Economics assignment report study on: Globalization & competitiveness for sustainability

Executive Summary

With increase in importance of globalization in the modern era, it is becoming extremely competitive to sustain as an organization. Organizations now face a difficult task of increasing their presence across the globe and at the same time maintaining profitability such that the shareholders’ get the return expected from their investment. Moreover, profitability also increases the probability for further investments and growth of the company. Profitability always reflects how much return is the organization able to make from the investments it makes.Corvette has been into luxury sports cars, and its products are in demand across the globe. Therefore, it is imminent that it faces with many challenges in delivering its products to the customers. One of the important challenges, as mentioned above, is maintaining profitability, thus, the volatility exchange rates of the local currencies of the countries with respect to US Dollars will affect the revenues which in turn will affect the profitability.

HSBC is a global bank present in countries across the globe and is exposed to all kinds of risk due the basic business model of borrowing and lending as a bank. Exchange rate is one of the key parameters for a bank as many transactions are done through a bank and it is assumed that any bank has expertise of different markets. Nevertheless, HSBC- like any other bank- has to maintain profitability so as to sustain in the business.The paper attempts to discuss the different options and scenarios that Corvette and HSBC could face in such a situation and an attempt is made to provide an adequate choice of options for both the company and the bank. It also attempts to address the different kinds of risk involved with respect to exchange rate so as to help the reader understand and be prepared for such kind of scenarios.

Introduction

The paper is structured in a manner that it starts with a data of orders of luxury cars from different countries to Corvette, their exchange rates and statistical estimates like mean and standard deviation of these interest rates. Different probabilities are calculated so as to check different scenarios of profitability for Corvette.

The paper then introduces HSBC as a party to a transaction, more commonly termed as currency swap, wherein the bank pays a fixed amount in return for the uncertain revenues that Corvette would be getting as a part of its luxury car orders. A detailed explanation of risks involved for both the bank and the company follows.Multiple scenarios and concepts like hedging are discussed in brief in order to familiarize the reader in the following section. An attempt to evaluate the transaction from view point of both the parties involved s explained to provide a clear picture of the scenario.

Corvette, HSBC: Mitigating exchange rate risk by using Currency Swap as a hedge

The table below shows the details of the orders that are to be delivered by Corvette in twelve months time:

*FC- Foreign Currency

The uncertainty in the revenues is mainly due to the volatility in the exchange rates of the US Dollar with respect to that of the currencies of the countries mentioned above. The supply and demand of a currency with respect to another is affected by factors like inflation, GDP of the country, political scenario etc., thus, affecting the exchange rate. Therefore, exchange rate plays a very important role mainly for companies involved in global operations, trade etc.It is mentioned that the estimates shown in the above are normally distributed and are independent of each other. Therefore, it would be a fair assumption that the distribution of the uncertain revenues of Corvette from the above orders. The simplest form of normal distribution is a standard normal distribution with a mean of 0 and standard deviation of 1 and is symmetric at the mean as shown below:

Figure 1: Standard Normal Distribution (www.mathisfun.com)

In the case of Corvette, considering the given data, the uncertain revenues follow a normal distribution with a mean of $2,175,398 and a standard deviation of $44,346.

The mean of uncertain revenues indicates that over a period of time as the exchange rates fluctuate, the company would earn average revenue of US$ 2,175,398 from its delivery of the luxury cars to the respective countries during the same period. The standard deviation indicates the amount by which the revenues may deviate from its average value during the same period. Thus, these two parameters are indicators of the ability of the company’s earnings due to the volatility in the exchange rates.Multiple statistical tests can be conducted in order to find the probabilities of the revenues that Corvette can earn. The probabilities of generating certain amounts of revenues have been calculated and presented in the appendix. Such calculation helps the management in making few important decisions about the risk they are exposed due to the exchange rate volatility. Exchange rate volatility in this scenario directly impacts the earnings volatility which in turn affects the profitability (assuming costs are incurred in the domestic, US$, currency).

One of the ways in which the company can reduce its exposure to the exchange rate fluctuations is by entering into a contract where in it could receive a fixed amount in return for its uncertain revenues. This would help Corvette in eliminating the exchange rate risk, this kind of transaction is known as a swap and the procedure is known as hedging. Many companies try to lock in the revenues much before their product delivery date mainly to eliminate the aforementioned risk.

