Management of Foreign Exchange Risk

Introduction

There are three major types of foreign exchange risks namely transactional, translational, and economic uncertainty. The commonwealth bank of Australia is an international firm with businesses interest in Asia, Britain, Asia, and New Zealand.  Therefore, the bank will experience any of the three risks during its operations. The transactional risk is common during importing and exporting activities (Papaioannou, 2006). It occurs when a currency exchange rate changes between the date of making a transaction and final period of settlement. The translational cost is also, common because the bank operates in foreign markets hence, it assets and liabilities are in a   foreign currency. Therefore, a shift in the exchange rate of the foreign currency against the local is a risk for the company. Finally, unexpected change of exchange rates affects the future cash flows and expenditures of the commonwealth bank of Australia subsidiaries operating abroad thus posing economic risks for the firms. The Common Wealth bank of Australia utilises different hedging strategies to reduce the various currency risks effectively.

This paper evaluates how the Commonwealth Bank of Australia manages the foreign exchange rate risks and the effectiveness of the risk control techniques. The article also compares the current risk management plan of commonwealth bank to other methods of controlling foreign exchange risks. It also highlights the significant factors to consider when deciding on how to manage risk.

Demonstrate a detailed understanding of foreign risk management

The objective of implementing foreign exchange risk management is to reduce potential currency losses, which occurs because currencies are volatile.  There are numerous ways of managing foreign exchange risk and are applicable dependent on an organisation preference of management technique and also, the size of the firm.

Methods of managing transactional risk

Forward contracts

The company engaging in the contracts consents to either receive or pay a fixed sum of foreign currency at a specified date in future. When the firm becomes a party to the agreement, it means that they know the future value of their asset or liability. Consequently, a change in the exchange rates never affects the value of their contract (Graham, 2014).

Future contracts

The future contracts can be exchange-traded and have unique features which also, make them useful in safeguarding against foreign exchange risk. The characteristics of the future contract are they occur in standard contract sizes, and also, have maturity dates. The futures contracts also trade in the secondary market thus there is a broader market for trading (Jacque, 2013). Firms can close their position when the timing of the deal fails to match the exposure to currency fluctuations.

Money Market Hedge

The technique is popularly termed as a synthetic forward contract. The method is based on the concept of covered interest uniformity. Therefore, the forward price is equivalent to the present exchange rate multiplied by the riskless return ratio of the two currencies. The technique is a form of funding the foreign exchange transaction. Employing the method enables a firm that agrees to pay to determine both the present value of the international currency and convert it accurately to a home currency based on the current spot exchange rate.  The technique eliminates exchange risks present in the money market. Also, when a firm is to receive payment in foreign currency at a future date, then it calculates the current value of international receipt and borrows a similar amount in foreign currency. The organisation then converts into its local currency at the current exchange rate. The company can also, use the international receipt to pay off high-value debt or obtain financing (Papaioannou, 2006).

Options

Options give an individual the right but not an obligation to trade the domestic currency for the foreign money in a given amount over a specified duration. The average rate option is important for eliminating foreign exchange risks. The payoff price of the option is the average spot price of the currency during the lifetime of the contract. Option financial instruments are suitable, for firms with a significant flow of income in particular currency over a long period. A single average rate option helps hedge a considerable number of cash flows.

The firms also, use the basket rate option, its calculation is getting the weighted average of currencies which are consistent with the transaction trend. The imperfect correlation between currencies reduces the volatility of the exchange rates, and the option is affordable. A firm can diversify in currencies as a method of risk management.

Leading and lagging

A firm can engage in a business transaction at those times when the foreign exchange rate favours their performance. For instance, a firm can opt to pay off it`s foreign currency liabilities when the foreign currency is beginning to appreciate. Also, the company can wait until the spot rate increase before collecting it debts (Graham, 2014). When the foreign currency is depreciating the firm can collect it obligations while waiting for further depreciation to pay off its creditors.

Risk Shifting

A firm can opt to invoice all its transaction in its domestic currency thus eliminating the foreign exchange risk.

Methods of managing economic exposure

Managing a firms’ debt denomination

Firms can manage their economic risks by evaluating the currency denomination of its debt.  The firm should strive to match the firms’ foreign currency inflows to its foreign currency outflow.  The firm must also ensure that part of it long term debt is in a foreign currency denomination to reduce it payment when there is a decline in the foreign currency value (Graham, 2014).

Swaps

Also, firms can manage economic exposure through exchanges. Swaps refer to a financial instrument allowing the buyer to change one group of cash flows for another set of cash flow statement (Jacque, 2013). The most common transactions are interest rate swaps and entail a firm agreeing to pay the floating rate over a given period based on the decided principal. The firm receives a fixed charge on the principal amount over a similar period. The present value of both the receipts and the payment is alike.

