Risk Management Framework Case Studies Example
Dear Marketing Department,
I am ecstatic to see the zeal and the effort you are putting in to find new products and purchase destinations for our company. I am also are that you have forwarded the request to purchase woolen sweaters from Kreploc, and also lucrative payment structure of 90 days offered by the supplier. However, for now, I have to reject the proposal because of significant exchange risk involved in the whole transaction. Since the supplier is based in an offshore country, we will have to make payment in Slobodian Blivit, transactional currency of Kreploc. I would also like to add that Slobodian Blivit tends to vary as much as 30% in a 90 day period, and will expose us to significant foreign exchange risk provided we do not enter into any hedging contract to hedge the exchange rate effectively.
Please consider the following hypothetical situation where I assume that we order 1 million woolen sweaters, and sell them each at $37 per unit. For now we are procuring them from our domestic supplier at the product cost of $18 and with additional cost of $17 per unit, we earn a profit of 40-(17+18)= $5/ unit. Now, Kreploc is ready to ship the product at $16 per unit, and with similar additional cost of $17 per unit, our profit will surge to 37-(14+17)= $6/ unit. However, the whole transaction is not easy as it seems on the surface. As I disclosed before, Slobodian Blivit is prone to fluctuate by as much as 30% over 90 days, and if at the time of payment, Blivit appreciates against US Dollars by 30%, we will have to pay 16(1.30)= $20.80 per unit and even with additional cost of $17 per unit in our factory, we will end up at loss of 37-(20.80+17)= $0.80 per unit, and $800000 on a million pieces, which we surely cannot afford to lose at all.
But, fortunately, we can mitigate the exchange risk through the following ways:
Pre-payment to Kreploc: If you are sure about the quality of the product, we can prepay Kreploc at the spot rate and avoid any exchange rate risk. Moreover, we can also ask for cash discounts from Kreploc as we will be avoiding the 90-day payment structure offered by them.
Derivative Instruments: There are many derivative instruments available in the exchange through which we hedge our exchange rate risk. We can consider taking up 90-day future delivery of Slobodian Blivt for the billed amount, but forwards are exposed to counterparty default risk. Hence, I suggest for 90-day future contracts of Slobodian Blivt as this derivative contract is free from an counterparty defualt risk and eventually we will be sure of at what rate we will be purchasing Slobodian Blivt to make final payment to Kreploc at the end of credit period.
While I appreciate your initiative in searching for new product opportunities, I think that our company needs to consider this opportunity only after it finds an effective way to hedge its foreign exchange risk against the Slobodian blivit.
Thank you for your suggestions over controlling the foreign exchange risk that our company is exposed to. Although, I do appreciate your effort and participation in this concern, but I suggest that your idea to mitigate the exchange rate risk by borrowing enough money from the bank to buy a six- month supply of foreign currency that it would keep in a safety deposit box until used we use it, is full of drawbacks. Here are the reasons that validate my argument:
At first, getting large sums of funds from bank and keeping it in safety box is full of risk. In addition, we have to spend a lot safeguarding the cash and accounting for it.
It will not be possible to send a thousand dollar payments daily to our suppliers that too in Europe and Far East. Not only this practice is illegal, it is also a case of money laundering. Furthermore, even if we convert them in cashier checks, or sending through money brokers, it will involve a lot of commission charges again.
Thus, considering the above situations, where may find ourselves with too much idle cash of one foreign currency on hand and too little of another; we will then face foreign exchange risks in the course of buying additional currency and lost interest on the cash sitting idle in the safe deposit box. Even if we consider your suggestion, the best way for us will be a little modification of your idea by opening several foreign-currency bank accounts and make payments accordingly as an when they become due. Thus, going through the conventional practices, we can draw checks and issue payments to our suppliers. But, my friend, while this process will mitigate the risks inherent in holding cash it may not mitigate foreign exchange risk if the exchange rate is unfavorable when we honor the payments to our suppliers. Hence, the best way for us is to use the following methods that will completely hedge our exchange risk:
i)Prepayment to suppliers:
This will be the safest method for us to mitigate the exchange risk. If our suppliers agree, we can make them prepayments for all our purchases on the spot rates. Thus, we will be locking our payment position and there will not be in any worries regarding future exchange rate and exchange losses. However, doing so, we may lose interest that we can earn during the credit period, but if manage to get the cash discount for advance payments from suppliers, this option seems most prudent to me.
ii) Forward Contracts:
Forwards are the derivative contracts through which we can lock-in the currency that we need to hedge, tailored to close to when we will need the money. Thus, at the time of expiry of forward contract we will liquidate our positions at the prices we set when we bought them and use the proceeds to buy the foreign currencies we need in order to pay our suppliers. However, the major disadvantage of forward contracts that we will be exposed to counterparty risk, and we will be left empty handed to accept the foreign exchange losses that can go up to millions.
Since we fear of the counter-party risk in the forward contracts, we might consider the organized derivative instruments, forward contracts. Futures trade on recognized exchanges, and are free from any counterparty risks. Thus, accordingly we can purchase currency futures for the suitable time period that aligns with our payment period. In addition, we can also buy currency future options as they offer more flexible terms that future contracts.
I hope that all the above discussion will be useful for you to understand the risk of foreign exchange trading, and how our company can mitigate it in much better manner than holding cash sum in our safety box
If the contingency turns true, and if the buyer company is unable to send payments to ABD owing to political restrictions, then the entity might end up losing all the cash flow from the transaction. If the country completely debars payment to the foreign investors, then the only way ABD company can expect a successful run is by asking for advance payment equivalent to the cost price of the project to be deposited with a banking or financial institution as escrow money. This will eventually put the company on the safer side of the transaction, as even if the buyers are unable to honor the payment owing to political restrictions, ABD can claim their cost price from the bank.
Forward Contracts. n.d. http://www.investopedia.com/terms/f/forwardcontract.asp. 17 April 2015.
Lander, Steve. How Do Companies Mitigate the Risk of Foreign Currency? n.d. http://smallbusiness.chron.com/companies-mitigate-risk-foreign-currency-73294.html. 17 April 2015.
Walker, Russel Smith and John. The illegal movement of cash and bearer negotiable instruments: Typologies and regulatory responses. n.d. http://www.aic.gov.au/publications/current%20series/tandi/401-420/tandi402.html. 17 April 2015.
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