In this scenario, the company has got an offer from HSBC of $2.15 million in return for their revenues in the local currencies. However, before accepting the offer we need to test the feasibility (profitability) of the transaction. A statistical testing called hypothesis testing was done in order to check profitability of Corvette if it goes through the transaction. The results from the test (shown in the appendix) indicate that Corvette should accept HSBC’s offer in exchange of the uncertain revenues. Such types of transactions help organizations in concentrating on main issues that affect their bottom line. Exchange rate fluctuation is one of the risks which is inherent while conducting businesses in different currencies, and proper management of these risks is required so as to ensure generation and reporting of stable revenues. One of the disadvantages of hedging is that there is no scope of booking profits in case the exchange rates move in a favorable direction to the company, thus, hedging is always done with the aim of risk elimination rather than booking profits.

Risk is defined as the probability of getting an undesired result in a particular event. Risk is always positively correlated with returns, i.e., higher is the risk one is willing to take, higher will be the probability of making greater returns. Similarly, Risk appetite indicates the amount of risk an investor can take to achieve desired returns (KPMG, 2008), and it varies from investor to investor. Risk averse investors, basically, avoid taking high risks and settle for investments that give a fixed and guaranteed amount of return. Therefore, in Corvette the sales manager is more risk averse than the CEO as he is ready to accept the fixed amount of revenue which would eliminate the uncertainty in the revenues. The CEO, however, is willing to take risks as he/she does not want to lose on the opportunity of getting higher revenues in case the exchange rates move in his/her favor. The CEO’s approach towards the uncertain revenues can be termed as a more of aggressive strategy wherein one takes a chance against losing money, but at the same time the strategy might be rewarding provided the outcome is a favorable one.

The bank (HSBC), on the other hand, is ready to take a chance at the volatile exchange rates by giving up only a certain fixed amount in return. This shows the ability to take risks or in other words, the bank’s risk appetite is very high. There may be several reasons why the bank is willing to do so, e.g., HSBC being a global bank has exposures or assets across the globe and it might be planning to use these uncertain revenues to offset any loss or to make a payment as part of its obligation to some other party in the countries mentioned above.

In order to understand the risks taken by the bank in undergoing such a transaction, we need to first understand the transaction. Here, HSBC is the party which pays a fixed amount in exchange for the volatile/uncertain revenues in twelve months time. This type of transaction basically forms a currency swap, where HSBC is the fixed leg payer and Corvette is the floating leg payer. Apart from the volatility in the exchange rates, HSBC is exposed to the following risks:a)      Interest Rate Risk (Eun, Resnick, 2007): As explained above, this transaction has a fixed part and a floating part. The fixed part is nominated in US$, whereas the floating part is in 4 different currencies. In order to calculate the value of the revenues at any point of time, we need to know the interest rates in the particular currency e.g., we need to know the interest rates in the UK in order to value the transaction. Therefore, for each of the four currencies, the four interest rates are required in addition to that in the US. This is required in order to discount the cash flows to be received/paid after twelve months to present time. Therefore, any changes in the interest rates will affect the profitability to the bank in the transaction exposing it to the interest rate risk.

b)      Basis Risk (Eun, Resnick, 2007): Basis risk arises when the two parties of the transaction do not have the same benchmark for measurement of interest rates. For example, LIBOR (London Interbank Offer Rate) is used as benchmark in transactions wherein forward interest rates are necessary for calculation of the value of the instrument used. In our scenario also interest rates could have been used and basis risk would arise if Corvette uses LIBOR and HSBC uses the spot rate or any other benchmark for that purpose. This means that a change in the benchmark might result in an adverse scenario causing loss to one of the parties involved. Thus, HSBC would be exposed to basis risk if any kind of interest rate calculations is involved.

c)      Counterparty Credit Risk (Eun, Resnick, 2007): Such types of risks are very common in Over The Counter transactions wherein two parties come together and agree to exchange cash/any financial instrument/commodities at an agreed upon  rate on a future date. Whenever there is a possibility for the counterparty to default on its payment, credit risk is said to exist. Thus, in this case HSBC is exposed to the credit risk such that there is a possibility that Corvette might not fulfill its obligation, although there is a very low probability of Corvette doing so.

d)      Sovereign Risk (Eun, Resnick, 2007): Sovereign risk is related to the country whose currency’s exchange rate affects the parties in the transaction. In the case of HSBC, it is exposed to the risk of four different countries’ policy towards exchange rate such that any regulations related to imposing exchange rate restrictions might adversely affect the bank.

