Foreign Exchange Risk Assessment and Hedging Strategies Report

This report delves into the intricacies of foreign exchange risk, focusing on the exposure faced by a parent company importing from a subsidiary. It explores various hedging techniques, including forward contracts, futures, and options, providing detailed explanations and calculations. The report also examines the factors determining option prices and illustrates how options can be used to hedge currency risk. Furthermore, it analyzes value-at-risk (VaR) as a risk management method, discussing its strengths and limitations. Finally, the report investigates methods banks use to assess credit quality and manage credit exposures for both international bond issuers and small domestic retailers, providing a comprehensive overview of financial risk management strategies.

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Topic
EMA

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Index
Question No. Page No.
Question 1...................................................................... 2
Question 2...................................................................... 5
Question 3...................................................................... 5
Question 4...................................................................... 6
Question 5...................................................................... 8
References..................................................................... 10

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Question
1.)
i) What types of foreign exchange risk is the parent company exposed to and in what
ways can it hedge these risks? (12 marks)
Answer:
Suppose the parent firm buys (imports) from subsidiary firm located in Austria, and parent
company’s accounts payable are denominated in Euros. The current dollar–euro rate as $1.25,
but suppose that each day the dollar depreciates. Assume an exchange rate of $1.31 a month
from now, when you make your payment. In this way instead of paying $1.25 for every Euro,
the importer will have to pay 1.31.dollar for every Euro (WealthHow. 2018).
Hence, importer incurred loss of $ 1.31- $1.25 = $ 0.06 per Euro.
Exchange rate hedging can be done in following ways:
a) Forwards:
Informal way of hedging traded over the counter. Forward contracts specify an
amount, exchange rate and date for a currency exchange between two parties. It
permits participating player to wind-up the contact at prevailing prices. It does not
associate any cost; however, there is all the time an issue of compliance by any of the
two parties involved in contract.
Consider a case, where Japanese is selling camera to an Indian buyer and will ship
monthly for a year. They sign a forward stating that the buyer will pay at the end of
the year at today's exchange rate. Any changes in the exchange rate will not change
the contract guarantees that the buyer will still spend the same amount of yen and the
company will still receive the same amount of rupee.
b) Futures:
Formalised way of hedging traded in more formalised market. Futures contracts are
financial instruments with conditions for a currency exchange, including the amount,
rate and expiry date. Futures eliminate the non-compliance risk, like in forwards, so
they are common when there are credit risks. But it is only available in major
currencies of the world. By selling futures, investors might hedge currencies falling
value. By buying futures, they hedge currencies increasing value.
c) Option:
Give buyer right to buy or sell but not obligation. An options contract is an agreement
between a buyer and seller that gives the buyer of the option the right to buy or sell a
particular asset at a later date at an agreed price. Options contracts are often used in
all types of financial instruments mainly for the hedging purpose.
d) SWAPS:
In brief, currency swapping between two parties with interest rate is called Swaps.
Swaps are contracts between two parties that need foreign currency, but don't want to
borrow from a foreign bank.

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What will be the type and strategy of currency hedging will be decided as per the
expectations and requirements of the importer. If importer does not need very fixed or rigid
type of strategy, he may go for swaps and options. Whereas, if both parties are familiar to
each other they may wanted to go for forward contracts as per both parties requirements and
suitability. Just opposite to forward, future contracts are more formal in nature, because,
future contract is very regulated and standardised kind of hedging strategy than forward.
ii. Using the forward margin methodology, calculate what rate of exchange between
EUR and USD the parent company could hedge the exposure arising from the
commitment of the parent company to pay EUR 100m in 6 months’ time. For this
question the ‘base’ currency is the EUR and the ‘terms’ currency is the USD. Note that
both currencies use a 360-day convention for one year. (4 marks)
Answer:
Forward Margin =
(Spot rate * forward period in days * difference in interest) / (100 * no. of days in year)
After putting data from given question answer will be
Forward margin = 0.005
They could hedge 0.005 cent above the given rate.
That is, Eur 1 = USD 1.3
iii. Define the factors determining the prices of the options. (6 marks)
Answer:
Factor which decides the pricing of option are as given below:
Volatility in Option and Pricing:
Volatility is inherent feature of market any expected news, news, or any fear factor causes
premium to rise or cause the effect in rise of premium of option (Singh, 2019).
Underlying prices of Currency:
Any change in underlying prices of security, changes the premium of call or put option. If
security prices rises call premium rises same way a fall in security price could lead to fall in
premium of put option.
Strike Price of option