Currency swap allows a firm to use either fixed or floating interest rates to manage economic exposure.  The fixed currency swaps are common and entail a fixed rate of one currency being the exchange percentage for another bill. The principal amounts of the two currencies are equal value to the spot rate. When a swap is complete, the principal amount is swapped back.

Market selection

Companies should pull out of markets that are operating at losses due to the appreciation of exchange rates. The firms should, however, pursue markets that have a depreciating exchange rate because their products will be cheaper for consumers.

The key factors to address when managing risk

Financial implications

The risk management team must address the financial risk that comes along with the different alternatives available for managing foreign currency risks. The company must ensure that the alternatives they consider are from a credible source so that the financial exposure is correct. Addressing financial risk minimizes the losses the firm faces when the technique fails to achieve it intended objective.

Strategic compatibility

The company must ensure that its desirable technique of controlling the adverse effect of exchange rate depreciation is consistent with the overall vision of the company. When the style of controlling risk supports the objectives of an organization the company achieves both its long term and short-term goals.

Compatibility with operational-technical risk

The risk management team should suggest alternatives that reduce disruptions of the routine operation of business. Such methods ensure that the firm avoids incurring other expenses trying to replace the resources spent of the risk management process. Demonstrate foreign currency Risk management process of Commonwealth Bank of Australia. The collective wealth Bank of Australia engages in different business in Australia and around the world. Therefore, it faces many risks which the risk management handles by first identifying, then carry out an assessment and report threats to facilitate making decisions that guarantee optimum returns for the firm. The risk management process involves two significant steps namely risk profiling and hedging.

Risk Profiling

Risk profiling entails engaging in the four activities discussed below.

Listing of all risk the business is likely to face

The firm’s risk management team identifies all the challenges the company will experience because of a change in foreign exchange rate. A list f common difficulties firm will face consist of pricing challenges due to changing exchange rate, constant revision of promotion strategies, and scrutiny by regulatory bodies over misunderstanding resulting from adopting techniques to reduce foreign exchange risk exposure. The list of challenges for commonwealth bank is numerous because of its international presence and diversified products (Pompella & Scordis, 2017).

Categorisation of risks

The risk management team then groups the listed challenges into broader categories. Typical categories for foreign exchange risk are an economical and transactional risk (Papaioannou, 2006). Grouping of the problems a firm is likely to experience makes the challenges manageable.

Measuring the extent to which the Commonwealth bank exposure to each risk. The risk management group considers what areas each risk effects, for instance, the earnings of a firm or the firm’s value. It is simple to calculate the results of the exchange rate shift on the gains of commonwealth bank when compared to the effects of the rate on the worth of the firm. The Commonwealth Bank of Australia can use either the qualitative or quantitative technique to measure risk exposure. Qualitative measurement of risk happens when risk assessment happens for strategic analysis (Zhao & Huchzermeier, 2018). The result of using the method reveals a firm vulnerability to exchange rate movement. Some of the subjective scales contain three levels namely low, average and high impact levels.

Quantitative measurement is also, used at universal wealth bank of Australia when the earnings of the company continue to change because of a shift in the foreign exchange. The method entails looking at the past financial statement, determining how much they have changed about exchange rates. The company also evaluates how firms within the financial service industry have their performance affected by the exchange rates (Banasiewicz, 2014). Analysis of related firms improves the credibility of how much exchange rate affects Commonwealth bank performance.

Risk analysis

The step entails weighing the different approaches the firm can employ to manage the different types of risk. The risk management team considers the economic, organisational, and financial feasibility of each possible decision.

Hedging

Commonwealth decision to hedge or avoid different hedging risk considers the issues listed below.

Cost of hedging

Hedging brings creates implicit costs, explicit costs, and distress cost. The commonwealth bank continuously explores the hedging method of using single currency in different geographic regions to reduce inherent cost. The technique also reduces default payments because of an increase in the exchange rate (Bychuk & Haughey, 2011). Further, the bank ensures it employs hedging methods that have a minimum protection charge.

The company also prefers the hedging techniques that bring along benefits such as tax credits (Deventer, Imai& Mesler, 2013). An effective risk management instrument should reduce the probability of the bank experiencing a distress call. Finally, the hedging technique should have informational benefits on the investor.

Advantages and disadvantages of Commonwealth risk management process

Benefits of the method

The bank employs a comprehensive strategy when deciding on how to bear risks. An In-depth analysis ensures that the policy the firm chooses to use is productive in the long run. Further, the quantitative evaluation of risks eliminates any bias that the risk management team has when selecting on the suggestions to present to the board (Banasiewicz, 2014). The management process also improves another aspect of business such as the debt ratio while reducing exposure to the exchange rate shift.

The disadvantage of the risk management technique

The method requires much time to implement yet the foreign exchange rate is highly volatile. Therefore, the rigidity of the risk analysis process can result in opportunity cost when the exchange rates suddenly become favorable for business in the short run.

