. In 12-month (June 2018), Xinjiang will receive $25,000,000 and will also exchange
them at a rate of CNY6.22755/$, receiving CNY 155,688,750. In December 2017, the amount
money received is CNY1,065,250 less than the uncertain CNY 166,649,000 expected from the
unhedged position.While for December 2018, the amount receive is CNY 8,782,500 less than
the uncertain CNY 164,471,250 expected from the unhedged position. The total amount
receivable in both settlement period of December 2017 and June 2018 is CNY 321,272,500
which is certain.

The forward contract creates a foreign exchange loss of CNY 2,535,000

{($25,000,000(6.72475-6.62335)}in December 2017 and CNY12,430,000
{($25,000,000(6.72475-6.22755)}.

Contract Rate Receive from Forward

Contract
180-day CNY6.62335/$ CNY165,583,750 ($25,000,0006.62335)
Forward (certain)
 360-day CNY6.22755/$ CNY155,688,750 ($25,000,0006.22755)
Forward (certain)
Total CNY321,272,500
(certain)

The third technique which can be use by Xinjiang is using Money Market Hedge. A
money market hedge on receivables involves borrowing the currency that will be received and
using the receivables to pay off the loan (Madura,2006). To hedge in the money market,
Xinjiang will borrow dollar in New York (country where the receivable originates). The first
step that Xinjiang can do is by calculating the amount to borrow. Xinjiang needs to discount
the present value of $25,000,000 at the U.S. borrowing rate. Thus Xinjiang must borrow
$24,468,423.4995 today and repay $25,000,000 in 180-day (6 months) with the proceeds from
sale. This hedge creates a dollar denominated liability that offsets with a dollar denominated
assets, thus creating a balance sheet hedge. In December 2017, the total assets is $25,000,000
while liabilities and equities which is include the bank loan (principal) with $24,468,423.4995
and interest payable $531,576.500527 ($24,468,423.49950.021725). In June 2018, the total
assets also $25,000,000, and from the liabilities and equity side the bank loan(principal)
contribute for $23,923,444.9761 and interest payable is $1,076,555.02392. Therefore, Xinjiang
should borrow $24,468,423.4995 today and and in 6 month time repay this amount plus
$531,576.500527 in interest ($25,000,000) from the proceeds of the sale directly from
American Fast Track Inc, (AFT). The next step is to convert the sum borrowed in New York
($24,468,423.4995) for 180-day and $23,923,444.9761 for 360-day at the spot rate of
CNY6.72475/$. And it will get CNY164,544,030.928 receivable in December 2017 and
CNY160,879,186.603 in June 2018. The next step is the sum borrowed and converted earlier
can now be invested in 6 months and 12 months at the China investing rate of 2.323% and
2.001%.The future value will then beCNY166,455,209.847 and CNY164,098,379.127. The
total expected value of cash to be received on both periods is CNY 330,553,588.974. These
amounts are guaranteed.

Amount U.S 180- $25,000,000/(1+0.04345:2) $24,468,423.4995

to borrow day
interest
rates
U.S. One $25,000,000/(1+0.045) $23,923,444.9761
year
 interest
rates
Convert 180-day $24,468,423.4995 CNY6.72475/$ CNY164,544,030.928
the sum
borrowed
360-day $23,923,444.9761 CNY6.72475/$ CNY160,879,186.603
Invest in 180-day CNY164,544,030.928(1+0.02323:2 CNY166,455,209.847
China (2.323-
interest 2.452%)
rates
360-day CNY160,879,186.603(1+0.02001) CNY164,098,379.127
(2.001-
2.225%)
Total CNY 330,553,588.974

