We are discussing the case study of Merton Electronics Corporation (MEC). Although company is doing well as far as sales is concern but their net profit is dipping. This is due to increasingly difficult market conditions as well as fluctuation in international currency prices. Patricia Merton is president and majority shareholder of MEC. MEC is exposed to three currencies Japanese Yen, US Dollar & Taiwanese Dollar. Major concern of MEC is volatility of Yen and Taiwanese Dollar. With over 60 percent of purchases are subjected to currency fluctuation, company is suffering from heavy monetary losses. We are discussing various hedging methods available in front of MEC to get a shield from exchange rate fluctuation.
1.Currency Risk Exposure
Currency risk is the type of risk that arises because of change in prices of one currency against other. Any company which have business or assets in different countries they are exposed to currency risk unless they hedged their position. Currency risk exists regardless of whether you are investing domestically or abroad. If you invest in your home country, and your home currency devalues, you have lost money. Any and all stock market investments are subject to currency risk, regardless of the nationality of the investor or the investment, and whether they are the same or different. The only way to avoid currency risk is to invest in commodities, which hold value independent of any monetary system.
Currency risk exposure is the dollar amount that is at risk if exchange rates move in an unfavorable direction. A company has currency exposure when the currencies for its expenditures and revenues are not the same. Future payments or distributions payable in foreign currency carries the risk that the foreign currency will depreciate in value before the foreign currency payment is received and converted into US dollars. Although there is a chance for profit, most businesses and lenders give up that chance in order to eliminate the risk of currency exchange loss. It is measured as the amount in receivables or payables the company has committed to, for which the exchange rate has not been determined (http://www.vsb.org/publications/valawyer/june_july01/kelley.pdf). A currency is exposed to exchange rate fluctuations to the extent that it is used to conduct transactions with external markets. The greater the proportion of “inter-currency” exchange to total monetary transactions for a given market, the greater the exposure to changes in exchange rates. Businesses conducting international trade are exposed to exchange rate fluctuations in proportion to their total volume of transactions. As the magnitude of “inter-currency transactions” increases relative to aggregate transactions, a business unit realizes greater exposure to exchange rate fluctuations. When a firm conducts transactions in different currencies, it exposes itself to risk. The risk arises because currencies may move in relation to each other. If a firm is buying and selling in different currencies, then revenue and costs can move upwards or downwards as exchange rates between currencies change. If a firm has borrowed funds in a different currency, the repayments on the debt could change or, if the firm has invested overseas, the returns on investment may alter with exchange rate movements — this is usually known as currency risk exposure.
For example if you are a U.S. investor and you have stocks in Japan, the return that you will realize is affected by both the change in the price of the stocks and the change of the Japanese Yen against the U.S. dollar. Suppose that you realized a return in the stocks of 10% but if the Japanese Yen depreciated 10% against the U.S. dollar, you would make a small loss.
Transaction risk is the risk that exchange rates will change unfavourably over time. It can be hedged against using forward currency contracts; Translation risk is an accounting risk,...