DERIVATIVES AND RISK

Derivatives and Risk

Derivatives and Risk

Question 1

a) All organizations that invest in like Green Plc, sell into or source from economies which have a currency other than their domestic currency will be exposed to foreign currency (FX) risk. There are main types of FX risk namely:

Translation - Impairment in Balance Sheet value of foreign assets/investments between year-end dates due to adverse foreign exchange rate movements. Translation risk is an accounting risk, proportional to the amount of assets held in foreign currencies. Changes in the exchange rate over time will render a report inaccurate, and so assets are usually balanced by borrowings in that currency. The exchange risk associated with a foreign denominated instrument is a key element in foreign investment. This risk flows from differential monetary policy and growth in real productivity, which results in differential inflation rates.

Transaction - Transaction impairment as a result of adverse foreign exchange rate movements between the date of inception and completion. When a firm conducts transactions in different currencies, it exposes itself to risk. The risk arises because currencies may move in relation to each other. If a firm is buying and selling in different currencies, then revenue and costs can move upwards or downwards as exchange rates between currencies change. If a firm has borrowed funds in a different currency, the repayments on the debt could change or, if the firm has invested overseas, the returns on investment may alter with exchange rate movements — this is usually known as foreign currency exposure. Currency risk exists regardless of whether funds are invested domestically or abroad. If investment in the home country and home currency devalues, investor will loose money. Any and all stock market investments are subject to currency risk, regardless of the nationality of the investor or the investment, and whether they are the same or different. The only way to avoid currency risk is to invest in commodities, which hold value independent of any monetary system.

Economic - Broad risk of reduced international competitiveness on which foreign exchange rates can impact significantly. Economic risks can be manifested in lower incomes or higher expenditures than expected. The causes can be many, for instance, the hike in the price for raw materials, the lapsing of deadlines for construction of a new operating facility, disruptions in a production process, emergence of a serious competitor on the market, the loss of key personnel, the change of a political regime, or natural disasters.

b) Hedging is necessary for companies such as Green Plc. Green Plc should review its policy. The company must analyze each transaction on an individual basis. For transactions that may be subject to high volatility, it is reasonable to hedge a percentage of the nominal amount of the transaction. The current policy of hedging does account for the instability in the calculations, which will be insured. A mechanism for hedging volatile currencies such high guarantees that the company is not losing money. This policy should be changed the balance of the net impact evaluation ...