Foreign exchange risk

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Foreign exchange risk

  1. 1. [Tang Huynh Yen Phuong] 2011 UNIVERSITY OF ECONOMICS HO CHI MINH CITY FACULTY OF COMMERCE– TOURISM- MARKETING GRADUATE THESISTopic“EVALUATING TRANSACTION EXPOSURES AND HEDGINGSOLUTIONS FOR IMPORTING STEEL AT CONSTRUCTIONAND MATERIALS TRADING JOINT STOCK COMPANY.” ADVISOR: NGUYEN KIM THAO, MBA. STUDENT: TANG HUYNH YEN PHUONG CLASS: FT1 - COURSE: 33 2007-2011 1
  2. 2. [Tang Huynh Yen Phuong] 2011 2
  3. 3. [Tang Huynh Yen Phuong] 2011Evaluating transaction exposures and hedging solutions for importing steel at Construction and materials trading joint stock company Tang Huynh Yen Phuong University of Economics of Ho Chi Minh City Foreign Trade 1 Nguyen Kim Thao, MBA May 22rd ,2011 3
  4. 4. [Tang Huynh Yen Phuong] 2011 ACKNOWLEDGEMENTThis paper could not have been completed without the help,encouragement, and support from a number of people who all deservemy sincerest gratitude and appreciation.First and foremost, I would like to express my deepest and sinceregratitude to my thesis advisor, Professor Nguyen Kim Thao, MBA., forher invaluable comments, and for her expert and constant guidance, andfor her encouragement, patience, and support during the entire process ofthis thesis.I am grateful to Professor Nguyen Thi Hong Thu, MBA., for helping meon my thesis. Without her direction and advice, this thesis could not havebeen completed.I would also like to sincerely thank to the Vice General Director ofConstruction and Materials Trading Company, Mr Phung Dat Duc, andthe Manager of Sales Department No. 2, Mr Tran Chi Hieu for giving mepermission to commence this thesis in the first instance, and to do thenecessary research work and to use departmental resources.Special words of thank also go to the members of Sales Department No.2, Mr. Nguyen Hoang Duy, and Ms. Le Bao Thao Nguyen, for theirsupport, and guidance during my time of internship.Finally, my deepest gratitude and appreciation go to my family. Theirlove, support and constant encouragement gave me a great deal ofstrength and determination that helped me during the stressful time ofwriting this paper.Ho Chi Minh City, May 2011Tang Huynh Yen Phuong 4
  5. 5. [Tang Huynh Yen Phuong] 2011 COMMENTS OF THE COMPANYNhận xét của cơ quan thực tập: ...................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................... Ho Chi Minh City, April ......., 2011 Signature 5
  6. 6. [Tang Huynh Yen Phuong] 2011 COMMENTS OF THE ADVISOR................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................ 6
  7. 7. [Tang Huynh Yen Phuong] 2011 ABSTRACT“EVALUATING TRANSACTION EXPOSURES AND HEDGING SOLUTIONSFOR IMPORTING STEEL AT CONSTRUCTION AND MATERIALS TRADING JOINT STOCK COMPANY.” By Tang Huynh Yen Phuong University of Economics Ho Chi Minh City Professor Nguyen Kim Thao, MBA., Thesis AdvisorThe international trade allows goods ,and services to travel across countries ,as wellas the currency. Construction and Materials Trading Company (CNT) has majorbusiness activities internationally and domestically. Therefore, it is an enduring taskfor the company in dealing with the effects of exchange rate volatility on the cost ofimports. Over the past few years, CNT has been using the price decisions hedgingstrategy in handling its transaction exposures. However, this hedging tool began toshow some drawbacks because it could not reduce transaction risks, especiallyduring the period of global economic crisis. Therefore, the research would like toevaluate the transaction exposure in import activities at CNT. It also studies otheravailable hedging tools to offer some alternative choices for CNT‟s hedgingstrategies in managing their transaction exposure. 7
  8. 8. [Tang Huynh Yen Phuong] 2011 TABLE OF CONTENTSCHAPTER 1- LITERATURE REVIEW ......................................................... 4 1.1. IMPORT.................................................................................................................. 4 1.1.1. Definition of importing ..................................................................................4 1.1.2. The benefits and drawbacks of importing .....................................................5 1.2. FOREIGN EXCHANGE MARKET .......................................................................... 5 1.3. EXCHANGE RATE DETERMINANTS ................................................................... 5 1.3.1. Purchasing Power Parity (PPP) .....................................................................6 1.3.1.1. Absolute Purchasing Power Parity.........................................................6 1.3.1.2. Relative Purchasing Power Parity ..........................................................6 1.3.2. Interest Rate Parity theory (IRP) ...................................................................6 1.4. FOREIGN EXCHANGE RISK AND FOREIGN EXCHANGE EXPOSURES ............. 7 1.4.1. Foreign exchange risk ....................................................................................7 1.4.2. Foreign exchange exposure ...........................................................................7 1.5. TRANSACTION EXPOSURES AND MANAGING TRANSACTION EXPOSURES 9 1.5.1. Transaction exposure .....................................................................................9 1.5.2. Managing transaction exposures....................................................................10 1.5.2.1. Identify the degree of exposures ............................................................10 1.5.2.2. Make decision on hedging the exposures ..............................................10 1.5.2.3. Choose a hedging technique ..................................................................10 1.5.2.3.1. Hedging techniques ..........................................................................11 1.5.2.3.2. Operational techniques .....................................................................15 1.6. OVERVIEW OF VIETNAM FOREIGN EXCHANGE MARKET .............................. 