exchange rate risk management project

1 | P a g e C123 Exchange Rate Risk Measurement

DEPARTMENT OF CONSTRUCTION MANAGEMENT

PROJECT COVER SHEET

STUDENT NAME: DC

STUDENT NUMBER: C 123

COURSE/ YEAR DT117/4

SUBJECT: Construction Project Finance

PROJECT TITLE: Exchange Rate Risk Management

LECTURER:

FOR OFFICE USE ONLY:

DATE DUE: 19th November 2015

DATE RECEIVED:

RECEIVED BY:

REPEAT PROJECT?

MARKS:


Contents Introduction ............................................................................................................................................ 3

Types of exchange rate risk .................................................................................................................... 3

Definition of Hedging .............................................................................................................................. 4

The Construction Project ........................................................................................................................ 4

Spot Rate ......................................................................................................................................... 4

Exchange Risk Graphs ............................................................................................................................. 6

Quarter 1 ................................................................................................................................................. 7

Natural Hedging .................................................................................................................................. 7

Quarter 2 ................................................................................................................................................. 8

Forward Market Hedging .................................................................................................................... 8

Quarter 3 ................................................................................................................................................. 9

FX options contract ............................................................................................................................. 9

Quarter 4 ............................................................................................................................................... 10

Transfer ............................................................................................................................................. 10

Quarter 5 ............................................................................................................................................... 11

Natural Hedging ................................................................................................................................ 11

Quarter 6 ............................................................................................................................................... 12

FX Swap ............................................................................................................................................. 12

Quarter 7 ............................................................................................................................................... 13

FX options contract ........................................................................................................................... 13

Quarter 8 ............................................................................................................................................... 14

Leading .............................................................................................................................................. 14

Quarter 9 ............................................................................................................................................... 15

Swap .................................................................................................................................................. 15

Quarter 10 ............................................................................................................................................. 16

Natural Hedging ................................................................................................................................ 16

Quarter 11 ............................................................................................................................................. 17

Natural Hedging ................................................................................................................................ 17

Quarter 12 ............................................................................................................................................. 18

Transfer ............................................................................................................................................. 18

Conclusion ............................................................................................................................................. 20

References ............................................................................................... Error! Bookmark not defined.


Introduction As a company’s financial accountant I will set out a detailed report on the Project ‘Educational

Hub’ that has recently been tendered for and won for the United Kingdom subsidiary using

selective tendering. In this report I will outline different Hedging techniques that will help the

company to hedge the risk of losing its profit due to currency exchange and fluctuation.

Looking at the currency fluctuations over the past years it seem that the economy is on a down

turn and detailed analysis have to be made for keeping some of the profit.

The project background is: ‘Educational Hub’ for the University of London that will have a

total duration of 3 years and the cost of £45,000,000. The project is to start in March 30th 2016.

As taking on project that will be based in Great Britain I will have to deal in GBP, therefore I

must exchange the Pound Sterling back to Euro. I will conduct my studies on current exchange

rate between Euros and GBP.

The definition of foreign exchange risk is ‘the exchange rate will change unfavourably before

the payment is made or received in home currency’. If my company will take on the project in

the UK the UK will not have any effect on the currency but my company will have to take on

the risk associated with fluctuations in the value of the GBP against the Euro.

A way in which I will try to reduce or minimise the risk is by using Foreign Exchange Rate

Hedging. Which is a strategy that can assist and protect our business from uncertainty. As with

risk of treading, hedging can result in low returns but it also lowers the risk of losing

considerable sums of money. My analysis will include comprehensive details of Foreign

exchange rate (FX) risk.

Types of exchange rate risk The common definition of exchange rate is the unexpected exchange rate changes, defined as

the possible direct loss. In order to manage this, we need to determine the type of current risk

exposed and encountered. The three main types of exchange rate risk are.

1. Transaction risk, is the risk of opposing exchange rate movements occurring from a

normal international day trading. A company receives or pays foreign currency at a

future date, may change due to floating exchange rates

2. Translation risk, is balance sheet exchange rate risk, depending on foreign exchange

rates the asset value of the subsidiary will be reduced in the balance sheet.

