The Company I’ve chosen for the dissertation deals with projects in providing offshore solutions and infrastructure to the Oil & Gas extraction companies. As the projects are high investment oriented and needs millions and billions of dollars and other foreign currencies as the firm deals with the countries like Italy, Germany, France, UK and Japan for procurement of inventory materials and the skilled professional to perform and accomplish the objectives of the projects with the maximum customer satisfaction and optimum return to the stake holders. As and when the project progress, the payments have to be made to the suppliers of the materials and the services of the subcontractors that have been ordered and assigned respectively. In this stage, the company gets the exposure in to the risk of cash out flow in other foreign currencies such as EURO, GBP, YEN, NOK other than the functional currency USD. The cash flow’s exposure to the risk factors is the sensitivity of the cash flow to the unexpected changes in the risk factor. The risk factor is the variable such as price, quantity that can change unexpectedly for reasons beyond one’s control. Exposure to cash flow to risk factor = change in cash flow per unit change in risk factor. Lest us consider a simple example of purchasing an inventory for EUR 20,000 needs to be paid in due course at the market rate. At the beginning the exchange rate was 1.20 dollar per euro which gives cash out flow of $24,000. But when the real payment has to be made the rate has spiked up to 1.41 dollars per euro ended up in out flow of $28,200 resulting in a loss of $4,200.
To eliminate or minimize these risks on the Cash flow of the project, the firm enters into financial agreement with a counterparty called a hedge. A financial position that reduces the risk resulting from exposure to a risk factor called a financial hedge. Here the firm chooses a financial hedge is a forward contract. In the above given example, the firm will enter into a forward contract say with a Bank, with an obligation to serve the contract at a given period of time with an agreed price. Like the firm will agree with the bank to buy 20,000 at the end of 3 month from the date of contract at an agreed price of say $1.32 inclusive of charges and commission. This will minimize the risk of the firm by $1,800, which is a notional gain for the company. The above example is very simple vanilla explanation of a foreign currency exposure in a single cash flow with assuming constant exchange rates, no inflation and no other source of uncertainty. But in actual financial market conditions the firm will face catastrophic uncertainties. This dissertation gives a detail study about how the company deals with the cash flow risk through forward hedging and how the various factors affect the pricing of the derivatives. The possibilities of the firm to maintain the effectiveness, the balancing act between the uncertainties and the techniques to overcome the uncertainties. As the risk factor is unlimited in the foreign currency exposure cash flows and the company is not fine tune its practice and procedures to curtail the risk of the firm, then the interest of the stakeholders of the will be in jeopardy. To safe guard the interest of the investor, the regulatory authorities inflict every company to comply with the set financial reporting procedures in relation to every financial aspect of the company. FASB statement No-133 establishes a uniform procedure of accounting for Derivative Instruments and Hedging Activities, and related amendments and implementation issues.
The company that I have chosen is one of the leading worldwide marine solutions companies with fabrication facilities in the Americas, Middle East, Caspian and Asia Pacific. They are the leading provider of engineering, procurement, construction and installation in the global oil and gas industry.” It is a project based firm. Company’s self description to the market is “Challenging Projects. It’s What We Do.” This company does EPCI Projects (Engineering, Procurement, Construction and Installation). Our major budget is for the procurement (Nearly 60% to 70% for the total budget) of steels, Inconel pipes and valves from various parts of the world. All the three are very highly priced and also have fluctuations in price very often. We need to make huge payments to the vendors who supply these materials according to the achievement of agreed milestones. After the award of the project, the engineering phase will start; followed by procurement as per the specifications drawn by the engineers. The procurement functional department with the Project specific Procurement Manager decides the modus operandi and then gets the price quotes from repute vendors and vendors recommended by the “Client”. In this place the PMT and the functional department decides the vendor to whom the order should be placed; who fulfill the technical and commercial conditions. Simultaneously a detailed procurement plan will be prepared and will be passed on over to the Project Accountant to prepare the cash flow which will be the designated item to hedge.