16 1.6.1. Background of Vietnam‟s exchange rate regime...........................................16 1.6.2. Vietnam‟s exchange rate regime during 1994-2011 periods .........................17 1.6.3. Mechanisms to support stability of the VND/USD rate ................................18 1.6.3.1. Official exchange rate ............................................................................18 1.6.3.2. Allowable trading band ..........................................................................21 1.6.3.3. Official intervention ...............................................................................21 1.7. OVERVIEW OF VIETNAM‟S DERIVATIVES MARKET ....................................... 22 1.7.1. Forward transaction .......................................................................................23 1.7.2. Currency options ............................................................................................26 1.7.3. Swap ..............................................................................................................28 1.7.4. Evaluation ......................................................................................................29 8
  9. 9. [Tang Huynh Yen Phuong] 2011CHAPTER 2- RISK ANALYSIS OF TRANSACTION EXPOSURE .......... 31 2.1. PROFILE OF CNT................................................................................................... 31 2.1.1. Introduction....................................................................................................31 2.1.2. Establishment and history ..............................................................................32 2.1.3. Vision and mission ........................................................................................33 2.1.4. Scope of Business ..........................................................................................33 2.1.4.1. Construction ...........................................................................................33 2.1.4.2. Investment ..............................................................................................33 2.1.4.3. Industrial and construction material production ....................................34 2.1.4.4. Import - export trade ..............................................................................34 2.1.4.5. Local product trade ................................................................................34 2.1.5. Organizational structure.................................................................................35 2.1.5.1. General Shareholder‟s Meeting .............................................................36 2.1.5.2. Board of management ............................................................................36 2.1.5.3. Board of supervisors ..............................................................................36 2.1.5.4. Board of directors...................................................................................36 2.1.5.5. Functional departments ..........................................................................36 2.1.6. Human resources ...........................................................................................37 2.1.7. Business performance ....................................................................................37 2.1.7.1. Profit structure........................................................................................37 2.1.7.2. The situation of import activity..............................................................41 2.1.7.2.1. Import-turnover ..............................................................................41 2.1.7.2.2. Distribution of imports by commodity ...........................................42 2.1.7.2.3. Distribution of imports by country of origin ..................................43 2.1.8. Evaluate the position of CNT ........................................................................45 2.2. RISK ANALYSIS OF TRANSACTION EXPOSURES AT CNT ............................... 46 2.2.1. Overview of Steel import activities ...............................................................46 2.2.2. Analyze the procedure of Steel trade. ............................................................50 2.2.3. Transaction exposures from 2006-2010 ........................................................55 2.2.5. Current Risk management strategies at CNT and evaluation ........................66CHAPTER 3- HEDGING STRATEGY .......................................................... 75 3.1. AVAILABLE HEDGING TOOLS FOR CNT COMPANY AND EVALUATION ....... 75 3.1.1. Lead strategy ..................................................................................................76 3.1.2. Credit loans denominated in Vietnam dong ..................................................78 3.1.3. Hedging techniques .......................................................................................79 3.1.3.1. Forward ..................................................................................................80 3.1.3.2. Option.....................................................................................................83 3.1.4. Risk sharing ...................................................................................................84 3.2. DESIGN HEDGING STRATEGY FOR THE COMPANY ......................................... 87 9
  10. 10. [Tang Huynh Yen Phuong] 20113.3. RECOMMENDATION FOR STATE BANK OF VIETNAM ....................................... 90CONCLUSION .................................................................................................. 93APPENDIX ......................................................................................................... 95REFERENCE ..................................................................................................... 118LIST OF APPENDIXSAppendix 1-Balance Sheet 2009Appendix 2-Income Statement 2009Appendix 3- Balance Sheet 2010Appendix 4- Income Statement 2010Appendix 5- Forward Contract at EximbankAppendix 6- Option Contract at EximbankAppendix 7- Contract Exercise RequestAppendix 8- Agreement On Currency OptionsAppendix 9- Revenue Structure 2008-2010Appendix 10- Costs Of Goods Sold 2008-2010Appendix 11- Gross Profit Structure 2008-2010Appendix 12- Income Statement 2006-2010Appendix 13- Main Financial Indicators Of CNT 2006-2010Appendix 14- Transaction Exposures Of Steel Import Activities In 2006-2010Appendix 15-The Effects Of Transaction Exposure After Hedging On The Profit MarginOf Some Import Contract In 2006-2010Appendix 16 -Steel import proposal of Phu My Steel Company. 10