All the risks above might or might not be present all the time, however, one should always make arrangements for adverse situations. Now, if we consider the possibility that the payment of the sure sum amount by HSBC is to be done in 3 months time rather than the previously agreed upon delivery date i.e. after twelve months, there will be lot of factors that would affect both the parties in the transaction. Out of the two parties, the receiver of the assured payment will be the beneficiary as it receives the payment 9 months prior to the original delivery date and considering only the time value of money we can say that the value of money 3 months from now would be more than that after 12 months. Moreover, the bank (HSBC) is exposed to maturity mismatch as there is a gap of 9 months between the assured sum payment and the receivables (uncertain revenues). Another argument in this context is that, for the bank it would be an opportunity cost as it could have lent the amount over the next 9 months and could have earned interest on that, whereas for Corvette it would be an additional income for the same period (9 months).  Therefore, the bank would like to make the payment only at the original date, but Corvette would find it more profitable to receive the sum assured payment 3 months from now.Now, consider a case where in Corvette accepts the bank’s offer and the bank converts all the currencies into US Dollars. In such a case the main risk that the bank is exposed to is the exchange rate risk which in anyway the bank is willing to take. The bank is also losing any arbitrage opportunity available in the local market which could be etaken advantage of f it invests in the local market. However, the bank will incur loss only if the revenues are less than the sure sum amount that the bank paid to Corvette i.e. $2,150,000. So, in order to find the probability of the loss we need to use the normal distribution table and the mean and standard deviation of the uncertain revenues of Corvette. The probability that the uncertain revenues will be less than the sure sum amount was found to be 28.34%.

In order to know the amount of risk that the bank is exposed to, we can calculate the Value at Risk at a 5% significance level which would give us an idea about the maximum loss that the bank will incur in twelve months due to the uncertainty in rates. As it is shown in the appendix, the value at risk was found to be $2,102,455.66

Assuming that the bank has not converted all or some of the local currencies into US Dollars, the following alternatives are available for the bank:

• Lending in the local currency: With the inflow of the revenues in local currencies, the bank can use it in lending in the local market and earn some interest as return on investment. However, the bank has to first check if such an option is more profitable than converting into US dollars. This would highly depend on the interest rates prevailing in both the US and the local markets.
• Investing in the local market: The bank can use the revenue received from Corvette and use it in investing in the local capital market or in any mutual fund or any other type of investment which could fetch itself a good return and simultaneously can sign a forward contract in order to convert the local currency into US Dollars at a future point of time.

Each of the time series in the graph below indicates the fluctuation of the exchange rate over the period of 92 months. Such a period of time covers almost all the business cycles of an economy, and as we are dealing with exchange rates, it reflects the effect of supply and demand of the currencies.The graph below shows the monthly data for the four exchange rates for the last 92 months

The graph below shows the weekly data for the four exchange rates for the last 92 weeks:

Both the graphs above merely show the movement of the exchange rates with respect to time.

 Taking all the above data for each of the four exchange rates two different linear regression models were created for both monthly and weekly exchange rates. The two models were different in the aspect that in one model the dependent variable (the variable to be estimated) was the week/month number and the independent variable was the exchange rate e.g. USD/EUR while the second model had exchange rate as the dependent variable with the week/month number as the independent variable.

In order to forecast the exchange rate, we need to use the second model as only through this we would be able to use the regression output i.e. the estimates, to calculate the exchange rate for nth week/month from now. The appendix shows the detailed regression output of each of the four exchange rates for both weekly/monthly data.Conclusion

The paper has made an attempt to discuss the different intricacies and concepts involved in dealing with exchange rates with the point of view of a luxury sports car exporter as well as a global bank. A brief explanation about all the scenarios highlighted the importance of need for mitigating the risk through hedging. It was explained in the paper the volatility that the exchange rates bring into a company’s balance sheet and at the same time provides business opportunity for a bank.

To conclude, it could be said that exchange rate risk brings along with it different kinds of risks and at the same time might be rewarding if there is any favorable movement. However, attention is required while considering profitability and volatility that exchange rates bring into the financials of the organization. All these volatility and uncertainty can be eliminated with correct and timely decisions with respect to mitigating these risks.

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