Project revenues (cash inflows) of almost all the Projects are in US Dollars. Hence, when these huge procurement orders are being placed with Vendors from Germany, UK and Japan, the MNC has to pay them in their currency. THE COMPANY faces the foreign currency exposure at this juncture. To protect the firm from adverse/unfavorable changes in foreign currency exposure, Firm enters into forward contracts to hedge the EURO and GBP cash flows. In other words, the Firm hedges its cash flow of the currencies other than its base currency in order to reduce the volatility of the Cash flows. A Hedge is a position in a hedging instrument (here it’s Forward Contract) put on to reduce the risk resulting from the exposure to a risk factor.
The predicament our company faces is the cash flow forecast of the EURO and GBP as it being keeps on roll over due to non-achievement of milestones by the vendors. The payments of such milestones keep on delaying month by month. In this circumstance, the hedge becomes ineffective. Hedge Effectiveness reflects the degree to which changes in the performance of an underlying risk exposure, i.e., underlying hedged item, in respect of a designated risk are offset by changes in the performance of a designated hedging instrument. Effectiveness clearly depends upon the specific hedging objectives which are reflecting on two key factors: – The specific performance metric being used, – The designated risk being hedged If there is lack of offset between the hedging instrument and the hedged item then the hedge is said to be ineffective. The range of offset is 80 – 120 percentages.
This study visualizes the following: Analyze the currency exposure and cash flows Understand the current approach of hedging other currency cash flows. Identify the other possible ways of hedging the risk Make Models and run using historical data Find and recommend the company better solutions to minimize risks. I’ll work on the data available within “The Company” and “The Reuters & Bloomberg” for the Spot and Forward rates. The research methodology would be worked out using the knowledge acquired on hedging strategies through the EMBA Curriculum and the work experience. The final outcome will have the following: Information on EURO GBP Cash flows Identification of risks in the deployment of EURO and GBP Use of Forwards, Futures or Options to minimize risks or rather make profit. Build and evaluate models and demonstrate its benefits Testing the Models Final Recommendations.
AASB-139: The Cash flow hedge is hedge of exposure to the inconsistency or volatility in cash flows that are attributable to a particular risk associated with a recognized asset or liability or a forecast transaction Examples of circumstances to which cash flow hedges may be appropriate include: Hedge of future foreign currency exchange risk associated with an unrecognized contractual commitment to purchase stocks (inventory) or commodity for a fixed foreign exchange amount; or Hedge of change in price of inventory stock or commodity relating to an unrecognized commitment to purchase at a fixed price with payment in the domestic currency; or Use of a swap to change a floating rate debt into fixed rate debt. This dissertation narrates about the first point noted above. Cash Flow Hedging Example Company ABC Limited is an American retail company with USD as its functional currency. It has projected to order EUR 3,000,000 new game consoles for the Xmas period to be delivered in December 20xx. Payment is due to occur in January 20xy in EUR. In January 20xx the company management decides to hedge the foreign currency risk arising from the projected purchase. ABC Limited has determined the transaction is highly probable and the company has entered into a forward contract to buy EUR against USD. Assume hedges have been effective prospectively and retrospectively The fair value and movement in the fair value of forward contract and the fair value of the hedged item i.e. hypothetical derivative are set out below for each measurement date. 1 Jan xx USD $ 000 30 June xx USD $ 000 31 Dec xx USD $ 000 Fair value of hypothetical Derivative 0 (190) 55 Change in value of Hypothetical Derivative (190) 245 (55+190) Fair Value of derivative 0 200 (50) Change in Fair Value of derivative in period 200 (250)=(-50-200)
No entry required for the derivative as it was entered into at market rates and no cash was exchanged. Fair value of derivative at inception is nil
Derivative DR 200,000 Unrealized Gain – Cash Flow Reserve CR Unrealized Gain – Other Income CR To record clean fair value of the derivative &post cash flow hedge reserve entries
Unrealized Gain – Cash Flow Reserve DR 250,000 Derivative CR Unrealized Gain – Other Income DR 10,000 Cash Flow Reserve CR To record clean fair value of the derivative &post cash flow hedge reserve entries Cash Flow Reserve DR 50,000 Inventory CR To record transfer of the balance of the cash flow reserve to inventory on the physical receipt of the inventory Inventory DR 3,500,000 Accounts Payable CR To reflect the receipt of Inventory