The last technique is by using Options Market Hedge. Currency options are other tools
that can be used to mitigate transaction exposure. Standard options give a company the right,
but not the obligation, to buy or sell foreign exchange in the future at a pre-determined exchange
rate. Because these options do not oblige the company to sell or buy foreign currency (contrary
to forward contracts), they are often used by companies that bid on contracts. Currency options
allow companies to benefit from favourable movements in exchange rates, which is why most
types of currency options carry an upfront cost(EDC, 2010). In the case of Xinjiang, it could
cover $25,000,000 exposure by purchasing a put option on USD. The limits downside risk
while allowing for gains if the dollar appreciates. Xinjiang could purchase a 180-day Put Option
on USD with strike price of CNY6.650/$ sells at CNY0.05/$ premium. The cost (premium) of
this options would be CNY1,250,000 payable now, and need to borrow this money at the
borrowing rate of 2.452%p.a, the result will be CNY1,265,325(CNY1,250,000(1+2.452%:2).
If exercised, the $25,000,000 will be sold for CNY at the strike price agreed CNY6.650/$ equals
to CNY166,250,000. After paying the option premium the net proceed is
CNY164,984,675(CNY166,250,000- CNY1,265,325). The option will not be exercised if the
spot rate in 6 months is greater than CNY6.650/$. For 360-day Put Option, the strike price is
CNY6.250/$ and a premium of CNY0.04/$. The cost(premium) of this options would be
CNY1,000,000 ($25,000,0000.04) and need to borrow this money at the borrowing rate of
2.225% p.a, the amount would be CNY1,022,250 (CNY1,000,000(1+2.225%). If exercised,
the $25,000,000 will be sold for CNY at the strike price agreed CNY6.250/$ equals to
CNY156,250,000. After paying the option premium the net proceed is CNY155,227,750
(CNY156,250,000- CNY1,022,250). The total expected value of cash to be received from both
periods is CNY320,212,425. However, The option will not be exercised if the spot rate in 6
months is greater than CNY6.250/$. Below are the Summary of all hedging alternatives. The
money market hedge gives the highest value of cash amongst the other.

Hedging Techniques Term Receive

Remain unhedged 180-day CNY166,649,000(uncertain)
360-day CNY164,471,250 (uncertain)
Forward Market Hedge 180-day CNY165,583,750 (certain)
360-day CNY155,688,750(certain)
Money Market Hedge 180-day CNY166,455,209.847 (certain)
360-day CNY164,098,379.127 (certain)
Option Market Hedge 180-day CNY164,984,675
360-day CNY155,227,750

Firms recognize that hedging techniques such as the forward hedge and money market
hedge can backfire when a payables currency depreciates or a receivables currency appreciates
over the hedged period. In these situations, an unhedged strategy would likely outperform the
forward hedge or money market hedge. The ideal hedge would insulate the firm from adverse
exchange rate movements but allow the firm to benefit from favorable exchange rate
movements. Currency options exhibit these attributes. However, a firm must assess whether the
advantages of a currency option hedge are worth the price (premium) paid for it
(Marrison,2002). From the table above, the higher receivable conversion is the Money Market
Hedge which can provide CNY166,455,209.847 receivable in December 2017 and
CNY164,098,379.127 in June 2018, with the total expected value of cash to be received is CNY
330,553,588.974 . The total value from forward contract is CNY321,272,500 which is
CNY9,281,088.974 lower compared with the money market hedge. While for options market
hedge, the total expected value of cash is the lowest one with CNY320,212,425, the difference
is CNY10,341,163.9740 lower than money market hedge and CNY1,060,075 lower than the
forward market hedge. Therefore, if the company want a certainty and do not want to risk the
loss due to the movement of exchange rate, the money market hedge would be the best
alternative for Xinjiang to reduce and minimize the risk of exchange rate movement, which is
unpredictable in the future and can be move up or down. Moreover, the cost of money market
hedge can be determined with certainty, same as forward market hedge. If the MNC does not
need any short-term funds to support existing operations, it can still obtain a loan, convert the
funds to dollars, and invest the dollars in the money market (Madura, 2006). This situation
gives a picture for Xinjiang, which it will receive the money in two settlement dates, if the
company does not need to fund any of their short term liabilities, then the company can apply
for loan and use money market hedging technique to minimize the risk of the exchange rate
movement in the future. There are some disadvantages of hedging in money market, such as it
is more complicated to organize than using forward market hedge, and fixes the future rate that
gives no opportunity to benefit from favourable movements in exchange rate. However, it will
be compensated with the advantages by using this technique such as fixes the future rate ,thus
eliminating downside risk exposure, the second one is flexibility with regard to the amount to
be covered, and last but not least, money market hedges may be feasible as a way of hedging
for currencies where forward contracts are not available.

There is unrealized gain for both settlement periods. On December 2017 and in June 2018,
if the actual exchange rates between U.S Dollar and the Chinese Yuan is CNY6.8255/$ and
CNY6.950/$ respectively. Then, in December 2017 Xinjiang would have realized
CNY170,562,500($25,000,000 CNY6.8255/$ ) which is higher by CNY4,107,290.153
(CNY170,562,500- CNY166,455,209.847). This turns out to be unrealized gain by not hedging
in money market. And in June 2018, Xinjiang would have realized CNY
173,750,000($25,000,000CNY6.950/$),whichis higher by CNY 9,651,620.873(CNY
173,750,000- CNY 164,098,379.127). This turns out to be unrealized gain by not hedging in
money market. Based on the calculation, Xinjiang earns an unrealized gain if not hedging in
money market for both periods. Unrealized gain happen when a company earn a higher amount
of money by not hedging. In this case, if Xinjiang not hedging in money market, given the
current exchange rate on December 2017 with CNY6.8255/$, Xinjiang can exchange the dollar
amount with this exchange rate, which is result in a higher amount rather than hedging in money
market(CNY170,562,500 > CNY166,455,209.847). This also happen in June 2018, the
exchange rate between dollar and yuan is CNY6.950/$, which means that Xinjiang can
exchange the dollar amount they receive with this exchange rate. It will earn more than if it
hedge in the money market (CNY173,750,000 > CNY164,098,379.127).