3. Economic risk, which reflects the risk of the company’s present value of future cash

flows will change due to exchange rate movements

(Thomas Power, 2005) (Dohring, 2008)


Definition of Hedging Company’s use hedging to protect themselves against uncertainty. It is like insuring money,

when a company decides to hedge they are making uncertain outcomes certain. Specifically,

in the case of exchange rate risk the results of hedging is that the business is not influenced

by the movement in currency exchange rate. (Investopedia, 2015)

If this event happens and the company has properly hedged the impact is reduced. In other

words it won’t make the company money but it will reduced the potential loss (Investopedia,

2015)

The Construction Project As recently tendered for and successively won a contract for their UK construction subsidiary

to build Educational Hub for University of London.

This, three year project is expected to generate receipts in the region of £45,000,000 at today’s

Foreign exchange spot rate.

Spot Rate £1 → € 1.401 (8/11/15) (X-rates.com)

Equating to: € 63’045’000 (45,000,000 x 1.401)

€ 1 → £ 0.713 (8/11/15) (X-rates.com)

In the following report I will focus on:

A Graphical representation of the Spot FX rate in relation to Historic FX rates over the

past 3 years from January 2012 – December 2015.

A Graphical representation of the Spot FX rate in relation to Historic FX rates over the

past 3 years from November 2015 – December 2018.

In addition, detailed calculations of the following for each Quarter, which include:

FX rate Risk based on Historic FX rates & its effect on expected Receipts from January

2012 – end 2015

FX rate Risk based on forecasted FX rates which are based on the above Historic FX

rates and their effect on forecasted Receipts from November 2015 – December 2018

Hedging calculations.

FX rate Risk & the Net effect on Receipts after Hedging FX rate risk.


Figure 1. Risk based on Historic FX rates & its effect on expected Receipts (this will not be outlined any further in the report)

Table 2: FX Risk based on forecasted FX rates & its effect on forecasted Receipts (6th November 2015.)

Table 1: FX Risk based on Historic

FX rates & its effect on expected

Receipts

Q1 Q2 Q3 Q4 Q5 Q6 Q7 Q8 Q9 Q10 Q11 Q12 Totals

31/03/2012 30/06/2012 30/09/2012 31/12/2012 31/03/2013 30/06/2013 30/09/2013 31/12/2013 31/03/2014 30/06/2014 30/09/2014 31/12/2014

Expected Receipts GB£ 3,750,000 6,500,000 6,000,000 3,000,000 4,500,000 4,500,000 2,000,000 5,000,000 1,000,000 3,750,000 2,000,000 3,000,000 45,000,000

Today's FX rate (Spot Rate) GB£ → € 1.401 1.401 1.401 1.401 1.401 1.401 1.401 1.401 1.401 1.401 1.401 1.401

Expected Receipts at the current spot

rate € 5,253,750 9,106,500 8,406,000 4,203,000 6,304,500 6,304,500 2,802,000 7,005,000 1,401,000 5,253,750 2,802,000 4,203,000 63,045,000

Historic FX rate GB£ → € 1.198 1.24 1.257 1.233 1.186 1.169 1.195 1.203 1.21 1.249 1.284 1.287

Expected Receipts at Historic FX

Rates € 4,492,500 8,060,000 7,542,000 3,699,000 5,337,000 5,260,500 2,390,000 6,015,000 1,210,000 4,683,750 2,568,000 3,861,000 55,118,750

Historic receipts - Expected Receipts

(761,250) (1,046,500) (864,000) (504,000) (967,500) (1,044,000) (412,000) (990,000) (191,000) (570,000) (234,000) (342,000) (7,926,250)

Table 2: FX Risk based on forecasted

FX rates & its effect on forecasted

Receipts

Q1 Q2 Q3 Q4 Q5 Q6 Q7 Q8 Q9 Q10 Q11 Q12 Totals

31/03/2016 30/06/2016 30/09/2016 31/12/2016 31/03/2017 30/06/2017 30/09/2017 31/12/2017 31/03/2018 30/06/2018 30/09/2018 31/12/2018

Today's FX rate (Spot Rate) GB£ → € 1.401 1.401 1.401 1.401 1.401 1.401 1.401 1.401 1.401 1.401 1.401 1.401