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In deciding option prices it is seen that how far strike price is from current market price (Spot
price), if it is very far from current market price option premium will be very low. If strike
price is very near to spot price premium will be very high.
Contract duration and option price:
Option has fixed time to executive the contract, if someone bought the option in beginning of
contract, it will have higher premium, if option is bought very near to ending date of option
contract it will have very low premium, Option premium decided based concept of time
decay. If time left in contract is very less very strike price has almost no value that is why
premium will very low.
Interest rate:
Interest rate only has importance in deciding interest of carrying forward trade and cost of
interest rate of that period.
Intrinsic value:
Intrinsic value is decided based on concept of In the Money, Out of the Money and At the
money concept. If strike price of a call option is below current market price, it will called In
the Money call option, if call option strike price is far away from current market price of
underlying price of stock, it will be called as Out of the Money Option. Similarly, if strike
price and current price are the same, option will be called as At the Money Option. Option
premium depend upon all the three factors equally. Basically, option prices decoded on above
factors and option premium vary as per the changes in all the mentioned factors.
iv. Explain how the parent company could hedge its foreign currency risk using options.
You are required to:
o select the appropriate options contract from those shown
Answer:
Parent company can buy Put option since parent company is importer from Austria
and have to pay in Euro.
o explain the reason for difference in the prices of the two options contracts
Answer:
Option premium are calculated based on risk and implied volatility (IV) basis, higher
the risk and volatility higher the premium.
o Show, and explain, using pay-off diagrams, how the option you select would perform
given changes in exchange rates from EUR 0.5 = USD 1 to EUR 1.4 = USD 1.

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o under what circumstances would it be rational for ABC’s parent company to use
options rather than the forward foreign exchange market to hedge its exposure to the
EUR 100m payment? (8 marks)
Answer:
Option has limited risk, only upto premium paid but has unlimited gain, no upper
limit to gain, like loss. That is why; it is preferred as currency hedging.
Question
2.
Answer:
i) To enter into contract under FRA Contract Company will pay to bank Euro 286000.
ii) Bling could hedge by selling interest rate future at 98.1 on 1 June and buy this
STIR in Dec 97.64, which will give profit of 98.1 - 97.64 = 0.46
= 1000000*0.46% = 46000
iii) The price of STIR on December 1 = 97.64
iv) It does not provide perfect hedging to Bling because it only for Short term Interest
rate future
v) Advantage of using STIR over FRAs is STIR is more formal kind of arrangement
with standard rule and regulation, whereas, FRAs are over the counter two party
arrangement and there is risk of not fulfilling the arrangement by any one or both the
parties, after completion of the period, which is not possible in future contract.
Question
3.
critically review value-at-risk (VaR) as a method for measuring and managing risk. You
should do this by applying the following framework:
i. What is the purpose of VaR? (2 marks)
Answer:
Main purpose of value at risk is the knowing your maximum loss in one day, one week, one
month or even a year. It is generally given as percentage wise like maximum loss in one
day/week/month/year will 5%.
In other way it is, also like saying that in single day your losses can be (5%) Rs. 5000/ or
more has just 5% chances. Or, that, 95% confidentiality of minimising your losses upto just
Rs. 5000 (5%) in a given time period.