  11. 11. [Tang Huynh Yen Phuong] 2011 LIST OF TABLESTable 1.1- Comparison of translation, transaction and operating exposure ...................09Table 1.2- Changes of average inter-bank exchange rates and allowable trading bands during 2008-2011 period..............................................................................18Table 1.3- Changes of average inter-bank exchange rates during 2007-2011 period. ...19Table 1.5- Option transaction premium of Eximbank in March 2011............................27Table 1.4- Spot rate and forward rate of Eximbank on March 2011 ..............................25Table 2.1- List of shareholders holding over 5% as of May 14, 2010............................31Table 2.2-Staffs and employees (2010) ..........................................................................37Table 2.3- Profit structure of CNT during 2006-2010 ....................................................38Table 2.4- Import-turnover 2008-2010 ...........................................................................41Table 2.5- Distribution of imports by commodity ..........................................................42Table 2.6- Distribution of imports by country of origin .................................................43Table 2.7- The situation of signing and implementing Steel import contract ................46Table 2.8- Steel import proposal of CNT company........................................................52Table 2.9 -Transaction exposures of some Steel Beam contracts during 2006-2010 .....56Table 2.10 -Transaction exposures of some Steel Beam contracts during 2006-2007 ...57Table 2.11- Transaction exposures of some Steel Beam contracts in 2008 ...................60Table 2.12- Transaction exposures of some Steel Beam contracts in 2009 ...................62Table 2.13- Transaction exposures of some Steel Beam contracts in 2010 ...................64Table 2.14- Import proposal of CNT with price decision hedging tool. ........................67Table 2.16- The actual transaction exposure after hedging in 2006-2007. .....................69Table 2.17- The actual transaction exposure after hedging in 2008-2009. .....................71Table 2.18- The actual transaction exposure after hedging in 2010. ..............................73 11
  12. 12. [Tang Huynh Yen Phuong] 2011 LIST OF FIGURESFigure 1.1- Types of Foreign Exchange Exposure ............................................................ 8Figure 1.2- Hedging techniques to manage transaction exposure ..................................... 11Figure 1.3- Allowable Variations around Official Exchange Rate Mar 1989 - Mar 2011 . 21Figure 2.1-Establishment and history of CNT .................................................................... 32Figure 2.2- Organizational structure ................................................................................... 35Figure 2.3- Staffs and employees ....................................................................................... 37Figure 2.4- Profit structure of CNT during 2006-2010 Chart............................................. 39Figure 2.5- The procedure of Steel Beams trade. ............................................................... 50Figure 2.6- Price decidion hedging tool .............................................................................. 66Figure 3.1- Available hedging tools for CNT ..................................................................... 75Figure 3.2- Lead strategy to hedge transaction risk ............................................................ 76Figure 3.3- Credit loans denominated in Vietnam dong ..................................................... 78Figure 3.4- Financial instruments ....................................................................................... 79Figure 3.5- Forward transaction procedures ....................................................................... 81Figure 3.6- Risk sharing hedging tool ................................................................................ 84 12
  13. 13. [Tang Huynh Yen Phuong] 2011 PREFACEIn the nature of international trade, many companies are exposed to the risk ofexchange rate fluctuation. The purchases from international suppliers in othercountries, and sales to domestic buyers with account payables and accountreceivables in different currencies will give rise to foreign exchange risks.1. General problem statementIn an effort to meet the demand of the Vietnamese building materials market,Construction and Materials Trading Company is involved greatly in theinternational trade. Profit from materials trading makes up approximately 75 percentof CNT‟s total profit. In CNT company, the imports of Steel such as Steel Beams,Steel Plate, Steel Sheet... often create account payables in foreign currency (USdollar) with the suppliers. The sales of these commodities often create accountreceivables in home currency (VND) with domestic buyers. Therefore, the companysuffers from transaction risks during its steel trading process from the beginning ofthe purchase made until the payment is settled.According to CNT‟s management, the transaction exposure loss rarely happens, andis considered insignificant because the State Bank of Vietnam uses manymechanisms to support stability of the VND/USD exchange rate. Therefore, therewere only minor transactions, which were hedged in the past. The hedging strategyused is only limited with the price decisions tool. However, it is a necessary task forthe company to design a flexible hedging strategy with different hedging tools. Aproper hedging strategy can help the company to deal with the risk of exchange ratevolatility in different stages of the economic cycle. Thus, the research would like toanalyze other currency hedging tools which are possible to implement at CNTcompany, and design a suitable hedging strategy for the company for the long-term.There are two aspects of the research problem: 1. The influences of Vietnam dong fluctuation against US dollar to the accounts payable of CNT over the last five years. 13