Expected Receipts GB£ 3,750,000 6,500,000 6,000,000 3,000,000 4,500,000 4,500,000 2,000,000 5,000,000 1,000,000 3,750,000 2,000,000 3,000,000 45,000,000

Expected Receipts at today's FX rate

(Spot Rate) € 5,253,750 9,106,500 8,406,000 4,203,000 6,304,500 6,304,500 2,802,000 7,005,000 1,401,000 5,253,750 2,802,000 4,203,000 63,045,000

Forecasted FX rate GB£ → € (based

on self-assumptions) 1.366 1.36 1.359 1.351 1.348 1.345 1.355 1.361 1.366 1.369 1.372 1.375

Actual Receipts based on forecasted

FX rates € 5,122,500 8,840,000 8,154,000 4,053,000 6,066,000 6,052,500 2,710,000 6,805,000 1,366,000 5,133,750 2,744,000 4,125,000 61,171,750

Expected Receipts less forecasted

Receipts € (131,250) (266,500) (252,000) (150,000) (238,500) (252,000) (92,000) (200,000) (35,000) (120,000) (58,000) (78,000) (1,873,250)


Exchange Risk Graphs

Figure 3. Shows a representation of spot exchange rate in relation to historical exchange

rates.

Figure 4. The figures taken above are used as the forecasted exchange rates taken from data

tables on figures 1 and 2

0.000

0.500

1.000

1.500

Q1 Q2 Q3 Q4 Q5 Q6 Q7 Q8 Q9 Q10 Q11 Q12

GB£ → €

Quarter

GB£ → € FX Rates

Spot FX Rate

Historic FX Rate

1.300

1.320

1.340

1.360

1.380

1.400

1.420

Q1 Q2 Q3 Q4 Q5 Q6 Q7 Q8 Q9 Q10 Q11 Q12

GB£ → €

Quarter

GB£ → € FX Rates

Spot FX Rate

Forecasted FX Rates


Quarter 1

Table 2: FX Risk based on forecasted FX rates & its effect on forecasted

Receipts

Q1

31/03/2016

Today's FX rate (Spot Rate) GB£ → € 1.401

Expected Receipts GB£ 3,750,000

Expected Receipts at today's FX rate (Spot Rate) € 5,253,750

Forecasted FX rate GB£ → € (based on self-assumptions) 1.366

Actual Receipts based on forecasted FX rates € 5,122,500

Expected Receipts less forecasted Receipts € (131,250)

Figure 5. FX Risk based on forecasted FX rates & its effect on forecasted Receipts.

Natural Hedging A method of reducing financial risk by investing in the currency of Great Britain where the

transaction will take place. By doing so the expenses will cancel each other out. However,

natural hedging is imperfect, and do not eliminate risk completely as the company will still

have £500,000 to be exchanged. (Investopidia.com 2015) (PWC, 2014)

Sales in one country holds a natural hedge on its currency risk if it also generates expenses in

that currency

Our company could match GB£ receipts with their GB£ Expenses by buying for Q 1.

Expected receipts = GB£ 3,750,000

Expected Expenses = GB£3,250,000 for Q1.

3,750,000 – 3,250,000 = GB£500,000

It shows now that the company is only exposed to GB£500,000 in relation to currency

exchange.

Table 3: FX Risk & the Net effect on Receipts after Hedging FX risk Q1

31/03/2016

Today's FX rate (Spot Rate x-rates.com) GB£ → € 1.401

Expected Receipts GB£ 500,000

Expected Receipts at today's FX rate (Spot Rate) € 700,500

Forecasted FX rate GB£ → € 1.366

Actual Receipts based on forecasted FX rates € 683,000

Net Expected Receipts less forecasted Receipts after Hedging € (17,500)

The table above shows that the expenses are reduced with its potential FX rate loss by:

€ 131,250 – 17,500 = € 113’750 (saving)


Quarter 2


Receipts Q2

30/06/2016







Forward Market Hedging By using FX forward will mean that The Company will go in contract with the bank to

exchange the amount of £6,500,000 at a certain period of time in the future. This will mean

that the currency will be € 1.401 as the forward rate (x-rates.com)

This is a contract to buy FX rate security at a price that is fixed today.

