Question

1) Explain how hedging may create value for a firm. How would a treasure determine whether or not to hedge, as well as the correct strategy to hedge FX risks

2) Explain how expected changes in FX rates affects a decision to invest or borrow abroad. Should the cash management function be centralized?  Explain the advantages and disadvantages of having a centralized cash management system.

Answer 1

1) Hedging is analogous to taking out an insurance policy.

If you own a car in a flood-prone area, you will want to protect that asset from the risk of flooding – to hedge it, in other words – by taking out flood insurance. In this example, you cannot prevent a flood, but you can work ahead of time to mitigate the dangers if and when a flood occurs

The most common way of hedging in the investment world is through derivatives.Derivatives are securities that move in correspondence to one or more underlying assets. They include options, swaps, futures and forward contracts. The underlying assets can be stocks, bonds, commodities, currencies, indices or interest rates. Derivatives can be effective hedges against their underlying assets, since the relationship between the two is more or less clearly defined. It’s possible to use derivatives to set up a trading strategy in which a loss for one investment is mitigated or offset by a gain in a comparable derivative.

Companies should hedge only exposures that pose a material risk to there financial health.

A high probability of cash shortfall given non discretionary cash requirement, such as cash requirement, such as debt obligations or maintenance capital expenditures.

An effective risk management program often includes a combination of financial hedging.

2)Transaction exposure. This arises from the effect that exchange rate fluctuations have on a company’s obligations to make or receive payments denominated in foreign currency. This type of exposure is short-term to medium-term in nature.Translation exposure. This exposure arises from the effect of currency fluctuations on a company’s consolidated financial statements, particularly when it has foreign subsidiaries. This type of exposure is medium-term to long-term.Economic (or operating) exposure. This is lesser-known than the previous two, but is a significant risk nevertheless. It is caused by the effect of unexpected currency fluctuations on a company’s future cash flows and market value, and is long-term in nature. The impact can be substantial, as unanticipated exchange rate changes can greatly affect a company’s competitive position, even if it does not operate or sell overseas. For example, a U.S. furniture manufacturer who only sells locally still has to contend with imports from Asia and Europe, which may get cheaper and thus more competitive if the dollar strengthens markedly

Note that economic exposure deals with unexpected changes in exchange rates – which by definition are impossible to predict – since a company’s management bases their budgets and forecasts on certain assumptions, which represents their expected change in currency rates. In addition, while transaction and translation exposure can be accurately estimated and therefore hedged, economic exposure is difficult to quantify precisely and as a result is challenging to hedge

Advantages of having a centralized cash management system as

1. The corporation can manage with smaller amount of cash , each operations will maintain transaction balances.
2. By reducing total assets, profitability is enhanced and financial cost reduced.
3. All decision can be made using the overall corporate benefit.
4. Great expertise in cash and portfolio management exists if one group is responsible for this.

Disadvantages of having a centralized cash management system

1. Defining the different available payment channels
2. Analysis the different payment channels
3. To select the most effective methods of payment which can vary by country and customer
4. Giving specific instructions regarding procedure to the firm's customer and banks
5. They have to keep balance act to holding onto funds versus staying good terms with suppliers .