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ii. What are the strengths of VaR? (3 marks)
Answer:
It gives a single figure to your potential losses. Its main strength is, it tells you that, how
much risk you can able to take and trade accordingly or put your stop loss at that point as per
percentage Value of risk. It can save you from big losses and help you to remaining the
market.
iii. What are the limitations of VaR? (10 marks)
Answer:
VAR fail to quantify the maximum value of risk, suppose if losses go beyond 5% how much
it can/may fall maximum. If losses fall beyond 5% how much it can fall it fail to quantify.
This is biggest limitation of Value at Risk (VaR) method (YouTube. 2015).
VAR is based on historical numbers it does not take into account forward looking number or
what would happen in future.
It required having enough data to calculate Value at Risk, if data is not enough it is very
difficult to estimate or may go even wrong the predicted value (Value at Risk, 2019).
VaR can restrict your losses to a certain limit but it cannot help you immediately in
identifying risky holding.
Question
4.
Explain the different methods a bank could use to assess the credit quality of, and
manage credit exposures to, the following organisations:
i. A corporation with an active presence as a bond issuer in the international financial
markets. (10 marks)
Answer:
Banks follows following methods before granting any credit to bond issuer in
international market:
 Assessing Bond issuers capacity to repay its loan on time or fulfil its obligation
towards his investor as per given date and time.
 Quality of credit also depends upon the individual issuer or portfolio of bond and the
risk assigned to them depending upon level of risk.

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 Bank must also see the rating assigned to the bond issuer and what type rating is given
to that particular issuer before granting any credit.
 Past credit history/risk also needs to be look at before sanctioning loan or credit.
 Bond issuer presence in international market, mean, since how long this bond issuer
are involved in this business.
 What is the present liability of that bond issuer, if he has already big debt in his
balance sheet or no debt, decide the quality and also can manage it exposure
accordingly.
 Credit rating agency, who assigned the rating, his credibility in market, does rating
agency has credible past or very dubious.
 Credit exposure is consider to be total granted short and long term debt by a bank to
various organisation/Company.
 Current liability and current asset ratio
 Assigned credit rating also play major role in granting credit exposure to a company.
 Generally, big international financial company has sound financial position; get
higher priority in bank’s credit exposure (Economictimes.indiatimes.com. 2019).
ii. A small high-street retailing company trading in only the domestic market. (10
marks)
Answer:
Any Banks grant credit to small retail domestic company based on following criteria:
 Its present liability, if any
 Retail company’s business history and its past performance
 Retail business location and associated business risk
 What is the company’s credit rating, if company assigned, any
 Future prospects of his company in terms of business’ performance
 Past liability and its service of its past liability
 Liquidity ratio of company, how liquid is its balance sheet?
 Banks’ generally grant maximum credit whose credit rating is very high and avoid
giving credit to low Credit Rating Company.
 Sometimes, bank takes pre-emptive measures to avoid credit exposure, in case of
potential losses in a credit.
 Pre-defined limit for various organisations for granting loan
 Company can also hedge the credit exposure by various method of hedging, like
option, swaps, forward and future, depending upon the circumstance sand
requirements (Economictimes.indiatimes.com. 2019).
Above given measure are some of the important steps that bank generally take to assess the
credit quality and exposure limit to both type of organisation, big at international level and
small company at national level. But, it would be prudent to think that above adopted
measures company to company.

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Question
5.
Review the sections of Unilever’s Annual Report and Accounts 2017 that focus on risk
management and assess its overall risk management processes.
i. What do you see as the strengths and weaknesses in Unilever’s risk management
processes?
(15 marks)
Answer:
Unilever strength is that it has very effective management system in place to deal effectively
with any short of crisis arising out of at any stage of its business. Whether it is operation,
planning, strategy formulation, marketing or any issue related to inventory pile up, shortage
of raw material, currency hedging, etc it has team in standby mode to effectively take action
and mitigate the problem than and there itself. So it biggest strength is, it has very strong and
capable expert are in place to deal with any emergency crisis in organisation (Unilever.com.
2018).
Unilever has weakness in it risk management team as well like its Brand Equity in recent
years has put into real test. With ever changing technology and it impact on business
operation is becoming challenging day by day. Consumer trends are also changing very fast
and it will be challenge to not let it affect the business of company with proper risk
management.
With advent of e-commerce business, it is posing challenge to Unilever. With many online
business are coming up it will be challenge to devise effective strategy to counter it. It will be
challenge for Unilever to accept this challenge and continue to maintain its customer base as
it is.
With growing number of cybercrime and cyber attack, it will be prudent for Unilever
management to take proactive steps and deal with this ever growing challenge and devise risk
management strategy in advance.
It is always challenging to meet your shareholder expectation and generate good return on
their investment so that their faith in company remain intact as always and do not allow them
to leave the company. To meet this challenges top management have to maintain its strong
earnings Quarter on Quarter and Year on Year, so that all the stakeholders’ faith should
remain intact in company’s business.
ii. Explain whether, in your view, Unilever practices enterprise risk management
(ERM). (10 marks)
Answer:
Unilever not only practice enterprise risk management but it also has very established and
sound system to implement it effectively in its organisation. Unilever has very robust risk

