Comprehensive Report on Treasury and Risk Management Strategies

This report provides a comprehensive analysis of treasury and risk management strategies, focusing on a case study involving foreign exchange risk. It examines four primary hedging techniques: unhedged strategy, forward hedge strategy, money market hedge, and option hedge. The report calculates potential outcomes for each strategy, considering factors like interest rates and spot rates. It highlights the risks associated with each approach, such as transaction risk, counterparty risk, and the potential for loss. The analysis concludes by identifying the money market strategy as the optimal hedging approach based on the highest potential cash flow. The report references relevant literature to support its findings and provides a detailed comparison of the different strategies' effectiveness in mitigating financial risks.

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

Treasury, and Risk Management 4
Money market hedge faces similar risks to forward hedge strategy. However, the main risks
facing money market hedge are default risk, transactional risk, and counter-party risk
(Lakshman, 2009). The bank accepting deposits may go under hence exposing the deposit to
default risks. Besides, it may not be easy to get counter-party, if needed (Kaplan Financial
Knowledge Bank, 2012).
Money market hedge is the hedge against exposure resulting from foreign currency risks. The
risk is created by borrowing or fixing payments and receipts in domestic currency by depositing
an acceptable sum of money today. Since ABC Company is expected to receive a 50 million
Euro Payment, foreign currency receipt strategy of money market hedging is used. According to
the money Market strategy,
Foreign Loan=¿
Therefore, for ABC to apply money market Strategy, it will borrow Euro, convert the amount to
dollars, invest the dollars, and then repay Euro loan in one year.
Amount of Euro¿ borrow = P
(1+i )n = 50,000,000
( 1+0.02 )1 =50,000,000
1.02
¿ 49,019,607.84 euros
T h e amount borrowed ∈dollars , converted at spot rate ,=49,019,607.84∗1.10
¿ $ 53,921,568.63
For one year period, the interest rate in the United States is 5.5%. Investing the dollars in the
U.S, the accumulated amount at the end of one year is calculated as:

Treasury, and Risk Management 5
A=P ( 1+i ) n
A=$ 53,921,568.63 ( 1+0.055 )1
¿ $ 56,887,254.90
Thus using the money market hedging strategy, ABC will be worth $56,887,254.90 at the end of
the one year.
iv) Option Hedge
The main risk of option hedge strategy is the existence of probability of losing 100% premium
paid (Riehl, 2015). That is the uncertainty in option hedging potentially unlimited. Besides,
currency options can be illiquid hence making it difficult to convert to cash. Consequently, there
is a probability that this strategy may render ABC’s investment worthless (Walmsley, 2011).
ABC should purchase a one-year put option to hedge receivables. The given exercise is $1.11/$,
with one-year expiry. The following is the probability distribution of the United States Dollars to
be received in a one-year period:
Possible Spot
Rate in one year
(Forecasted spot
rate):
Premium per
dollar paid for
the option
Exercise Option
Alternative?
The amount
Received per unit
after accounting
for the premium.
The total amount
of dollars
acquired from
the conversion of
5000000 Euros.
1.13 $0.06 No ¿ 1.13−0.06
¿ $ 1.07
¿ $ 1.07∗50,000,000
¿ $ 53,500,000
Hence using put option hedging strategy gives an expected cash receipt of $53,500,000.

Treasury, and Risk Management 6
b) Optimal Hedge
Money market strategy is the optimal hedging strategy from the above four strategies.
Comparing the above four approaches, money market strategy provides the highest
amount of cash in one year.
Strategy Value of the Cash Flow
Un-hedged Strategy $ 55,000,000
Forward Hedge Strategy $56,500,000
Money Market Hedge $ 56,887,254.90
Option Hedge $53,500,000

Treasury, and Risk Management 7
References
Bollen, B., 2013. To hedge or not to hedge. [Online] Available at:
https://www.ft.com/content/5f33f404-953c-11e2-a151-00144feabdc0 [Accessed 18 September
2018].
Calverton Finance, 2015. Foreign Exchange Risks - The very basics. [Online] Available at:
https://www.calvertonfinance.co.uk/blog/foreign-exchange-risks---the-basics.html [Accessed 18
September 2018].
Kaplan Financial Knowledge Bank, 2012. Money Market Hedges. [Online] Available at:
http://kfknowledgebank.kaplan.co.uk/KFKB/Wiki%20Pages/Money%20Market
%20Hedges.aspx [Accessed 18 September 2018].
Lakshman, R., 2009. An Introduction to Foreign Exchange & Financial Risk Management. 1st
ed. Mumbai: Shroff Publishers and Distributors Pvt. Ltd.
Riehl, H., 2015. Managing Risk in the Foreign Exchange, Money and Derivative Markets. 3rd
ed. New York: McGraw-Hill Education.
Walmsley, J., 2011. International Money and Foreign Exchange Markets: An Introduction. New
York: Wiley.