Question

Intrepid Plc are proposing to expand their operations to the USA and you as corporate treasurer have been asked to recommend to the board of directors how you might manage the translation risk in the balance sheet and also how Intrepid Plc can utilise currency swaps as a mean of long term hedging.

Question:

Advise the board on the operation of a sterling/US dollar swap and discuss any potential problems or drawbacks in utilising currency swaps.

Answer 1

Businesses that operate domestically or internationally must deal with numerous risks when they are trading in currencies other than their domestic currency.

Companies typically generate capital either by issuing equity or by borrowing debt and then use this to further invest in assets and try to generate a return on the investment. The investment might be in assets in other countries and financed in foreign currencies, or the company's products might be sold to customers in other countries who pay in their local currencies.

TRANSLATION RISKS

A company that has operations in other countries will need to translate the foreign currency values of each of these assets and liabilities into its domestic currency.

Further, it will have to consolidate them with its domestic currency assets and liabilities before it can publish its consolidated financial accounts i.e. profit and loss account and balance sheet.

The process of translation can result in unfavorable equivalent domestic currency values of assets and liabilities.

POTENTIAL DRAWBACK IN UTILISING CURRENCY SWAPS

Currency risks can have numerous effects on a company, whether it operates internationally or domestically.

Tanslation risk has no cash flow effect, although it could be transformed into transaction risk or economic risk if the company were to realize the value of its foreign currency assets or liabilities.

Risk can be a little tricky to understand, but by breaking it up into categories, it would beeasier to see how that risk affects a company's balance sheet