Currency risks are threats that result from fluctuations in the relative estimation of currencies. These alterations can generate gains and losses when the revenues or dividends from an investment are changed from a foreign currency into U.S. dollars. Stockholders can diminish currency risk by using different hedging instruments and other methods intended to counterbalance any currency-related profits or losses. (Kuepper, 2017)
Starbucks Corporation, the American coffee company, admits in one of their latest annual reports that one of their inherent risks is the foreign currency exchange rate fluctuations. Starbucks accomplishes their exposure to market-based risks in accordance with a market price risk management policy. According to this policy, market-based risks are measured and appraised for possible mitigation strategies, like incoming into hedging transactions. The market price risk management policy rules how hedging instruments may be used to alleviate threats. Risk boundaries are fixed annually and ban the hypothetical trading activity. The main part of the revenue, expenses and capital purchasing activities are accomplished in U.S. dollars. However, because a part of their operations is outside the U.S., they also have transactions in different currencies such as CAD, Japanese yen, British pound, euro etc. In order to moderate cash flow unpredictability from foreign currency fluctuations, they use different instruments, such as forward and swap contracts, to hedge portions of cash flows of inventory acquisition, intercompany borrowing and lending activities etc. The subsequent table outlines the possible impact to Starbucks future net profits and other comprehensive income from fluctuations in the fair value of these derived financial tools due to a variation in the value of the U.S. dollar as compared to foreign exchange rates (in millions) (Starbucks, 2016):
Since most of the VS’s clients were from Canada, they paid for the packages in Canadian dollars, but all the hotels would accept payment only in U.S. dollars. Therefore, Voyage Soleil is subjected to Transaction Exposure and Operation Exposure.
Transaction exposure is the possibility of loss from a variation in exchange rates during the progression of a business contract. This exposure is resulting from fluctuations in foreign exchange rates amid the periods when a transaction is booked and when it is established. (AccountingTools, 2017)
Spot exchange rate
Euro-U.S. dollar interest rate
0.925 (for 6 months, 1.85 per year)
Six-months forward rate
Euro-Canadian dollar interest rate
1.35 (for 6 months, 2.70 per year)
In the VS case, they can either invest their money in the Canadian dollar market or in the U.S. dollar market. The calculations provided below show that investing in the Canadian dollar market will bring them 1,012,500 profit while investing in U.S. dollar market will produce 7,290,284.64 profit. In conclusion, the best option would be investing their sales revenues of 75,000,000 CAD in the U.S. dollar market. For the calculations the following numbers were used:
Operating exposure indicates the extent to which the company’s future cash flows become affected due to the variation in the foreign exchange rates alongside with price fluctuations. (Jargons) Below is presented a calculation for the baseline operating exposure. Unfortunately, the numbers are not accurate due to the fact that key information (such as operating expense, interest rate) is missing.
There are three main strategies used to hedge transaction risks. Based on the actual borrowing and lending rates these theories will be compared below.
The first theory is the unhedged position which basically means that you don’t do anything. Therefore, if the spot rate doesn’t change then the payment will be equal to 74,074,074.07 CAD (60,000,000 USD/0.81). If the CAD depreciates then the payment is going to be higher and respectively the payment is going to be lower if the CAD appreciates.
The second method is the forward market hedge. Firstly, the forward rate has to be calculated: Frate=1.2345*(1.0136)0.5/(1.0161)0.5=1.2329 (Research, 2018) (Bank of Canada, 2018). Consequently, 1.2329*60,000,000=73,978,823.42 CAD is the future payment.
The last theory is the money market hedge which means that you borrow money in CDA and invest them in USD. The 6-month euro-dollar deposit rate is 1.30 (Reserves, 2016) therefore, you need to invest 59,230,009.87 USD (60,000,000/1.013).Then you need to convert the money back into CAD 59,230,009.87/0,81=73,123,468.98 CAD. Lastly, 73,123,468.98*1.0075=73,671,895 is the amount of money you need to borrow in CAD in order to invest in USD. The unhedged position alternative and the money market hedge alternative have a higher risk that is why the optimal variant would be to engage in forward contracts.