Derivative DR 50,000 Cash CR To record settlement of derivative Cash Flow Hedge Reserve Reconciliation 190,000 Gain/(Loss) on Derivative 190,000 (250,000) Transfer from prior period P&L 10,000 Balance 190,000 (50,000) Transfer to inventory 50,000 Final Balance 190,000 0 Profit &Loss 10,000 (10,000) When calculating or obtaining (from bankers) fair values of derivatives or hedged items the “clean” fair value should be used. The clean fair value excludes accrued interest. The “dirty” fair value is the fair value including accrued interest. The use of clean values in effectiveness testing results often results in less ineffectiveness than the use of dirty values. With cash flow hedges as there is no hedged item to perform effectiveness testing and generate accounting entries it is necessary to use a proxy derivative or hypothetical derivative. The hypothetical derivative can be derived by selecting a derivative that is similar to the expected cash flows. Alternatively the fair values of the cash flows being hedged can be used as the hypothetical derivative. Hedge accounting is discontinued and the balance of the hedge reserve is transferred straight to profit and loss when the firm commitment or forecast transaction is no longer expected to occur. Hedge accounting is discontinued and remains in equity until the firm commitment or forecast transaction occurs: Hedged instrument is sold , terminated or expired; or The hedge no longer meets hedging criteria for hedge accounting;
Forecasting the cash out flow arises out of payments of the foreign currencies or exchange can be difficult, as the exact timing of future payments is often unpredictable. Firms have cash flows that are stochastic and wish to hedge them. When the exchange rates fluctuate, this uncertainty makes managing cash flow and maintaining the precincts even more challenging. So, if optimizing cash flow is critical to your business, Forward Contracts may be just the tool you need to gain control over foreign payments. What is a Forward Contract? It is a foreign exchange instrument or may be a derivative agreement for purchasing a set amount of a foreign currency at a fixed rate for distribution over a predetermined length of time. It provides a range of days – a “window” of time – for settling the contract at a previously agreed price. Forward Contracts are often used when you expect to make foreign payments, but payment dates are uncertain. You benefit from greater flexibility, certainty and convenience because you establish your exchange rate in advance and pay invoices as they become due. In addition, Forward Contracts do not require upfront funding. Payment is required only when the contract is drawn down and only for the amount you need. Therefore, you have access to funds, and your cash in hand will continue to earn interest all while establishing your foreign exchange costs in advance. If a firm has undertaken a cash flow hedge, it has to demonstrate that this hedge is “Effective”. If a cash flow hedge is effective, the derivative qualifies for hedge accounting treatment. The effectiveness of the hedge requires the hedge to meet a standard set by the Company as to how the gains of the hedge offset the changes in cash flows being hedged. This standard has to be set at the time the derivative position is entered. If the standard is no longer met at some point during the life the hedge, the firm looses the use of the hedge accounting. The effective part of the gains and losses of the derivative that offset the changes in cash flows being hedged. The gains and losses of the derivatives flow through “Other Comprehensive Income” rather than earnings and hence do not affect earnings as long as the gains and losses of the hedged cash flows are not recognized. When the gains or losses on the hedged cash flows are realized, the gains and losses that went through “Other Comprehensive Income” are used to offset the gains or losses on the hedged cash flows.
Though the firm’s core competency is building projects, the ultimate mission and goal is to increase the shareholders’ wealth and satisfaction. So it is very important to tap the opportunities wherever available to make or realize revenues and enhance the earnings of the company. Hence to accomplish the aphorism we need to analyze the following positions with the available facts, figures and the extensive learning. Is Insurance a Proper hedge for OR? The discussions about the appropriateness of insurance to protect against the operational risk have dominated the topic of operational risk hedging. The mains issue is that the definition and classification of operational risk varies significantly. Therefore insurers fear being held liable for losses that have not be factored into their premium calculations. As a result, insurers generally word policies very carefully in order to exclude risks that are not definite in amount, time, place or cause. Consequently this may lead to gaps in the available cover, preventing the insurance of all risks encompassing OR (although some “business risk types”, which are not included in regulatory capital, might be included). In addition, where policies have not been properly worded there is the possibility of lengthy disputes over whether a loss really is covered or not. This can at best lead to long delays in the payment of claims. Decision making on whether to opt the hedging for the disbursement of the cash flow or not How to make the Hedging function as profit centre of the business
The main purpose of this dissertation is to gain an understanding on the value implications of the cash flow hedging. In other words how the corporate hedging affects the value of the firm. What are the merits and demerits of Cash out flow hedging? Is Hedging Model gives maximum returns or gains while reducing the uncertainty of the cash flows that are stochastic?
