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Risk management strategy in managing foreign exchange risk: Wesfarmers Company
Foreign exchange risk background
Wesfarmers sells its products internationally and get paid in the international/foreign currencies. The company’s primary exposure is to the US dollar as well as the increase from sales/purchases by a dissection in currencies instead of the dissection’s functional currency. Also, Wesfarmers Company is unprotected from both the US dollar and the Euro since it engage in foreign borrowing facilities. Due to the operations in New Zealand, the Company’s balance sheet is more likely to be unsettled when it comes to the movement in the Australian Dollar or New Zealand Dollar exchange rates. For example, there are three assumptions to be in this case; one, the annual pay of $43 billion to the (both foreign and indigenous) suppliers is likely to be affected by the fluctuating exchange rates (Annual report, 2015). Two, there will be tax charges and credits on $ 85 million equity which are attributed to the exchange rate variances on international arrangements. Three, the foreign exchange contracts are dominated by the USD and EURO, therefore, there is high likelihood of increase in cost of liabilities.
Hedging with options: This involves a contract between two parties. In this case, Wesfarmers have the operating revenue increased to $62,447 million from $60,181 million in financial year 2015. The foreign exchange currency risk is likely to be offset by the USD and EURO since the market location of the company is dominated by the two currencies (Lönnrot, 2016). Since the Australian (specific segment) is dominated by the Australian currency, any fluctuation (increase) in exchange rate of the AU will of course increase the operational cost (Kleinman, 2013). In this case, hedging with option will mean that USD and Euro are protected relative to AU, with the total exposure of $62,447 million (appendix 1), the average exchange rates for USD and Euro relative to AU are 0.77 and 0.68 respectively (appendix 2). For this particular risk, the trend is upward therefore calls will be used (Graham, 2014).
Hedging with future: With the second assumption, say the interest rates could expand expectedly, the future cost of production will increase without change in the price of the company’s products (Ito, McCauley and Chan 2015). Apparently, the change may become negative to the company’s revenue. The Euro and USD futures contract trading in Australian exchange have extremely liquid contracts (Annual report, 2015). Wesfarmers current hedge contracts are due in June 2017. Considering that it has hedged 100% of the USD and Euro borrowings, the company believe that the AU will not remain weak for an lengthy period of time (Díez, Cid and Blanco, 2016).
Advantages for foreign currency hedging strategy in Wesfarmers Company
The future contract until June 2017 means that the AU futures is important to offset the risk of AU depreciation relative to USD and Euro by focusing on the exchange rates. In this case, the company is able to avoid $0.69 loss for 1 USD and $0.61 for 1 Euro (Appendix 2).
Limitations for using hedging strategy
Hedging with future is bonded by a legal obligation. In this case, having a legal obligation perhaps may have a problem to the company community. For instance, Coles and Kmart are the main suppliers to Wesfarmers. If the company does engage in hedging with future when projects are still in bidding process, apparently, the company can turn into speculative position particularly when the bidding become unsuccessful. Also, using hedging strategy, the loss or profits in the current process may be offset by the outcome of the future transactions (future profit and loss). For example, if Wesfarmers Company sells the Euro in the expectation of depreciation of Euros in future, however, if the Euro is to appreciate, the company then has to forgo the favorable movements.
Annual report,. (2015). Delivering value today and tomorrow..
Díez, S. Á., Cid, E. A., & Blanco, M. O. F. (2016). Hedging foreign exchange rate risk: Multi-currency diversification. European journal of management and business economics, 25(1), 2-7.
Graham, A. (2014). Hedging Currency Exposure. Hoboken: Taylor and Francis.
Ito, H., McCauley, R., & Chan, T. (2015). Emerging Market Currency Composition of Reserves, Denomination of Trade and Currency Movements.Forthcoming in Emerging Markets Review.
Kleinman, G. (2013). Trading Commodities and Financial Futures: A Step-by-Step Guide to Mastering the Markets, Fourth Edition. FT Press.
Lönnrot, M. (2016). Derivative hedging strategies for bitumen price risk.
Adopted from Wesfarmers Annual report 2015
Average exchange rates
Adopted from Wesfarmers Annual report 2015