In 2nd quarter it is forecasted to make one of its biggest losses in relation to FX rate risk,

therefore our company could enter into a contract with the Bank to fix the interest rate in

advance at today’s spot rate of 1.401 GB£ → €

This provides the protection of a known FX rate should the spot rate in Q2 not go in their

favour.

It should be noted that the Banks charge a fee for this service.

For the purpose of this report, bank charges are assumed to be €15,000.


30/06/2016




Agreed FX rate GB£ → € 1.401


Bank charges € 15,000


€ 266,500 – 15,000 = € 251’500 (saving)


Quarter 3 Table 2: FX Risk based on forecasted FX rates & its effect on forecasted

Receipts Q3

30/09/2016







FX options contract This is the purchase of a currency option from, for example, a Bank, which gives the buyer the

right but not the obligation, for a specified period of time, to exchange an agreed amount of

one currency for another. (T.M. Kenneddy, 1995)

The company could enter into a contract with the bank, to fix the FX Rate in advance at today’s

(6/11/15) spot rate of 1.401 GB£ → € (x-rates.com 2015)

This measure provides the protection of a known FX rate should the spot rate in Q3 turn out to

be not in favour.

However, if the spot FX rate in Q3 turns out to be better that the agreed FX rate, under the FX

options contract of 1.401 GB£ → €, The company can allow this contract to lapse and take

their money at the preferred Q3 spot FX rate when the time comes.

It should be noted that banks charge a higher fee for the security of an FX options contract

when compared with forward market hedging.

For the purpose of the report it is assumed the Bank will charge €20,000 for the FX options

Contract.


30/09/2016






Bank Charges FX option contract € 20,000


€ 252,000 – 20,000 = € 232’000 (saving)


Quarter 4


Receipts

Q4

31/12/2016







Transfer US subsidiary for Q4 is forecasted to receive Net receipts of US$ 470,000 at a forecasted FX

rate of US$ → € = 0.933 (X-Rates.com, 2014)

Equating to: US$ 470,000 * 0.933 = € 429,290

This can be used to off-set some of the FX rate losses that are forecasted in the UK for Q4.

€ (504,000) + € 429,290 = € (74,710)


31/12/2016







Transferee from the US subsidiary € 429,290

Net expected receipts less forecasted receipts after hedging (74,710)


€ 150,000– 74,710 = € 75’290 (saving)


Quarter 5


Receipts

Q5

31/03/2017







Natural Hedging Natural Hedge is a simple concept which is to offset future sterling payments against future

sterling receivables. To do this we require to have certain know receivables and payments

which coincide exactly. If the exchange rate decreases then then reduction in the value of the

sterling receivables, an income is offset by the decrease in value of the sterling payments, an

outgo and vice versa. This is the most efficient way to hedge. (PWC, 2014)

The ability to natural hedge payments is constrained by the availability of future payments and

receivables. We can only use Natural Hedging to hedge the proceeds of the construction project

the extent we have future sterling payments to make. (PWC, 2014)

The company could match receipts GB£ receipts with their GB£ Expenses for Q 5.

Expected receipts = GB£4,500,000

Expected Expenses = GB£4,300,000 for Q5. 4,500,000 – 4,300,000 = GB£200,000

The result is that the company is now only exposed to GB£200,000 in relation to FX rate risk.


31/03/2017








€ 238,500 – 10,600 = € 227’900 (saving)


Quarter 6


Receipts

Q6

30/06/2017







FX Swap A swap is binding contract with a bank in which we receive a schedule of fixed known

payments in EURO and make fixed known payments in £. The fixed EURO amounts we

receive will be less than the expected amount using the forecast rates; the bank won’t give full

value of the expected EURO payments – the reduction is used to cover the bank’s costs and

profits. Costs will reflect the company’s credit worthiness, if the company defaults then the

bank will suffer a loss. The bank’s charge will increase with time as uncertainty, and so the

bank’s risk increases with time. (T.M. Kennedy, 1995)

For Q the company could approach the Bank and make arrangements to swap currencies with

a British company (GB£) trading in the Euro currency zone (€)

However, banks do charge fees for facilitating this exchange.

