The Currency Exposure Faced by the British Venture Capitalist - Assignment Example

International Finance work 2 Question (a) The Currency Exposure Faced by the British Venture Capitalist The currency exposure is a corporation’s insecurity with respect to its future operating cash flows. It can be simply understood as the possible loss that results from a change in the exchange rates. It can also be technically defined as the possible direct loss or indirect loss in the corporation’s cash flows, assets and liabilities, net profit and, in turn, its stock market value following a move in exchange rate. For example, if money must be converted into a different currency to make a certain investment, changes in the value of the currency will affect the total loss or gain on the investment when the money is converted back. A firm therefore needs to keep the exchange rate risk at bay. Most firms do so by determining the specific type of exposure to risk, the hedging approach and they also find available instruments to deal with these currency risks. The international transactions the British Venture Capitalist is involved in, exposes them to exchange rate risk. They therefore have to plan in advance and take measures that will protect them against these risks to avoid incurring great losses. There are different types of risks or currency exposures the British Capitalist faces: Transaction risk or simply known as the cash flow risk deals with the effect of exchange rate changes position on transactional account exposure linked to receivable, or repatriation of dividends and payables. Any change in the currency exchange rate results in a transaction risk. Translation risk also known as balance sheet exchange rate risk shows the relationship of exchange rate change position to the valuation of a foreign subordinate firm and, in turn, to the consolidation of a foreign subordinate firm to the mother corporation’s balance sheet. It is measured by the introduction of net assets to potential exchange rate shifts when working with foreign subsidiary. Translation risks are treated in the following way when consolidation of the financial statements is being done. The translation is either carried out at close of the period exchange rate or at the ordinary exchange rate during the period depending on the company’s policy of the parent company. There is a difference however in translation when it comes to the income statements. In the income statement translations are done at the usual exchange rate during the time period. In the case of balance sheets, translations are done at the predominant present exchange rate at the time of consolidation. Economic risk is the risk which reflects the risk to the firm’s value of future operating cash flows from exchange rate movements. It is concerned with the effect of exchange rate changes on revenues and operating expenses. The revenues in this case include domestic sales and exports whereas operating expenses include the domestic inputs and imports. This type of risk is normally applied to the current worth of future cash flow operations of a firm. Question (b) How to Measure Economic/Operating Exposure After defining the types of economic/operating exposure that a firm is exposed to, a crucial aspect of a firm’s exchange rate risk management decisions is the measurement of economic/operating exposure. Measuring economic/operating exposure may seem to be challenging. Currently, the most commonly applied methodology is the value-at-risk (VaR) model. Generally, value at risk is defined as the highest loss for a given exposure over a given period of time with a certain percentage of confidence. The VaR method can be useful in computing a range of types of risk, helping corporations in their risk management. Nevertheless, the VaR does not suggest what happens to the exposure for the (100 – z) % point of confidence, i.e., the worst case scenario. The Value-at-Risk (VaR) calculation method of economic/operating exposure is applied by corporations to estimate the riskiness of a foreign exchange situation that culminates from a corporation’s undertakings, together with the foreign exchange situation of the treasury of its host country, over a substantial amount of period of time all other factors held constant(Holton, 2003). The VaR calculation is dependent on 3 constraints: The holding period: This is the total time period which the foreign exchange situation is scheduled to be held. 1 day is the normal holding period The confidence level: The level at which the approximation is scheduled to be made. The common confidence levels are 95% and 99%. The unit of currency that will be used for the value of the VaR. In a situation whereby the holding period is p days and the confidence level is x%, the VaR calculates the maximum loss, that is the reduction in the market worth of the position of foreign exchange over p days, if the p-days’ time period is not one of the (100-x)% p-days periods which are the worst days in normal situations. Therefore, if the position of the foreign exchange position has a 1-day VaR of $10 million at a confidence level of 99%, the corporation should presume that, with a likelihood of 99%, the worth of this position will reduce by less than $10 million in the 1 day period, given that normal conditions will be experienced over that time period which is 1 day. This is to mean that,, the corporation should estimate that the worth of its foreign exchange value position will fall by less than $10 million on 99 out of the possible 100 known foreign exchange trading days, or by a figure higher than $10 million on 1 out of every 100 normal foreign exchange trading days. Estimation of Exposure to the Exchange Risk in above case Probability = 0.70 A* = $1,000,000 B = $1.40 A = £714,300 Probability = 0.30 A* = $500,000 B = $1.60 A = £312,500 E(A) = (0.70) divided by (1.40) + (0.30) divided by (1.60) = £0.688/$ E(B) = (0.70) multiplied by (714,300) + (0.30) multiplied by(312,500) = £593,760/$ Variable (B) = 0.00167 Cov (A,B) = 7,535 Exposure to the Exchange Risk = Cov (A,B)/Var(B) = 7,535/0.00167 = $ 4,511,976 Question (c) Potential Strategies for Managing Economic/Operating Exposure Managing operating exposure In this capacity, we do have the issue of managing operating exposure. This deals with the aspect of strategizing and diversifying the operations and actions