Treasury and Risk Management: Risks and Optimal Hedge Strategies

Treasury, and Risk Management 1
Treasury and Risk Management
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Treasury, and Risk Management 2
Treasury and Risk Management
a) Risks and Estimated Dollar Cash Flows
i) Un-hedged Strategy
There are a number of risks that un-hedged strategy is exposed to. In fact, the un-hedged strategy
is exposed to all four significant risks in the foreign exchange market. These include leverage
risk, Interest rate risks, Transaction risks, counterparty risks, and country risks (Calverton
Finance, 2015). For example, transaction risk can affect the amount ABC receives if the
exchange rate between Euro and dollar will occur before one year elapses (Bollen, 2013).
T h e Spot Rate of t h e Euro as of today=$ 1.10
T h e amount Receivable∈Euro∈one year=50,000,000 Euro
Let ih ,∧if be t h e interest rate∈t h e United States ,∧t h e eurozone ,respectively .T h erefore ,
if =2 %
ih=5.5 %
Assuming t h at Interest Rate Parity ∃, t h en according ¿t h e Interest Rate Parity T h eory ,
One− year Forward Rate= ( Spot Rate )∗1+ ih
1+if
¿ 1.10∗1+0.055
1+0.02
¿ 1.10∗1.055
1.02

Treasury, and Risk Management 3
¿ $ 1.1377
However , t h e given spot rate=1.1
Consequently, the expected amount from the receivables with un-hedged strategy will be given
by:
50000000∗1.10=$ 55,000,000
ii) Forward hedge Strategy
The main risk facing Forward Hedge Strategy is counterparty risk, default risk (Walmsley,
2011). In case counter-party is needed, it may be difficult to find a suitable counter-party to buy
the contract. Additionally, financially, there is always the likelihood of default. Therefore, in
case the issuer of the contract is unable to meet the obligations of the contract, then ABC might
suffer a loss due to default risk (Riehl, 2015).
Forward hedge strategy us the same as the market hedge if the Interest Rate Parity exists, and
ABC bank does not incur commission costs. This is a result of interest rate differential between
the Euro and Dollar being reflected by the forward premium on the forward rate of Euros.
However, assuming that ABC does not satisfy Interest Rate Parity,
T h e value of t h e receipt after one year =Receibales∗1− year forward rate
¿ 50000000∗1.13
¿ $ 56,500,000
iii) Money Market Hedge