  14. 14. [Tang Huynh Yen Phuong] 2011 2. Determine which hedging tools are available for the company, and design a suitable hedging strategy for the company for the long-term.2. Research objectivesA company is subject to transaction exposure whenever there are receivables orpayables in foreign currency denominations. The hedging concept in managingtransaction exposure is to be able to reduce the risk from currency fluctuations. Inthe end, the research will be performed as an input for further improvement at CNT.According to that, the research objectives of this thesis are: 1. Acknowledgement of how CNT handle transaction exposure derived from the foreign exchange rate fluctuations of Vietnam dong against US dollar currency. 2. Study the hedging strategies available which CNT may possibly implement to reduce risks from the exchange rate fluctuations. 3. Provide alternative choices for CNT hedging strategies in managing transaction exposures.3. Scope of the thesisThe thesis aims to identify the effect of foreign exchange fluctuation on the profit ofsome Steel import contracts of Construction and Material Trading company.The timeframe of the study is limited to the last five years, starting with year 2006and ending with year 2010, depending on the availability, and reliability of the data.In this thesis, the author only has allowance to show certain parts of informationthat was given by the company because it is confidential. The data are collectedfrom the Import- Export sales department No.2 of CNT company, and focuses onSteel import contracts and relevant documents.The foreign exchange rate used in this thesis is the rate offered by Vietcombank, notthe foreign exchange rate in the black market. It is assumed that the company canapproach the US Dollar source at banks. 14
  15. 15. [Tang Huynh Yen Phuong] 20114. MethodologyThe methodology used to accomplish the objective, is by doing a literature study,collecting primary and secondary data, processing the data, performing inductiveand explanatory research, and analyzing the result.Literature study- to deepen knowledge about foreign exchange risk, and theoverview of the Vietnamese foreign exchange market.Collecting data- From the reported data provided by the company, specializedreference books, information from newspapers, magazines, internet, and someresearch related to the topic.Processing the data- through these methods. - Statistics by tables, charts, formula: statistics to find out common characteristics of analyzed factors. - Comparison methods: compare the same kind of numbers to find the increasing and decreasing in each year. - Methods of Experts: consult the experts.5. The organization of the thesisThe thesis would be divided into three chapters which consist of:CHAPTER 1: LITERATURE REVIEWThis chapter explains theories behind the analysis done in this thesis, the overviewof the foreign exchange market, and the derivatives market in Vietnam.CHAPTER 2: RISK ANALYSIS OF TRANSACTION EXPOSUREThis chapter gives a brief overview regarding the company, detailed analysis of thetransaction exposure in the last five years as well as the current hedging tool of thecompany.CHAPTER 3 DESIGNING HEDGING STRATEGYThis chapter includes some available hedging tools, and long-term hedging strategyfor the company and recommendations for the State Bank of Vietnam to manage thederivatives market. 15
  16. 16. [Tang Huynh Yen Phuong] 2011 CHAPTER 1- LITERATURE REVIEW1.1. Import1.1.1. Definition of importingImporting is the purchasing side of trade and takes place when one region acquiresgoods or services from another region. Importing is linked with international tradeand generally is distinguished from trade within a specific nation because importinginvolves government regulation. (Importing, n.d.)1.1.2. The benefits and drawbacks of importinga. BenefitsMany economists, businesses, and politicians continue to rely on the principle ofcomparative advantage and it still influences import theories and policies.Consequently, countries continue to import products because they can obtain themless expensively abroad.In addition, given the technology, labor costs, government incentives, and subsidiesof different countries, one country may be able to produce goods more efficientlythan other countries. Hence, other countries will seek to import these goods becauseof price and perhaps quality advantages. For example, other countries importRobusta Coffee from Vietnam, while Vietnam imports Machinery from othercountries such as Japan and China.Importing allows countries to achieve higher standards of living by obtainingproducts and resources that cannot be obtained domestically. For example, in orderfor the Vietnam to maintain its standard of living, it must import petrol, since thecountry cannot produce a sufficient amount to satisfy consumer demand.b.DrawbacksMany economists and governments believe that importing goods can lead to theerosion of their national economies- especially when imports exceed exports.Importing goods poses other problems such as the tacit acceptance of social valuesthat conflict with domestic values. Importing goods from countries that pay low 16