one has. The main aspect to the management of the operation exposure is basically to expect and impact the effect of what one does not expect in the alterations of the prevailing exchange rates on a company’s cash flows that will be expected in the future. We hence see that this kind of management can hence diversify the company’s sales, site of production facilities and the needed material requires for the production and inputs purpose. Matters dealing with finance are also diversified so as to aid in raising of more money needed in more than a single capital market and in various and numerous different currencies. By this, we hence see that this can hence alter the company’s and financial goals, obligations and policies. Strategic diversification of operations The issue of diversifying and having consistent strategic operations is also mandatory. We can hence observe a situation where there might be an alteration in the comparative expenses in the firm’s own equipment that can be situated in various countries. The top management can hence create shifts in terms of marginalizing them in acquiring the various and numerous materials, or to some extent the final output or what would rather be termed as commodities derived from the final part of the production process. If any additional spare space or capacity does come into existence, production strategies may even be thus be elongated in a chosen country so as to aid in reducing it in another country that the company does have its operations rooted. In some cases, there might exist an alteration in margins and volumes that are directly linked to the various margins and anticipated profits in one region as compared to another place. This will have a direct dependence on the current and prevailing prices and elasticities which do directly relate to incomes of demand. Nevertheless, issues that do deal with competition and the various reactions of competitors also do affect this overall process. We hence see that one can gear towards the promotion efforts and even affirming it in the markets which have a direct relation to the dealing of exports where the company’s products have hence become more competitive in terms of pricing and even the product quality owing to the fact that more attractive attributes have been added to it so as to make it appealing to the side of the final consumers in the global market. Diversification of finances The other aspect or issue regarding operating exposure management also comes to light in this regard. To be most specific, we are going to discuss on matters that do revolve the issue of finance diversification. In the mean time, we will see that it is evident that matters that do relate to differentials in the rates of interests. This cannot just be altered completely to the desired changes in the market rates of interests or which is sometimes simply referred to as interest rates. In this scenario, given the company has its own identity or did became established and is also vastly and widely respected and identified in the world, it hence can even alter the origin of its current and long term finances that it does have in its possession. By virtue of diversifying finances can hence assist in the reducing the issue of diversifying the numerous and various risks that do have a direct relation on the capital market policies or even to the competition that is in existence during the process of government borrowing in the same capital market of a country or even the world in general. This as we further see, does assist in diversifying the threats and risks that can be associated or do have a political origin. Such risks do include war, funds having to be blocked, laws that have become unfavorable with time and change of technology. This does slow the essence of competition as a factor that is present in the market. Changing of operating policies The issue of altering policies that do directly deal with the issue of operations also does come in this aspect. It does deal with aspects that do infuse leads and lags. It is hence evident that companies can hence make a reduction the levels of transactions and risks and threats that do relate with the matters rotating around the issue of operations. This hence accelerates or to some extent does decelerate the aspect of the timing o the payments that can be anticipated. In the mean time, this will also affect the exchange rates that are currently prevailing in the global market. Receivables are what companies do try to manipulate them either by virtue of either carrying out two operations that do include decelerating or even to some extent accelerating by just using the same reasons to justify their case that is in question or which is in the spotlight. We will hence realize that suppliers or also the potential customers may sometimes not need to cruise along this process. Hence, this may opt or need payments that are incentive oriented. Works Cited Allayannis, G., Ihrig, J., and Weston, J., , Exchange-Rate Hedging: Financial vs. Operational Strategies. American Economic Review Papers and Proceedings, 91 (2), pp. 391-395. 2001. Print Allen, S. L., 2003, Financial Risk Management: A Practitioner’s Guide to Managing Market and Credit Risk, Hoboken, New Jersey: John Wiley and Sons. 2003. Print Bank of International Settlements,, Quarterly Review. Basle: BIS (September). 2005. Print Bansal, R. and Dahlquist, M., , The Forward Premium Puzzle: Different Tales from Developed and Emerging Economies. Journal of International Economics, 51 (June), pp 115-144. 2000. Print Barton, T. L., Shenkir, W. G. and Walker, P. L., , Making Enterprise Risk Management Pay Off: How Leading Companies Implement Risk Management. Brookfield, Connecticut: Fei Research Foundation. 2002. Print Bodnar, G. and Gebhardt, G., Derivatives Usage in Risk Management by U.S. and German Non-Financial Firms: A Comparative Survey. NBER Working Paper No 6705, Cambridge, Massachusetts: NBER (August). 2007. Print Bodnar, G. M., Hayt, G., Marston, R. C., and Smithson, C.W, Wharton Survey of Derivatives. 1995. Print Usage by US Non-Financial Firms. Financial Management, 24 (2), pp. 104-114. Fama, E. F., 1984, Forward and Spot Exchanges. Journal of Monetary Economics, 14 (3), pp. 319- 338. 2004. Print Froot, K. and Thaler, R., 1990, Anomalies: Foreign Exchange. Journal of Economic Perspectives, 4 (3), pp. 179-192. Read More