Question

A UK power-generating company imports coal from Russia, purchasing the
coal in rubles. Coal prices are going through an unpredictable period and
prices are moving up and down on an irregular basis that doesn’t seem to
match the current winter season.
The UK also imports coal from the US and Colombia, so this would offer an
alternative for the company. The prices are more stable; however, transport
costs are would be a factor if the company switched suppliers.
Short term funds, of up to six months, are available from a UK bank at a cost
of 6% per annum. In Russia, a six-month commercial loan is available to
international clients (with an established office in the country) for 4% per
annum.
The US offers the possibility of borrowing at 3.5%, but the company does not
yet have an established office there. The rate is also linked to the US Treasury
bond rate, which has been increasing over the first few months of 2017.

1. Critically evaluate at least three of the various types of financial risk the
company is facing.

2.With reference to the risks identified in the previous question, critically
evaluate some of the various methods the company has available to it in
order to mitigate the risks.

Answer 1

Answer 1.

Three risk which company is facing.

a) Exchange risk:-

UK power-generating company imports coal from Russia, purchasing the coal in rubles. Coal prices are going through an unpredictable period and prices are moving up and down it means UK company is facing exchange risk.

Foreign-exchange risk refers to the potential loss from exposure to foreign exchange rate fluctuations while indulging in trade practices across borders.

b)Interest rate risk

Interest rate risk is the risk  that an unexpected change in interest rates will negatively affect the value of an investment and borrwing at higher rate will cost to company in terms of profit .

In the given situation UK power generating have short term funds of up to six months, are available from a UK bank at a cost of 6% per annum. In Russia, a six-month commercial loan is available to international clients (with an established office in the country) for 4% per annum.
The US offers the possibility of borrowing at 3.5%, but the company does not yet have an established office there. The rate is also linked to the US Treasury.Therefore UK power generating have to borrow at 6% among the alternatives which cost it more.

C) Interest rate risk

Liquidity risk is the risk that a company is unable to meet short term financial demands. In the above case its stated that "Short term funds, of up to six months, are available from a UK bank at a cost
of 6% per annum".So it the UK comapny is in liquidity risk .

Answer 2.Various methods to mitigate above risk

a) Forward contract

Currency forward contracts is used to mitigate exchange risk. A forward contract is an agreement between two parties to buy or sell a specific asset on a specific future date, at a specific price. These contracts can be used for speculation or hedging in foreign currency to take advantage of rise in price in international trade.

B)Mitigating liquidity risk

Identify the the risk earlier and continues monitoring on daily ,weekly as per convenience ,maintaing adequate working capital in advance are some of the measures to mitigate liquidity risk.UK Power generating must do weekly liquidity analysis.

C)Mitigating interest risk

Purchasing future contracts,Indulging in practices like interest rate swap ,are some of the method to mitigate fluctuations in interest and to maintain stable borrwing payments.An interest rate swap is a financial derivative that companies uses to exchange interest rate payments with each other.