  17. 17. [Tang Huynh Yen Phuong] 2011wages, for instance, can cripple domestic industries that cannot compete becausethey have a minimum wage, obligations to labor unions, and so forth.Furthermore, importing cheap goods, especially textiles, from countries that forceemployees- even children- to work in sweatshop conditions overlooks the type oftreatment of employees that many countries condemn.1.2. Foreign exchange marketAn exchange rate is a price of one currency against another currency. The foreignexchange market is a market in which national currencies are bought and soldagainst one another. The foreign exchange market is an over the counter marketbecause the market players are located in the major commercial banks around theworld. The foreign exchange market comprises transactions among four groups ofparticipants: dealers, brokers, cuctomers and central banks (Morris Goldstein,1993).Two fundamental types of the exchange rates (Gaurav Akrani. 2010) : Spot exchange rate : This refers to the price of foreign exchange in terms of domestic money payable for the immediate delivery of particular foreign currency. It is an existing or day-to-day exchange rate. Forward exchange rate : There are several future transactions whose delivery would be made sometime in the future. The rates at which these transactions are consummated are called as forward rate of exchange. It is the rate fulfilling the agreement between two parties based on future delivery of goods.1.3. Exchange rate determinantsThe exchange rate, just like commodities, determines its price responding to theforces of supply and demand. Therefore, if for some reason people increase theirdemand for a specific currency, then the price will rise, provided the supply remainsstable and vice versa.Some of the factors that influence currency supply and demand are inflation rates,interest rates, economic growth, and political and economic risks. 17
  18. 18. [Tang Huynh Yen Phuong] 2011Furthermore, international parity conditions describe the core financial theoriessurrounding the determination of exchange rates. This economic theory linksexchange rates, price levels and interest rates together. The international parityconditions encompassed:1.3.1. Purchasing Power Parity (PPP)1.3.1.1. Absolute Purchasing Power ParityIn it absolute version, purchasing power parity states that price levels should beequal worldwide when expressed in a common currency. However, absolutePurchasing Power Parity ignores the effects on free trade of transportation costs,tariffs, quotas and other restrictions and product differentiation (Alan C.Shapiro,2009) .1.3.1.2. Relative Purchasing Power ParityThe relative version of Purchasing Power Parity states that the exchange ratebetween the home currency and any foreign currency will adjust to reflect changesin the price levels of the two countries. (Alan C.Shapiro, 2009) .Formally, if ih and if are the rates of inflation for the home country and the foreigncountry, respectively; e0 is the home currency value of one unit of foreign currencyat the beginning of the period; and e1 is the spot exchange rate in period 1, then =1.3.2. Interest Rate Parity theory (IRP)According to interest rate parity theory, the currency if the country with a lowerinterest rate should be at a forward premium in terms of the currency of the countrywith the higher rate. More specifically, in an efficient market with no transactioncost, the interest differential should be (approximately) equal to the forwarddifferential. Interest rate parity holds when there are no covered interest arbitrageopportunities. According to Alan C.Shapiro, (2009) this no-arbitrage condition canbe stated as follows: 18
  19. 19. [Tang Huynh Yen Phuong] 2011 =rh: represents the nominal rate of home currencyrf: represents the nominal rate of foreign currencyf1:the forward rate at time 0 for delivery of one unit of foreign currency at time 1.1.4. Foreign exchange risk and foreign exchange exposures1.4.1. Foreign exchange riskMaurice D. Levi defined foreign exchange risk as “the variance of the domesticcurrency value of assets, liabilities, or operating incomes that is attributable tounanticipated changes in foreign exchange rates.” By definition, foreign exchangerisk depends on the exposure, as well as the variability of the unanticipated changesin the relevant exchange rate. “Foreign exchange risk is related to the variability ofdomestic currency values of assets or liabilities due to unanticipated changes inexchange rate.” (Maurice D. Levi, 2008, as cited in Thummuluri Siddaiah, 2009,pp.127)1.4.2. Foreign exchange exposureMaurice D. Levi also define the meaning of foreign exchange exposure. “It isshown that exposure is a measure of the sensitivity of changes in domestic currencyvalues of assets, liabilities or operating incomes to unanticipated changes inexchange rates” (Maurice D. Levi, 2009, pp. 283) 19
  20. 20. [Tang Huynh Yen Phuong] 2011Figure 1.1- Types of Foreign Exchange Exposure Foreign Exchange Exposure Economic exposure Translation exposure Transaction exposure Operating exposureAlan C.Shapiro (2005) cateforized foreign exchange exposure into economicexposure and translation exposure (see Figure 1.1). Economic exposure refers to potential changes in all future cash flows of a firm that result from unanticipated changes in exchange rates. Economic exposure may further be classified into transaction exposure and operating exposure. Transaction exposure refers to potential changes in the value of contractual future cash flows, or monetary assets and liabilites, resulting from changes in the exchange rate. Opreating exposure, on the other hand, represents the potential changes in the value of nonmonetary or real assests and liabilites due to unanticipated changes in exchange rates. Translation exposure is also knowns as accounting exposure. It arises when items of financial statements that are stated in foreign currencies are restated in the home currency of an multinational corporation. 20
