China Company Xinjiang - Foreign Currency Exchange Rate Risk

Part A

Foreign currency exchange rate risk is the risk that any business’s financial position or performance that will be afflicted through fluctuations in the exchange rates in between currencies. Foreign exchange rate risk management is an essential component in all the company’s decision on its currency exposure. The currency risk hedging strategies lead to reducing or getting rid of the risk and also desire all the way that the exchange rate risk can change the techniques and economic agents activity in dealing with the indirect risk conclusion.

The issue that I have to work on is that, I have to analyse all the possible alternatives on how the China company Xinjiang Locomotive can hedge with its U.S. dollar transaction exposure as the exchange rate risk of the USD continues to depreciate against the Chinese Yuan and Xinjiang Locomotive is tangled in receivable transaction exposure. There are four ways of hedging alternative and those are to remain unhedged, hedging with currency forward contracts, hedging with money market and hedging with options contract.

The first alternative way that is remaining unhedged will work like if the company Xinjiang accepts all the transaction risk by not taking any of the hedging propositions. If calculation that are made based on IRP at the future spot rate of receivables at 180 days and 360 days, the future spot rate will be CNY6.66947/$ and CNY6.57936/$. So the expected value of money that will be received by the company Xinjiang is CNY166,736,750 and it is uncertain receivable in December 2017 and CNY164,484,000 receivables in June 2018. The total expected money sum of both the period of receivables amount will be CNY331,220,750 that will be received by the company Xinjiang resulting with the transaction with the company AFT. But if the future spot rate is CNY6.72475/$, the company Xinjiang will only receive total sum of CNY168,118,750 which is CNY1,469,750 lesser receivable in December 2017 and CNY3,647,500 lower receivable in June 2018.    

The second alternative way that is currency forward market hedge and this way allow a company to fix exchange rate at which it will sell or buy a quantity of foreign currency in future. It is a flexible gear that easily matches the future transaction exposure. Hedging in forward market means selling $25,000,000 forward at the 180 days rate of CNY6.62335/$ and selling the other $25,000,000 forward at 360 days forward rate of CNY6.22755/$. In the 180 days (December 2017), Xinjiang will receive $25,000,000 and exchange it at the rate of CNY6.62335/$, and receive CNY165,583,750. In the 360 days (June 2018), Xinjiang will receive $25,000,000 and exchange it at the rate of CNY6.22755/$ and it will receive CNY155,688,750. In December 2017, the total money that will be received is CNY1,065,250 and it is less than the uncertain CNY166,649,000 which is expected from the unhedged position. During June 2018, the amount received is CNY8,782,500 which is less than the uncertain CNY164,471,250 expected from the unhedged position. So the total amount of receivable in both December 2017 and June 2018 will be CNY321,272,500 and it is certain. The forward contract will create exchange loss of CNY2,535,500 which is from [$25,000,000x(6.72475-6.2335)] in December 2016 and CNY12,430,000 from [$25,000,000x(6.72475-6.22755)] in June 2018.