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management system at every level of its operation from planning to marketing, operation,
finance, sales in place. Unilever operates battery of expert under its various head to take
prompt action at any stage of it operation and mitigate the risk with effective strategy without
any delay. It has a very wide range of processes in place to conduct study on climate change
and its effects, sustainable development, carbon emission and take effective steps with
proactive strategy to control it with the help of all concerned stakeholders. Risk management
is integrated into each and every stage of business and it perform its operation and keep
watch on all activities and take centralised action with the help of concerned team member.
All the system are effectively formalised in organisation to deal with any short of eventuality.
All the systems have proper check and balances in every state which centralised and
automated into transactional and automotive information in technologically advance system
(Unilever.com. 2018).
Unilever Boards assume overall responsibility to manage risk with utmost accountability. It
has clear organisation structure to deal with any risk in system, whether it si short term,
medium term or long term. Distributions of accountability are in place in each of the country
of its operation, so that prompt actions whenever require is taken to mitigate the risk.
In conclusion, it can be said that Unilever, do all the required things, which can be expected
from a world class company to minimize risk and enhance the wealth of company as well as
investors. It has own set of measure to mitigate risk by it quick action team and with adoption
of latest technologies and with the help of world class expert. They never take anything for
granted and perform the required measures as and when required. Unilever has world class
expert to handle these kind of issue so that loss can be minimize and reputation of company
kept as ever before. And any also can be avoided at any cost, so that investors and all others
stakeholders stakes can be taken care of. Unilever is spread over many countries of world and
basically involved in making Fast moving consumers Good (FMCG), which is link directly to
human kind wellbeings and any issues directly or indirectly related to the product can give
bad name to company and severely dent its position in the market in comparison to its rival
companies. To address this issue as well, Unilever has expert team to monitor the quality of
product and how its meet the prescribed standard of quality of world level and as per given
local market condition and regulation as well. They have expert of well versed with local
policy and regulation and act as per the situation required and take remedial measure as
quickly as possible. Unilever is known for assessing risk and take measure in advance to
mitigate the risk as earliest possible to avoid any major loss of life or property.
References

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Economictimes.indiatimes.com. (2019). Hindustan Unilever Competitors List - Compare Hindustan
Unilever Quotes - The Economic Times. [online] Available at:
https://economictimes.indiatimes.com/hindustan-unilever-ltd/quotecompare/companyid-13616.cms
[Accessed 23 Sep. 2019].
Singh, B. (2019). Factors Affecting Option Prices - TradingTechnicals. [online] TradingTechnicals.
Available at: https://www.tradethetechnicals.com/option-pricing-the-factors-affecting-option-prices/
[Accessed 23 Sep. 2019].
Unilever.com. (2018). Annual Report. [online] Available at:
https://www.unilever.com/Images/unilever-annual-report-and-accounts-2018_tcm244-534881_en.pdf
[Accessed 23 Sep. 2019].
Value at Risk: Monte Carlo Simulation. (2019). Strengths, Weaknesses, and Applications. [online]
Available at: https://valueatrisk.weebly.com/strengths-weaknesses-and-applications.html [Accessed
23 Sep. 2019].
WealthHow. (2018). Currency Hedging by Importers. [online] Available at:
https://wealthhow.com/currency-hedging-for-importers [Accessed 22 Sep. 2019].
YouTube. (2015). 2015 - FRM : VAR Methods Part I. [online] Available at:
https://www.youtube.com/watch?v=y88vSlGgDaU [Accessed 23 Sep. 2019].