  21. 21. [Tang Huynh Yen Phuong] 2011Table 1.1- Comparison of translation, transaction and operating exposure Comparison of translation, transaction and operating exposure Translation Exposure Operating ExposureChanges in income statement items and Changes in the amount of futurethe book value of balance sheet assets operating cash flows caused by anand liabilities that are caused by an exchange gains or losses are determinedexchange rate change. The resulting by changes in the firm‟s futureexchange gains and losses are competitive position and are real. Thedetermined by accounting rules and are measurement of operating exposure ispaper only. The measurement of prospective in nature as it is based onaccounting exposure is retrospective in future activities.nature as it is based on activities thatoccurred in the pastImpact: Balance sheet assets and Impact: Revenues and costs associatedliabilities and income statement items with future sales.that already exist. Exchange rate change occursImpacts: Contracts already enterd into, but... to be settled at a later date. Transaction exposureChanges in the value of outstanding foreign-currency-denominated contracts (i.e,contracts that give rise to the future foreign currency cash flows) that are broughtabout by an exchange rate change. The resulting exchange gains and losses aredetermined by the nature of the contracts already entered into and are real. Themeasurement of transaction exposure mixes the retropective and propextive becauseit is based on activities that occurres in the past but will be settles in the future.Contracts already on the balance sheet are part of accounting exposure, whereascontracts not yet on the balance sheet are part of operating exposure.Source: Alan C.Shapiro (5th). (2005) Foundations of multinational financialmanagement (pp,252)1.5. Transaction exposures and managing transaction exposures1.5.1. Transaction exposureAccording to Thummuluri Siddaiah (2009), transaction exposure refers to potentialchanges in the value of contractual cash flows that arise due to unexpected changesin the foreign exchange rate. It is a measure of the sensitivity of the home currency 21
  22. 22. [Tang Huynh Yen Phuong] 2011value of assets and liabilities in foreign currency to unanticipated changes inexchange rates. According to Henri L. Beenhakker (2002), transaction exposurearises from: Borrowing or lending funds when repayment is to be made in a foreign currency. Purchasing or selling on credit goods or services whose prices are stated in foreign currencies. Being a party to an unperformed foreign exchange forward contract. Acquiring assets or incurring liabilities denominated in foreign currencies.1.5.2. Managing transaction exposures1.5.2.1. Identify the degree of exposuresAfter identified the types of risk which a company is exposed to, the next crucialstep in a company‟s risk management decision is the risk measurement. Accordingto South/Western Thomson Learning (2003), to measure the transaction exposure acompany should project the net amount of inflows and outflows in each foreigncurrency and determine the overall risk of exposures to those currencies.(South/Western Thomson Learning, 2003, as cited in Yasmin Nur Annisa , 2008,p27) .1.5.2.2. Make decision on hedging the exposuresThe decision whether to hedge or not required a depth analysis. The company needsto consider to what extend a company are willing to take the risk, whether thecompany has the risk adverse attitude or not. The gains and losses shouls becompared with the existing exposure and the predetermined exchange rate budget,which has been agreed by the management. The company‟s level of certaintywhether a specific event will occur or not also determine the risk managementdecision. A company can decide to do notthing or to hedge its exposure. (YasminNur Annisa , 2008, p28)1.5.2.3. Choose a hedging technique 22
  23. 23. [Tang Huynh Yen Phuong] 2011According to Alan C.Shapiro (2005), there are many techniques by which the firmscan manage their transaction exposure. These techniques can be broadly divided into hedging techniques and operational techniques. Hedging refers to taking anoffsetting position in order to lock in the home currency value for the currencyecposure, eliminating the risk arising from changes in the exchange rate. Theimportant hedging techniques are forwards/futures, money market hedges, optionsand swaps. Operational techniques include exposure netting, leading and laggingand currency of invoicing.Figure 1.2- Hedging techniques to manage transaction exposure Managing transaction exposure Hedging Operational techniques techniques Forwards and Money Netting and future market hedge offsetting Currency of Swaps Options invoicing Leading and lagging1.5.2.3.1. Hedging techniques* The Derivatives Market is meant as the market where exchange of derivativestakes place. Derivatives are one type of securities whose price is derived from theunderlying assets. And value of these derivatives is determined by the fluctuationsin the underlying assets. These underlying assets are most commonly stocks, bonds,currencies, interest rates, commodities and market indices. The Derivatives can beclassified as Future Contracts, Forward Contracts, Options, Swaps and CreditDerivatives. (Meaning Derivatives Market, n.d.).(i) Forward 23
  24. 24. [Tang Huynh Yen Phuong] 2011The forward market involves contracting today for the future purchase or sale offoreign exchange. Forward contact is a legally binding agreement between twoparties calling for the sale of an asset or product in the future at a price agreed upontoday. The forward contract cannot be traded in the stock exchange but they aretraded among financial institutions or between financial institutions and its clients.Forward contract is tailor made on its currency rate, delivery date and the amountinvolved which is negotiated by the party involved in the contract. The forwardcontract value is equal zero but the future rate is changing and the delivery price isfixed. Therefore, there is a possibility for gain or losses realized on the settlementdate from the exchange rate fluctuation.Forward contacts are the most common means of hedging transactions in foreigncurrencies because of its simplicity. The trouble with forward contracts, however, isthat they require future performance, and sometines one party is unable to performon the contract. When that happens, the hedges disappears, sometimes at great costto the hedger.(ii) FuturesIn contrast to forward contract, a futures contract has standardized features on itscontract size, delivery date, daily resettlement and so forth. Futures are exchangetrade which means traded on organized exchanges rather than over the counter. Aclient desiring a position in futures contracts contacts his broker, who transmits theorder to the exchange floor where it is transferred to the trading floor. In the tradingfloor, the price for order is negotiated by open outery between floor brokers ortraders.Futures recognized the gain and losses daily because its daily resettlement features.Frequently, a futures exchange may have a daily price limit on the futures price, thatis, a limit as to how much the settlement price can increase or decrease form theprevious day‟s settlement price.Nevertheless, futures only allow companies to hedge approximately becausefutures‟ strandardized instruments on its contract size, delivery date and so forth. In 24
