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Currency Risks Essay

Founded by Sam Walton in 1962 in America, Wal-Mart Stores, Inc. operates a chain of large, discount department stores and, according to the Fortune Global 500 (2008), is the largest public corporation in the world by revenue. In the United States, Wal-Mart has an estimated 20% market share in the grocery and consumables retailing business, effectively making it the market leader. Apart from the United States, the company has set up dedicated operations, through direct presence and / or acquisitions of local chains abroad, in Europe, North America, South America and Asia.

With global sales in excess of USD 10 billion, YUM! Brands, Inc. is a highlight of the Fortune 500 corporations. Owning brands such as Taco Bell, KFC, Pizza Hut, and Long John Silver’s restaurants globally not to mention A&W Restaurants excluding its Canada operations, the company’s prime business is to operate and license franchises of its various food business brands. Headquartered in Louisville, Kentucky, according to the company website (2009), it operates in 110 countries with 35,000 restaurants catering to public demand.

For Wal-Mart, the upward revaluation in the Yuan would result adversely as its import bill would rise. Thus, it would be effectively getting less Yuan for every Dollar

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then before when it converts USD into Yuan on the currency market to pay the Chinese suppliers. The overall effect would be an increase in costs of sales, which would have to be absorbed by the company, or passed on to consumers. The net result would be a fall in underlying profitability as the cost structure alters. An example may help clarify things.

Regardless of what the real numbers are, a company that imports Yuan 500 worth of goods from China at a rate of Yuan 5 / USD, will find that it had to pay $100. If the exchange rate rises to Yuan 4 / USD, the import bill automatically rises to $125. For Yum Brands, the upward revaluation in the Yuan would result favorably as now when its China operations remit profits back to the United States, they will have to pay less Yuan for every dollar, hence raising the dollar value of receipts for the parent company in the United States hence raising sales volumes and underlying profitability. An example may help clarify things.

Regardless of what the real numbers are, a company that makes a profit of Yuan 500 and aims to remit USD back to headquarters at the prevailing exchange rate of Yuan 5 / USD, will find that it remitted $100. If the exchange rate rises to Yuan 4 / USD, the remitted amount stands at $125, thus effectively raising the dollar value of sales. It is worth noting that although Yum brands benefits as a result of the upward revaluation, there is a risk inherent there too as there is uncertainty in the management’s eyes as to what will be the ultimate dollar value of sales from its Chinese operations.

That being said, with a strong expectation that the Yuan would be revalued upwards; there is no commercial sense for the company to hedge itself against it as the net result is expected to be favorable and hence the company can save on hedging costs. The same cannot be said of Wal-Mart. With an upward revaluation looming large, the company would have to somehow hedge against this exposure to risk. To do so, in the very short term when the revaluation has not taken place, the firm may bank upon the following tools to hedge themselves:

i) Forward Commitments: According to Schweser (2008), “A forward commitment is a legally binding promise to perform some action in the future” (P. 125). Examples of forward commitments include forward contracts, futures contracts and swaps. ii) Option Contracts: According to Schweser (2008), “A contingent claim is a claim (to a payoff) that depends on a particular event” (P. 127). Option contracts are contingent claims that depend upon a price of an asset at a future date to become operative and materialize.

For purposes of understanding, lets tackle one tool from each of the above two categories to gain an idea of how these would work to eliminate / reduce exchange rate exposure. For this purpose, we will be looking at forward contracts and option contracts. Forward Contracts According to BPP (2008), Forward contracts are involve two parties contracting to transact a certain amount of currency at a predetermined exchange rate at a certain date in the future. The profit/loss at the inception of the contract is zero (P. 351). They are not exchange traded and can be tailor made to meet every ones specific requirements.

An example will illustrate the mechanics: Suppose an American company has imports planned worth Yuan 500 at the prevailing exchange rate of Yuan 5 / USD. With an upward revaluation in the Yuan expected, the company may enter into a forward contract with a Bank to buy Yuan at a rate of Yuan 4. 75 / USD. Thus, when the imports are made and USD is exchanged for Yuan, the effective amount of dollars that the company ends up paying is $105. 26 no matter what is the price in the market. Had the Yuan appreciated to Yuan 4/USD, the company would effectively save close to $20 on its import bill.

Options Contracts According to BPP (2008), Option contracts are of two types. Call options give the holder of the option the right but not the obligation to buy a specified amount of a currency at a particular price at a particular date in the future. Similarly, put options give the holder of the option the right but not the obligation to sell specified amount of a currency at a particular price at a particular date in the future. In both cases, the writer of the option has an obligation to perform for which he receives a premium (P. 372).

An example follows on the next page. Suppose an American company has imports planned worth Yuan 500 at the prevailing exchange rate of Yuan 5 / USD. With an upward revaluation in the Yuan expected, the company may buy an option contract to buy (call) 500 Yuan at an exchange rate of Yuan 4. 8 / USD paying a premium of USD 10. Thus, when the imports are made and the Yuan is more expensive in the market (for example at Yuan 4 / USD) the company may utilize its option contract and find a total import bill value (including cash paid for premium) of USD 114.

16, saving close to $ 10. What is important to remember here is that in forward contracts, there is an agreement to transact the currency no matter what while in option contracts, there is no obligation as such and the decision rests on the holder of the option. Conclusion While there are many ways through which American firms importing from China may hedge against adverse exchange rate exposure, bear in mind that financial derivatives are not a long-term solution.

With markets getting increasingly strong form efficient, it is highly likely that in the short to medium term, the full impact of an expected increase in the value of the Yuan against the USD will be incorporated in the pricing of financial derivatives themselves so that even through a hedge, the company would end up paying close to what it would pay without one. Thus, to hedge against such a long-term currency risk, firms like Wal-Mart would have to focus more on operating efficiencies. References: BPP. (2008). Advanced Financial Management. London: BPP Learning Media. Schweser. (2008). CFA Level One: Derivatives. London: Kaplan.

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