For the purpose of this report The Company will assume €2,000.


30/06/2017



Amount to be swapped GB£ 4,500,000

Bank Fees 2,000

Net after hedging (2,000)


€ 252,000 – 2,000 = € 250’000 (saving)


Quarter 7


Receipts

Q7

30/09/2017







FX options contract Bank guarantees to convert GB£ to € amount but the company is under no obligation to exercise

the option and convert the £ at that rate. This allows the company to protect against downside

currency movements. Options are more expensive compared to swaps and forward contracts

as a result and banks will charge an upfront fee for it (Dohring, 2008) (PWC, 2014).

The fee will reflect the guaranteed GBP->EUR exchange rate and how close that is to the

expected rate and how volatile the future exchanges are deemed to be. The company could

enter into a contract to with the bank to fix the interest rate in advance at today’s (08/11/15)

spot rate of 1.401 GB£ → € (X-Rates.com)

This provides the protection of a known FX rate should the spot FX rate in Q7 not be in favour.

However, if the spot FX rate in Q7 turns out to be better that the agreed FX rate under the FX

options contract of 1.401 GB£ → €, this can allow contract to lapse and take their money at the

preferred Q7 spot rate.

It is assumed the Bank will charge €6,000 for the FX options contract.


30/09/2017








€ 92,000 – 6,000 = € 86’000 (saving)


Quarter 8


Receipts

Q8

31/12/2017







Leading This is where we enter into agreement with the client to receive the purchase price now, instead

of in instalments each quarter. The client will need to be offered a discount as an incentive to

pay the instalments now. As we receive the payments now we can convert to EUR using the

current known spot rate. The table below shows the value of these payments today. (T.M.

Kennedy, 1995)

The discount required by the client is negotiated. The client will only accept paying now if the

amount of that payment is less than the NPV of the payment in the future. (PWC, 2014)

The company could make arrangements with its debtors to for-go its 3 month credit period and

pay them on the 30/09/2016 at the preferred forecasted spot FX rate of 1.361 GB£ → €.

However, The Company will have to give its debtors an incentive by way of a discount.

For the purposes of this report The Company will offer an early payment discount of 2 %.


31/12/2017



Discount (0.2%) 100’000

Expected Receipts GB£ - Discount 4,900,000






€ 200,000 – 196,000 = € 4’000 (saving)


Quarter 9


Receipts

Q9

31/03/2018







Swap The Company could again, approach the Bank and make arrangements to swap currencies

with a British company (GB£) trading in the Euro currency zone (€)

However, Banks do charge fees for facilitating this service.

For the purpose of this report The Company will assume Bank charges of €2,000.

The British company swaps €1,366,000 with other company for GB£1,000,000 at a cost to

The Company of €2,000

Resulting in a Net expected receipts for Q8 of € (2,000)


31/03/2018



Amount to be swapped GB£ 1,000,000

Bank Charges € 2,000 2,000

Net after Hedging € (2,000)


€ 35,000 – 2,000 = € 33’000 (saving)


Quarter 10


Receipts

Q10

30/06/2018







Natural Hedging The Company could again, match receipts GB£ receipts with our GB£ Expenses for Q 10


Expected Expenses = GB£3,500,000 for Q10

3,750,000 – 3,500,000

= GB£ 250,000

The result is that the company is now only exposed to GB£ 250,000 in relation to FX rate

risk.


30/06/2018








€ 120.000 – 8,000 = € 112’000 (saving)


Quarter 11


Receipts

Q11

30/09/2018







Natural Hedging The company could again, match forecasted GB£ receipts with its forecasted GB£ Expenses

for Q 11.


Expected Expenses = GB£1,000,000 for Q11.

2,000,000 – 1,000,000

= GB£ 1,000,000

The result is that the company is now only exposed to GB£ 1,000,000 in relation to FX risk.