Analyze the foreign currency cash flow of a corporate at a given period for their potential risks and the way to eliminate them through derivative trading and come up with the appropriate hedging model to maximize the earnings.
As the firm’s core competency of the firm is not Derivative trading, the company is not considering handling derivatives innovatively. They are just concentrating on developing, improvising, competing and sustaining the existing industry of building projects. This dissertation is to analyze and prove that the treasury also be a profit centre that being regarded as a supportive or service unit. This is to indulge the intrapreneurship upon the internal stake holders that they can also be part of the earnings of the Company and their ultimate mission and goal should align with the company’s mission to increase the shareholders’ wealth and satisfaction.
Refer APPENDIX-1 for the design or nomenclature followed by the company to enter into a derivative forward contract. All the data are supplied or collated through Secondary Data sources – which are very much from the internal and confidential. The data are consciously maneuvered to maintain the confidentiality of the firm, without affecting the objective of this thesis submission. The Other secondary sources are https://www.oanda.com, https://www.x-rates.com, https://www.bloomberg.com.
The Research methodology is purely qualitative as the analysis is based on the content of the collected data. The data collected were the cash flows in other foreign currencies other than the Company’s functional currency – US Dollars. To be specific the cash flows are the EURO and GBP payments forecasted to pay the vendors who have supplied the inventory for various projects. As already mentioned, the analysis is about how to decide upon whether the cash flow has to be hedged or not with objective of eliminating the uncertainty of the cash flows that are stochastic. The company is mainly deals with the “Foreign currency Forward Contracts”. A forward exchange contract (or forward contract) is a binding obligation to buy or sell a certain amount of foreign currency at a pre-agreed rate of exchange, on a certain future date. To take out a forward contract you need to advise us of the amount, the two currencies involved, the expiry date and whether you would like to buy or sell the currency. It can be possible to build in some flexibility to allow the purchase or sale of the currency between two pre-defined dates rather than a single maturity date. Consider a Forward contract where you agree on 1st of March to purchase EUR 1,000,000 on 1st of June at a price of F. The price of the deliverable asset for Spot Delivery would be SJune-1 at the maturity of the Contract. The pay off of the Contract at maturity is 1,000,000 (SJune-1 – F). To create a replicating portfolio for the forward contract, I’ve to purchase an asset on 1st of March that pays EUR 1,000,000 on 1st of June. I can purchase today an amount of EURO such that on 1st of June I’ve EUR 1,000,000 by buying EUR T-bills for a face value of EUR 1,000,000 maturing on 1st of June. The EUR T-bills maturing 1st of June must have equal value to the present value of the forward price.
The equation represents that the hedge ratio is one because the firm goes short one EURO forward for each EURO of exposure. The hedge ratio is the size of the hedge for a one-unit exposure to a risk factor. The key to pricing the Forward contract is that they can be replicated by the underlying asset and financing the purchase until the maturity of the contract. This allows the traders to price the contracts at arbitrage. This means that we can price a forward contract without having a clue as to the expected value of the underlying asset at maturity. To price a forward contract on a currency, we don’t need to know anything about the determinants of changes in the exchange rates. The Forward price depends upon: the interest rate that has to be paid to finance the purchase of the underlying asset; the cost to store it and the benefit from holding it.
The decision of going forward and place a forward contract hedging relies on two major factors: Trend line of the Exchange rate fluctuation or movement Cash flow of the Foreign currencies (i.e) Underlying asset To have reliable derivative instrument to protect the underlying asset from affecting the bottom line of the firm, we need to have a consistent and scientific way of structuring the cash flow through which it’s stochastic nature could be eliminated. The firm has a huge exposure and limitations on the reliability upon the formulation of cash flows as it involves various decisive factors. Some of them are: Approval of drawings and its documentation Approval/Passing of Quality check and the specifications of raw materials Delivery of the Product Submission of documents as per the contract.