Evaluate the efficiency of the risk management process

The company continues to increase the value of the shareholder’s wealth while maximising the level of customer satisfaction. The dividend rate per share in the financial year 2017/2018 was $4.29 increase from 4.20 dollars in the previous fiscal year (Livingstone & Nevran, 2017). An increase in the company’s earning facilitated the rise in dividend payment for the shareholders. An increase in revenue was possible because of the company’s risk management process that minimizes exposure to exchange rate risk. The institution also continues to sell financial instruments like the blockchain bonds, which are subject to exchange rate fluctuation. The tendency of regulatory agencies such as World Bank to allow the firm sells new financial means that the company risk management process is effective against exchange rate fluctuation (Navatra, 2018). The efficiency ratio for the financial year of 2017/2018 declined from 42.4 percent to 41.8 percent.

The reduction in the rate is an indicator of the need to review the risk management process. The review should help identify loopholes that increase the firm’s exposure to changes foreign exchange rates. The company must also, eliminate frauds that occur due to change in the foreign exchange rates, for instance, the regulatory body in Australia is investigating the bank for manipulating the bank bill swipe rate three times in 2012. The rate is essential for determining the interest rate to charge financial products like loans, currency derivatives, and also issuing bonds. Illegal methods of hedging risk increase the cost of risk management as firms end up paying hefty fines and also, exposing their trade secrets in public. Therefore, the company must review and hedging strategy to ensure it legal to improve on it efficiency.

A detailed comparison of the current risk management techniques with alternative methods

Financial techniques of managing risks

The Commonwealth Bank of Australia relies heavily on derivative to manage foreign exchange risk. The financial derivatives are useful in controlling the foreign currency risks but also expose the firm to severe risk if done wrong. The benefits of financial hedging are improving the business cash flow of the company (Deventer, Imai& Mesler, 2013). Firms that use derivatives significantly enjoy tax benefits because of the consistency of earnings over time.

Operational methods of managing risks

The commonwealth bank of Australia fails to employ the functional technique of managing foreign currency risk significantly. Operational methods of managing risks involve using promotional strategies in those regions that are performing well because the consumers are likely to afford the bank’s financial product (Zhao & Huchzermeier, 2018). The exchange rates also guide banks when deciding to start its operation in a new market. A bank should open in regions that have their currencies appreciate to gain from the benefit of economic growth.

Further, the pricing policies of products and services in the foreign market minimize a firm’s exposure to change in the exchanging rates. The operational technique of managing risk allows the financial institution to higher cheap labor from employees whose local economy is relatively weaker when compared to the company’s domestic currency (Bychuk & Haughey, 2011). The Commonwealth Bank of Australia fails to effectively utilize opportunities available in segments such as pricing and labor cost thus losing to rivals who employ the technique.

Conclusion

Firms must continually review their exposure to economic and transactional risk when operating in foreign nations. The companies should then employ an effective risk management process to limit risk they face from the exchange rate. An effective risk management procedure must entail risk profiling followed by a decision to employ either financial, operational or production hedging technique. The plan should be easy to implement because of the high volatility of the exchange rate. Further, institutions like commonwealth bank of Australia must be highly innovative on how to hedge the foreign exchange risk. The company should shift it a preference for a financial hedge to explore how operational and production hedging would minimize exposure to the changing rates. New ideas will enable the firm to remain profitable when compared to its rivals.

References

Banasiewicz, A. D. (2014). Risk Profiling of Organizations. Erudite Systems LLC,

Bychuk, O. V., & Haughey, B. (2011). Hedging Market Exposures: Identifying and Managing Market Risks. New York: John Wiley & Sons.

Clyde P. Stickney, R. L. (2009). Financial Accounting: An Introduction to Concepts, Methods, and Uses. Boston: Cengage Learning.

Deventer, D. R., Imai, K., & Mesler, M. (2013). Advanced Financial Risk Management: Tools and Techniques for Integrated Credit Risk and Interest Rate Risk Management. New York: John Wiley & Sons.

Graham, A. (2014). Hedging Currency Exposure. Oxfordshire: Routledge.

Jacque, L. L. (2013). Management and Control of Foreign Exchange Risk. New York: Springer Science & Business Media.

Livingstone, C., & Nevran, I. (2017). Retrieved from https://www.commbank.com.au/content/dam/commbank/about-us/shareholders/pdfs/annual-reports/annual_report_2017_14_aug_2017.pdf

Navatra, E. (2018). EDRISTI CURRENT AFFAIRS Q & A YEARLY 2018. India: E-dristi Navatra Publication .

Papaioannou, M. M. (2006). Exchange Rate Risk Measurement and Management: Issues and Approaches for Firms. Wahington: International Monetary Fund.

Pompella, M., & Scordis, N. A. (2017). The Palgrave Handbook of Unconventional Risk Transfer. New York Springer.

Zhao, L., & Huchzermeier, A. (2018). Supply Chain Finance: Integrating Operations and Finance in Global Supply Chains. New York Springer.