  25. 25. [Tang Huynh Yen Phuong] 2011addition, due to marking to market property, there are interim cash flows prior tothe maturity date of the futures contract that may have to be invested at uncertaininterest rates. As a result, exact hedging would be be difficult.(iii) OptionAn option contract is a type of contract agreement which give the owner the right,but not the obligation, to sell or buy underlying asset in a predetermined priceduring a certain period of time in the future. A person who buys an option contractpays a premium to the option‟s seller to compensate the ability of setting the flooror ceiling price decision. The option holder has the right not to exercise the contractit the market price moves outside the projected rate.There are two types of options, American and European. American option can beexercised anytime during the contract validity. European option only can beexercised at the maturity date. Option does not have standardized features and madeaccording to the company‟s specific needs. Option also differentiated as: Call Option, which is an option to buy an underlying asset. A company exercises the call option if the spot rate is in the money position, in this case when the spot rate is bigger than the exercise price. Put Option, which is an option to sell an underlying asset. A company exercises the put option if the exercise price is bigger than the spot rate.In hedging using options, options with its premium is considered more expensivebecause of its flexibility in the tailor made value. Options are particularly suited as ahedging tool for contingent cashflow, for example in bidding processes.(iv) Hedging with swap contractsA swap is an agreement between two parties to exchange a cash flow in onecurrency against a cash flow in another currency according to predetermined termsand conditions, to put it differently, a swap agreement requires periodic paymentsfrom one party to the other party in order to safeguard against unfavourableexchange rate movements. A firm which expects certain cash flows in a foreigncurrency in the future may enter into a swap contract in order to hedge those cash 25
  26. 26. [Tang Huynh Yen Phuong] 2011flows against foreign exchange rate fluctuation. Currency swap are generally usedto hedge long-term transaction exposures.(v) Money marketMoney market strategy for hedging involved the investing and borrowing in thecurrency market. The company can invest in the loan in the short term investmentsuch as buying securities or deposit in a bank. For example, a company hedges areceivable by locking in the value of a foreign currency transaction in the homecurrency and hedges a payable by locking in the value of a foreign currencytransaction in the foreign currency. The implementation of money market hedge forpayables is explained as below steps: Define how much is the liabilities‟size at the due rate. Define the present value of the payables with the foreign currency deposit interst rate, and then covert it to the home currency. Loan the money in the home currency, covert it in the foreign currency, and invest in the foreign currency deposit. At the due date, the deposit will cover the exact amount of the payables in the foreign currency. The cash outflow at the due date is exactly the same amount as the loan plus interest rate a company had. Therefore, the company can avoid the loss possibility for the exchange rate fluctuation if the home currency depreciated against the foreign currency.The most attractive feature from money market hedge is its liquidity. A companycan easily turn the funds into cash, for instance with writing a check. Money marketis probably one of the safest places for saving the capital. The funds are invested inrelatively secure government or other short-term, high-quality debt.However, a company has an opportunity cost by using the money market hedge.The funds invested in a money market account could have fared better in a differentinvestment instruments such as a stock or a bond. Moreover, money market cansometimes fail to keep pace with inflation which means an investor‟s purchasing 26
  27. 27. [Tang Huynh Yen Phuong] 2011power may decline each year. Thus, money market is not suitable for an extendedperiod of time.1.5.2.3.2. Operational techniques(i) Invoice currencyA company can hedge through the choice of invoice currency. The exchange ratecan be shifted to another party by invoicing another party using the company‟shome currency. Moreover, a company can share the risk by invoicing another partyby half in another party‟s currency and half in the company‟s domestic currency. Acompany can diversify the exchange rate exposure through basket of currencies asthe invoice currency. Invoicing in currency baskets can be a useful hedging toolwhen no forward or currency contracts are available. However, a company shouldalso consider the customer‟s convenient level. The customers may choose anothercompany which has simplier payment method.The important factors that govern invoicing are historic relationships between thetrading partners and the relative bargaining powers of partners. Sometimes, neitherof the parties involved may have any choice, as in the case of crude oil exports,which are conventionally invoiced in the U.S dollar.(ii) Lead/ Lag StrategyThe strategy involve adjusting timing of foreign currency receipts and payables andto take advantage of an expected currency depreciation or appreciation. Lead meansto pay or collect early and lag means to pay or collect late. If a currencyappreciating, a company should pay the bills in that currency early and let customerpay late as long as they pay in that appreciation currency. It a currency depreciating,a company should give incentives to customers to pay early and the companyshould pay the payables late. If the paying or receiving currency are equally weak orstrong, ther is no advantage in leading or lagging from a currency exposureviewpoint.A good relationship between suppliers and customers is required for implementingthe strategy, as to be willing to grant extra credit period or negotiating discount for 27
