Foreign Exchange Risk Exposure for Xinjiang Locomotives

Foreign exchange risk exposure refers to the financial risk which arises due to the financial transactions stated in the foreign currency, which is other than the domestic currency (Fleten et al. 2015). Due to the high volatility in the currency rates, the profit of the investor is significantly affected (Bettis, Bizjak and Kalpathy, 2015). There are three types of foreign risk exposure such as transaction exposure, operating exposure and translation exposure (Islam, and Chakraborti, 2015). However through the effective manner of the hedging, the foreign exchange risk can be mitigated to some extent, some hedging techniques are described below-

1. To hedge with by entering into the forward contract
2. Hedging the risk by money market hedging
3. By entering into the option contract (Bhatia, and Bhat,2016)

In the present study, Xinjiang company which is China-based will receive the amount of $ 50 million in future by entering into the deal in June 2017. On the basis of the terms of the deal, 50% of the amount will receive in December 2017 and another 50% in June 2018. The company has foreign exchange risk exposure due to the changing in the foreign currency rates. And if the value of the dollar will decrease, then there is a chance of the loss to the company. Therefore the company wants to hedge the foreign currency risk exposure. Through the following method, the company can hedge the risk.

Risk Management Strategies And Justification

Through the forward contract

If the company wants to cover its risk exposure through the forward contract, then the company will sale $ 25 Million forward contracts today at the 180 days forward rate and remaining $25 million forward contracts today at 360 days forward rate.

The 180-days forward rate= 1 $= CNY 6.62335

In 180 days company will receive $ 25 Million and sale this $ at the CNY 6.62335 and receive the CNY 165.584 M.

The 360-days forward rate= 1 $= CNY 6.22755

In 180 days company will receive $ 25 Million and sale this $ at the CNY 6.22755 and receive the CNY 155.689 M.

The amount computed above is certain. In the future, the amount will not be impacted by any volatility in the foreign exchange risk.

Through money market hedge

In the money market hedge technique, the company can hedge the amount by borrowing which is equal to the present value of the amount of foreign currency, and after this, the borrowed amount converted into the domestic currency through the spot rate. The amount will be invested into the domestic currency, and the amount received in the maturity will be along with the interest rate.

Hedging Alternatives

Hedging of the amount which will be received in December 2017

Step 1. Borrow the $ 25 Million at the rate prevailing in the US that is at 4%. The present value of the borrowed amount = $ 25 Million/1.04= $ 24.038 M.

So, the company will borrow the $ 24.038 M today and repay the amount with interest

Step 2. Convert the borrowed sum in the domestic currency of the company by applying the spot rate

Spot rate= 1 $ =CNY 6.72475

= $24.038 Million*CNY 6.72475 = CNY 161.649 M

Step 3. The above sum invested in the domestic currency and the interest will be received at the investing rate prevailing in China. The future value of the amount will be

= CNY 161.649*1.02452

= CNY 165.613 M

Hedging of the amount which will receive in December 2017

Step 1. Borrow the $ 25 Million at the borrowing rate prevailing in the US that is at 4.255%. The present value of the borrowed amount = $ 25 Million/1.04255= $ 23.980 M.

So, the company will borrow the $ 23.980 M today and repay the amount with interest

Step 2. Convert the borrowed sum in the domestic currency of the company by applying the spot rate

Spot rate= 1 $ =CNY 6.72475

= $23.980 Million*CNY 6.72475 = CNY 161.260 M

Step 3. The above sum invested in the domestic currency and the interest will be received at the investing rate prevailing in China. The future value of the amount will be

= CNY 161.260*1.02225

= CNY 164.848 M

It has been assumed that the interest rate which was given in the question, the low-interest rate reflects the borrowing interest rate and the high-interest rate reflect the investing rate.

Hedging through the option market

The company can cover the risk by buying the put option on $.

The company can purchase the 180 days put option on $ at a strike price of CNY 6.650/$ and a premium of CNY .05/$. The cost of premium would be $25*.05= CNY 1.25 M.

The company is required to borrow this money at a borrowing rate prevailing in the china that is 2.323%. The total amount of borrowing = 1.25*1.02323 = CNY 1.279 M

The realisation by selling the $ at a strike price = 25*6.650= CNY 166.25 M

The net realisation to the company= 166.25-1.279 = CNY 164.971 M

 Along with the above part, the company can purchase the 360 days put option on $ at a strike price of CNY 6.250/$ and a premium of CNY .04/$. The cost of premium would be $25*.04= CNY 1 M

Forward Contract

The company is required to borrow this money at a borrowing rate prevailing in the china that is 2.323%. The total amount of borrowing = 1*1.02001 = CNY 1.02001 M

The realisation by selling the $ at a strike price = 25*6.250= CNY 156.25 M

The net realisation to the company= 156.25-1.02001 = CNY 155.23 M

On the basis of the above analysis, the receivable by the company under the three alternatives given below

Particulars	180-days	360-days
Hedging through a forward contract	CNY 165.584 M	CNY 155.689 M
Money market hedge	CNY 165.613 M	CNY 164.848 M
Hedging through option	CNY 164.971 M	CNY 155.23 M

On the basis of the above data, it has been concluded that the company can maximise its receivables by entering into the money market hedge.  Therefore it is recommended to the company to adopt the money market hedge for the foreign currency risk exposures.

(i)

If on December 2017, the actual exchange rate 1 $= 6.8255, then unrealized gain/loss to the company from the above alternatives given below-

* Realisation from the actual exchange = 25*6.8255 = 170.62375M

 Unrealized gain/loss from the forward contract, CNY 5.039 M (170.623-165.584), this will be unrealized gain by not entering into the forward contract.