Risk is costly to export onto the business. Consequently if hedging has no cost, the firm chooses it to minimize the risk. To determine whether and how to hedge the cash flow it is essential to measure Value at Risk (VaR), Cash Flow at Risk (CFaR) and Volatility, so that the firm can determine how much of that risk it wants to bear. We consider the risk-minimizing hedges of a foreign currency position when risk is measured by volatility, VaR and CFaR. Value at Risk measures the potential risk or loss anticipated (worst case scenario) on an investment or an asset or portfolio over a defined time period for a given level of confidence. The notion of the VAR is simple – the maximum sum that you can lose in any investment over a particular period with a specified probability. CFaR measures the expected maximum decrease in the expected cash flows resulting from the adverse movement of the market, over a defined period for a given confidence interval. To calculate CFaR the following steps are performed: Setting time horizon and confidence interval. Cash flow mapping. Identifying risk factors. Simulation of risk factors. Revaluation of cash flows. Constructing the probability distribution of cash flows. Reading the value of the particular quartile of the cash flow distribution based on the confidence level. There are different methodologies of calculating at-Risk measures: Variance-covariance methodology (delta-normal) Historical simulation Monte Carlo simulation (Being used to evaluate the risk) Volatility-minimizing hedge of cash position, when the returns are identically independently distributed: Cov [r(cash).r(hedge)] I Cash Position Var [r(hedge) This equation makes clear that the risk-minimizing hedge depends on the size of the cash position. As the cash position increases, the volatility-minimizing hedge involves a larger dollar amount short in the hedge instrument.
With the detailed study, it’s evident that the Forward Contract can have substantial default risk. As financing and storage become more expensive, the forward price increases compared to the current price of the underlying asset. But the systematic risk reduces the forward prices to compensate the financing and storage risk. The important factors to consider while entering into forward contract is that measurement of VaR, CFaR and the Volatility of the underlying asset and also the basis risk (I,e) the determination of relation between the forward price and the spot price. Apart from these the other important factor is the market condition which is the systematic risk, which plays a vital role in the decision making. So the firm has to always watchful to take right decision on right time about when to enter the market and when to exit the out the hedging position.
After the detailed review of the firm’s role play in the field of Cash flow hedging I found that there cash flows are stochastic and they could not capitalize on the due the various factors that had been listed out in Statement of Research Findings. There is no access provided in the measurement of VaR, CFaR and the volatility which is the most important criterions in deciding upon the hedging instrument. I find there is no much need as the firm opts only forward contracts and not any other hedging instrument. As mentioned earlier, there is no need to fear the risk if you make sure that hedge ratio does not fall beyond control. But in this case, I found that due the major deviation in the cash flows, the ratio could not be managed and the forward contract could not be replicated by an underlying asset to purchase at the time of maturity, which resulted in the ineffectiveness of the hedge.
Due to the lack of proper system, it is very difficult for the firm to have a control on the cash flows and to round up the problems that are resulting in the ineffective cash flow. As a result of this dissertation, it was evident that the firm has to improve the status of the cash flow to have efficient and effective decision making on selection of the hedge instrument. And the same has been recommended to the Company along with other considerations on measuring the risk related to the Cash flow and Volatility, so that the firm can find other better options of derivative instruments rather sticking onto the Forward Contract alone.
Counter Party Bank Trading Desks access Misys/CMS via Internet and provide confirmation of FX transaction details Bank trading Desks offer Forex Rates to the treasury via Telephone or Bloomberg Corporate or Other Subsidiary Treasury Treasury sends Transaction confirmation to the subsidiary Treasury reviews Misys/CMS for confirmation of FX transaction details Treasury contacts Banks for the quotes via Telephone or Bloomberg Treasury proceeds with the txn and loads details into quantum or Bloomberg loads quantum automatically Forex Txn details automatically gets loaded into Misys /CMS for matching & confirmation with Bank counterparties MISYS/CMS Quantum (Treasury Work Station) Subsidiary provides the Hedge request to the Treasury.
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