Question

Suppose you are a Chief Financial Officer (CFO) of a UK based listed Part A - company. The company is currently trading at £10 per share and 10 million shares in issue. The total market value of the issued share capital of the company is £100 million. You have been requested to write a report to the board of directors with respect to raising an additional funding of £50 million to enable the next stage of development of international projects to be carried out. Note 2: For the report in Part A, it should critically review the advantages and disadvantages of the main funding options and have many appropriate academic references to strengthen your discussion. Further, your report should form the basis for a discussion at the next board meeting. In particular, you are required to include the different financing choices available through the equity and debt markets.

Part B - This additional funding will allow the business to become more global with the opportunity to develop a market in numerous countries with payment being made in the local currency. The directors are conservative in their attitude to risk. You have been requested to provide a report to the directors critically evaluating alternative derivatives including forwards, futures, options and swaps that are available in the market in order to minimize the risk with respect to payment in international currencies. : For the report in Part B. it should critically discuss and compare the use of derivatives including forwards, futures, options and swaps to hedge Foreign Exchange (FX) Risk. With reference to appropriate academic references, discussions must include: • how it works in mitigating FX risk. advantages and disadvantages of each type of derivative in managing FX risk.

Can you please assist in answering Part B in bold. thank you

Answer 1

Currency forwards

Forward are non-standardized contract entered by two parties with the intention of exchanging one currency for another at an agreed upon rate on a specified date in the future. The rate at which the contract is agreed upon is called strike price and the date at which the contract is exercised is called expiry date.

Benefit: The biggest advantage of forward is that it helps to eliminate future exchange rate risk by agreeing to a determined strike price. It helps to eliminate risk of loss due to currency fluctuations. This in turn leads to more accurate budgeting and calculation of returns from projects when expenses and income is in a foreign currency. Moreover, since forwards are non-standardized they allow for customization of terms of contract as per the requirements of the parties to the contract.

Drawbacks: The parties entering into a forward contract   are legally obliged to carry out their obligation at the maturity. Even when the exchange rate in the market moves against the holder’s interest, the firm is not allowed to escape from its contracted position to grab profit from such a profitable movement. The main limitation of forward contract involves its high degree of credit risk because there is no initial cost or deposit requirement when undertaking the contracts and the gains and losses between two parties are paid out at the time the contract expiry.

Currency Futures

Futures are standardized contract entered by two parties with the intention of exchanging one currency for another at an agreed upon rate on a specified date in the future and trade on standard exchanges. These contracts are designed to overcome the credit risk of forwards and seen as an upgraded form of forwards.

Benefit: The two first merits offered by forward contracts are available to futures as well. Apart from them, the standardized quantity and time to expiration features, combined with organized exchanges enables futures to increase the possibility of matching transactions and to speed up the process of trades. The requirement of margin money and daily cash adjustments to account balances, known as margin account, is aimed at ensuring that the default on delivery and payment will not take place.

Drawbacks: The main drawback of future contracts results from such standardized characteristics which cause traders a low likelihood of obtaining the perfect hedging. The public exchanges are the only decision-maker on what terms and conditions should be included which means that they are not customized to individual need. Also, substantial amount of deposit at the outset is required as margin and the additional cash which is demanded if margin account falls below the safety level.

Options

Currency option is the agreement that gives the holder the right but not the obligation to buy or sell currency at a specified price in the future. The holder has to pay premium to the seller of the option who is obliged to fulfill the contract if the option buyer decides to exercise it at expiry.

There are two types of options:

Call option gives the holder the right to buy a certain quantity of currency at the exercise price at a specified time.

Put option gives the holder the right to sell a certain quantity of currency at the exercise price at a specified time.

Benefit: The MAIN benefit of currency option trading is the fact that it offers the holder not only protection, when the market shows adverse exchange rate movement, but also the flexibility to benefit when the market shows favorable trend. Another advantage is if the company is expecting to engage in foreign currency denominated transactions but are uncertain about its implementation like for some unpredictable commercial reason the need for the exchange disappears, the holder has a legal right to let the option expire without trading.

Drawbacks: Similar to futures contract, the standardized features in option contract cause traders some difficulties in finding a perfect match in terms of duration and the size of company’s exposure. Also, options are complex financial derivatives and require deep analysis to identify proper strategies which can be complicated.

Swaps: It is an agreement between two parties to swap both the periodic interest payments and principal denominated in one currency into another currency at the agreed upon rate of exchange for the specific period of time. On the maturity date, each party is required to return the other the swapped principal sum. It is generally seen as a series of forward contracts and the value of such contracts are identifies through a process of replications.

Benefit: Swap allows both the participants a chance to get funds at lower rate compared with direct borrow from domestic bank because one borrower exchanges the comparative advantage possessed by him with the comparative advantage possessed by the other borrower. Swap can be employed to hedge long-term risk whereas the other types of derivatives are just applied in the short term.

Drawbacks: The main drawback relates to the high exposure of default risk and creditworthiness of the swap counter parties. If one party fails to meet the financial obligation upon the maturity date, the counter party will face trouble of confronting with default on principal payment together with interest. Also, compared to other derivative instruments, swap usually suffer from lack of liquidity.