From money market hedge, CNY 5.01M (170.623-165.613), this will be unrealized gain by not entering into the money market hedge.

From Option Contract, unrealized gain/or loss will be the difference from spot price of the June and the spot price of December that is (6.72475-6.8255)*25M = CNY 2.519 M, which is the unrealised gain by not entering into the option contract.

If on June 2018, the actual exchange rate 1 $= 6.950, then unrealized gain/loss to the company from the above alternatives given below-

* Realisation from the actual exchange = 25*6.950 = 173.75M

 Unrealized gain/loss from the forward contract, CNY 18.061 M (173.75-155.689), this will be unrealized gain by not entering into the forward contract.

From money market hedge, CNY 8.902 M (173.75-164.848), this will be unrealized gain by not entering into the money market hedge.

From Option Contract unrealized gain/or loss will be the difference from spot price of the June 2017 and the spot price of June 2018 that is (6.72475-6.950)*25M = CNY 5.631 M, which is the unrealised gain by not entering into the option contract.

(ii) 

Since, from hedging through the forward contract, the amount of realisation by the company is certain. In this case for the 180 days, the company entered to sale the dollar at a fixed rate of CNY 6.62335/$. However the present spot rate on December 2017 is CNY 6.8255/$. Therefore the company sold the dollar at a less price than the spot rate. So there will be the gain which was not realised by the company. In a similar manner, the 360 days forward rate CNY 6.22755/$, while the spot rate on June 2018 CNY 6.950/$, which is more than the rate of the company, therefore in this case also the gain, which was not realised by the company.

Money Market Hedge

By the money market hedge, company certain its realisation. Since, the realization by the company from the money market hedge was less than, if the company did not enter in the money market hedging. Therefore in this strategy also the company has unrealized gain by entering into the money market hedging.

Further, by option contract hedging the company acquire the right to sale the dollar in the market. Since the current spot price of the company in both the cases was more than the strike price, therefore, the company will not exercise the option. However if the company receive the payment in June 2017 then the realisation $ 50M * 6.72475 = CNY 336.2375, which is less than the comparison with the actual spot rate of December 2017 and June 2018. Therefore the company suffered from the unrealised gain in this case also.

(i) 

For mitigating the risk level in the business, many companies make the strategies. The risk may arise due to volatility in the currency rates, inflation rate, interest rate and etc.it are very important to make the strategy with an assist in reducing the risk of the foreign exchange (Cenedese, Sarno, and Tsiakas, 2014). There is a various alternative to manage the risk from the change in the exchange rate, which is already described above. By managing the foreign exchange risk, an investor can protect their profit (Bandaly, Shanker, and ?at?r, 2018). Along with this, even if in the future, the exchange rate changes adversely, then also by the risk management strategy investor can survive in the market. Moreover, the hedging risk not only protects from the change in the currency rate, but an investor can also safeguard from the commodity prices, interest rate, the rate of inflation and many others. An investor can maximise its profit by managing the risk. Although there is some cost involved in managing the risk, this cost can easily cover by the profit from the investment (Apergis, and Artikis, 2016).

On the other side, if the investor does not make an effort to manage the foreign exchange risk, then the investor has possessed so many risks due to the change in the market condition.  Since the change in the currency rate, interest rate, inflation rate, it is very typical to measure the change in the future. Therefore in any case, if the condition of the market moves adverse with the investment, then the chances of loss will very significant impact to the investor (Chong, Chang, and Tan, 2014). So, it is worth full for the investor to make the efforts for managing the risk due to the foreign exchange

(ii) 

If the company remain unhedged, then the company sell the $ 25 Million at the spot price of December 2017 and another  $ 25 Million at the spot rate on the date of June 2018.

Realisation on December 2017 = $ 25 M * 6.8255 = CNY 170.6375

Realisation on June 2018 = $ 25M *6.950= CNY 173.75

On the basis of the above calculation, it has been seen that the company, if not adopt any hedging alternative than obtaining the more realisation by selling the dollar at the spot prices.

References 

Apergis, N. and Artikis, P.G., 2016. Foreign exchange risk, equity risk factors and economic growth. Atlantic Economic Journal, 44(4), pp.425-445.

Bandaly, D., Shanker, L. and ?at?r, A., 2018. Integrated Financial and Operational Risk Management of Foreign Exchange Risk, Input Commodity Price Risk and Demand Uncertainty. IFAC-PapersOnLine, 51(11), pp.957-962.

Bettis, C., Bizjak, J. and Kalpathy, S., 2015. Why do insiders hedge their ownership? An empirical examination. Financial Management, 44(3), pp.655-683.

Bhatia, A. and Bhat, S.P., 2016, May. Optimal Static Hedging of Uncertain Future Foreign Currency Cash Flows Using FX Forwards. In Industrial Engineering, Management Science and Application (ICIMSA), 2016 International Conference on (pp. 1-5). IEEE.

Cenedese, G., Sarno, L. and Tsiakas, I., 2014. Foreign exchange risk and the predictability of carry trade returns. Journal of Banking & Finance, 42, pp.302-313.

Chong, L.L., Chang, X.J. and Tan, S.H., 2014. Determinants of corporate foreign exchange risk hedging. Managerial Finance, 40(2), pp.176-188.

Fleten, S.E., Hagen, L.A., Nygård, M.T., Smith-Sivertsen, R. and Sollie, J.M., 2015. The overnight risk premium in electricity forward contracts. Energy Economics, 49, pp.293-300.

Islam, M. and Chakraborti, J., 2015. Futures and forward contract as a route of hedging the risk. Risk Governance & Control: Financial Markets & Institutions, 5(4), pp.68-78.