Receipts

Q11

30/09/2018








€ 58,000 – 29’000 = € 29’000 (saving)


Quarter 12


Receipts

Q12

31/12/2018







Transfer The company’s US subsidiary for Q12 is forecasted to receive Net receipts of US$50,000 at a

forecasted (Cited: 06/11/15) FX rate of:

US$ → € = 0.933 (X-Rates.com, 2015)

Equating to US$ 50,000 * 0.933 = € 46,650

The Company can use some these monies to off-set some of the forecasted FX losses that

may be incurred in the UK for Q12

€46,650 + € (78,000) = € (31,350)


31/12/2018







Transfer from the US subsidiary € 46,650



€ 78,000 – 31,350 = € 46,650 (saving)


Figure 5. Representation of forward hedging in relation to the project and how each part of the hedging used impacted the overall savings in

comparison to doing nothing option as seen in figure 2.

Table 3: FX Risk & the

Net effect on Receipts

after Hedging FX risk

Q1 Q2 Q3 Q4 Q5 Q6 Q7 Q8 Q9 Q10 Q11 Q12

Totals

31/03/2016 30/06/2016 30/09/2016 31/12/2016 31/03/2017 30/06/2017 30/09/2017 31/12/2017 31/03/2018 30/06/2018 30/09/2018 31/12/2018

Today's FX rate (Spot

Rate) GB£ → € 1.401 1.401 1.401 1.401 1.401 1.401 1.401 1.401 1.401 1.401 1.401 1.401

Expected Receipts GB£ 500,000 6,500,000 6,000,000 3,000,000 200,000 4,500,000 2,000,000 4,900,000 1,000,000 250,000 1,000,000 3,000,000 32,850,000

Expected Receipts at

today's FX rate (Spot

Rate) €

700,500 9,106,500 8,406,000 4,203,000 280,200 6,304,500 2,802,000 6,864,900 1,401,000 350,250 1,401,000 4,203,000 46,022,850

Forecasted FX rate GB£

→ € 1.366 1.401 1.401 1.351 1.348 1.345 1.401 1.361 1.366 1.369 1.372 1.375

Actual Receipts based on

forecasted FX rates € 683,000 9,106,500 8,406,000 4,053,000 269,600 6,052,500 2,802,000 6,668,900 1,366,000 342,250 1,372,000 4,125,000 45,246,750

Net Expected Receipts

less forecasted Receipts

after Hedging €

(17,500) (15,000) (20,000) (74,710) (10,600) (2,000) (6,000) (196,000) (2,000) (8,000) (29,000) (31,350) (776,100)

Natural Hedging of

3,250,000 resulting in

FX exposure

of 200,000

Giving bank a charge of

15,000 (Forward

Market

Hedging)

Given FX options

contract bank

charges

assumed to be 20,000

Transfer of 429,290

from US subsidiary

Natural Hedge of

GB £ 4,300,000

Swapped

resulting in FX Bank

Exposure

charges of 200,000

Swapped for by Bank and

charged Charges of €

2,000

Agreed FX rate with the

bank under an FX

option

contract. Bank

charges of

€6,000

The Company

made arrangement

s to its

debtors to fore go their

90 day

credit period in order to

get paid at

(30/09/16) forecasted

rate of €500

GB$ to euro (Leading)

The Company

approached the bank in

order for

them to attain

currency

swap with UK

company

trading in the Euro

currency

zone. The bank

charged a

fee of € 2,000 for

facilitating

the Swap

Natural Hedging of

£ 3,500,000 resulting in

FX exposure

of £ 250,000

Natural Hedging of

£1,000,000 resulting in

FX exposure

of € 29,000

Transfer of Euro

46,650 from The

Company’s

US Subsidiary


Conclusion As can be seen from the preceding report, the risk in relation to FX has been reduced from an

expected loss of € 1,873,250 to a loss of € 776,100 which is a saving of € 1’097’150

I should be noted that the savings are based on FX rate predictions which are subject to often

volatile markets, meaning the rates can go down as well as up.

For a three year project overseas it is often difficult to predict with great certainty, forecasted

FX rates. However, to do nothing and run the risk could result in potentially catastrophic losses

as can be seen in quarter 4 and 8 respectively.

Therefore, it is important that Companies make reasonable, calculated assumptions and

decisions, generally, based on previous market trends and drawing on their own experience in

order to reduce their exposure to FX rate risk and in turn maximise their profit potential in

overseas ventures.