For some companies, managing foreign exchange risk may seem too complex, costly or
time consuming. Others may not know about hedging instruments and techniques or believe
that hedging is a speculative activity. Yet companies that choose not to manage foreign
exchange risk may be assuming that exchange rates will remain at their present levels or move
in a direction that will be favourable to the company something that closely resembles
speculation .Numerous studies have found that managing this risk can successfully reduce the
companys foreign exchange exposure. Managing foreign exchange risk provides numerous
benefits to many companies such as minimize the effects of exchange rate movements on profits
margins, increase the predictability of future cash flows, eliminate the need to accurately
forecast the future direction of exchange rates, facilitate the pricing of products sold on export
markets, and protect, temporarily, a companys competitiveness if the value of the domestic
currency moves unfavourable, thereby buying time company to improve productivity (Export
Development Canada, 2010). Given the reasons above, for Xinjiang, managing foreign
exchange risk is worth the amount of effort required. If a risk can be reduced at a reasonable
cost, then it is generally accepted that steps should be taken by managers to protect their
companies. The decision to purchase foreign exchange hedging instruments is similar to the
one made when the company buys other forms of insurance. The insured risk, in this case, is
the reduction in cash flows and profit margins caused by unfavourable changes in an exchange
rate (Hakala,2002). Many firms do not hesitate to protect their accounts receivable from the
risk of non-payment and all firms obtain property and casualty insurance. They do so in order
to protect cash flow and ensure that the companys efforts and talent are focused on its core
business activities.

Many companies, particularly smaller and medium-sized ones, do not actively manage
foreign exchange risk, means that they remain unhedged. This is surprising given how costly,
in terms of cash flow and profitability. Unfavourable changes in the value of the Chinese Yuan
against U.S. dollar. Xinjiang is involved in the foreign transaction with a company from U.S.
valued USD 50 million in total, which is a huge amount of transaction. A receivable party,
which will receive the money in the U.S. dollar currency than it set on the agreement, the issue
faced by Xinjiang is that the USD continue to depreciating against Chinese dollar, means that
it will receive the smaller amount of money if the dollar keep depreciating at the settlement
dates, which is in December 2017 and June 2018. Such situation in exchange rates directly
impact the profit margins of Xinjiang Locomotive that export (and receive U.S. dollars). If
Xinjiang remain unhedged , then implicitly (or explicitly) Xinjiang are assuming the exchange
rate will remain stable or trend in a direction favourable to the company, if this is the case, then
Xinjiang can choose to remain unhedged. Unfortunately, this does not happen consistently over
time. No one can predict the movement of the exchange rate. Therefore, Xinjiang needs to take
into effort for managing foreign exchange risk. Managing foreign exchange risk does not mean
Xinjiang need to forecast the future direction of exchange rates. It still can protect the company
from foreign risk even if Xinjiang do not know exactly when it will get paid for the company
export sales. An effective foreign exchange risk policy does not necessarily eliminate all risk,
but focuses instead on protecting against those risks that are unacceptable to your
company.(Barton, 2002)
Conclusion

There is no single best approach to use when deciding how to hedge foreign exchange risk. For
example, some companies protect only confirmed sales while others protect forecasted sales. Factors
such as the companys risk tolerance, sensitivity of earnings to changes in exchange rates and the
predictability of future sales will influence this decision. The four hedging strategies is remain
unhedged, forward market hedge, money market hedge and option market hedge. A company like
Xinjiang that involved in a foreign exchange transaction with U.S. based company, will receive
USD50 million can hedging by using the money market hedge as from the calculation above it
contributes the largest amount of value of cash in the settlement date. Although the method is quite
complicated, it is worth to try as the dollar keep depreciating, which will give the company less
profit from the transaction. The idea of remain unhedged might be considered if Xinjiang is
assuming the exchange rate will remain stable or trend in a direction favourable to the company.
Unfortunately, the exchange rate keeps fluctuate in unpredictable trend. Therefore, it would be better
for Xinjiang to hedge by using one of the alternative techniques such as money market hedge.

(2958 words)
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