  28. 28. [Tang Huynh Yen Phuong] 2011prompt payment. Thus, lead and lag strategy commonly applied to intercompanytransaction as there would be minimal conflict between suppliers and customers.(iii) Exposure nettingA firm may have a transaction exposure portfolio with exposures in differentcurrencies. When exchange rates change, there may be gains on some currenciesand losses on others. Exposure netting is a portfolio approach to hedging, accordingto which a firm may manage its trade transactions in such a way that exposures inone currency will be offset by exposures in the same or other currencies. This,infact, provides a natural hedge. A firm can have more stable cash flows if it hascurrency diversification, which can limit the potential impat of changes in anysingle currency on the cash flows of a firm.(iv) Price decisionsThe general rule on credit sales overseas is to convert between the foreign currencyprice and the dollar price by using the forward rate, not the spot rate. If the dollarprice is high enough, the exporter should follow through with the sale. Similarly, ifthe dollar price on a foreign-currency-denominated import is low enough, theimporter should follow through on the purchase. All this rule does is to recognizethat a euro (or any other foreign currency) tomorrow is not the same as a euro today.This rule is the international analogue to the insight that a dollar tomorrow is not thesame as a dollar today. In the case of a sequence of payments to be received atseveral points in time, the foreign currency price should be a weighted average ofthe forward rates for delivery in those dates.1.6. Overview of Vietnam Foreign exchange market1.6.1. Background of Vietnam’s exchange rate regimeIn line with the broader economic reform process, Vietnam‟s exchange rate regimehas evolved from a system of multiple exchange rates to a single announced fixedrate, then to the current system incorporating a narrow adjustable band around theofficial rate, which is itself set on a daily basis and is meant to reflect the interactionof market forces. 28
  29. 29. [Tang Huynh Yen Phuong] 2011The changes in exchange rate regime have allowed the creation of the necessaryinstitutional framework for the formation and development of an organized foreignexchange market in Vietnam. The country started to have an organized, modernforeign exchange market since the early 1990s. There are two key milestones inthis process. The first was the establishment of two foreign exchange trading floors(in 1991) and the second the birth of an interbank foreign exchange market (in1994).1.6.2. Vietnam’s exchange rate regime during 1994-2011 periods(i) 1994-1996 - Conventional fixed peg arrangementReplacement of the two foreign exchange transaction floors with an inter-bankforeign exchange market.Official Exchange rates were stable and set by the State Bank of Vietnam based oninter-bank Exchange rates. The Exchange rate band within which Commercialbanks set their own Exchange rates remained narrow at 0.5%- 1% around theofficial Exchange rate.(ii) 1997-1998 - Crawling bandsThe Exchange rate band was widened continuously, from 1% to 5% (02/97), andfrom 5% to 10% (13/10/97).Devaluation of the VND under pressure of falling foreign exchange reserves andincreases in balance of payment deficits.(iii) 1999-2000 -Conventional fixed peg arrangementInstead of declaring an official Exchange rate, since 26 Feb. 1999 the State Bank ofVietnam began announcing average inter-bank Exchange rates of the previousworking day, but the band has been tightened remarkably to 0.1%.(iv) 2001-2007 - Crawling pegThe average inter-bank Exchange rates were gradually adjusted from14,000VND/USD (2001) to 16,100 VND/USD (2007).The Exchange rate band was widen from 0.1% to 0.25% (07/2002) and from 0.25% to 0.5% (01/2007). 29
  30. 30. [Tang Huynh Yen Phuong] 2011(v)2008-2011 - Crawling bandsTable 1.2- Changes of average inter-bank exchange rates and allowabletrading bands during 2008-2011 period.Average inter-bank Exchange rates Allowable trading bands (VND/USD) (%)06/2008: 16,500 VND/USD 24/12/2007: 0.75%01/2009: 17,000 VND/USD 10/03/2008: 1%12/2009: 17,940 VND/USD 27/06/2008: 2%02/2010: 18,544 VND/USD 07/11/2008: 3%08/2010: 18,932 VND/USD 24/03/2009: 5%02/2011: 20,693 VND/USD 26/11/2009: 3% 11/02/2011: 1%Source: Various Decisions by the State Bank of Vietnam from 2008 to 20111.6.3. Mechanisms to support stability in the VND/USD rateAccording to Nguyen Tran Phuc (2009), the current exchange rate regime operateswithin the framework of an announced official exchange rate and an allowableexchange rate band. These two devices have been used to slow down short-termchanges in the exchange rate, even when there was strong market pressure for eithera depreciation or appreciation of the domestic currency. When the resultantcommercial exchange rates failed to clear the market, the authorities tended to relyon official intervention to meet part of the imbalance between demand and supply,supplemented by moral suasion and administrative measures.1.6.3.1. Official exchange rateSince 1999 the State Bank of Vietnam has determined the average VND/USDexchange rate on the interbank market on each banking day and announced it as theofficial exchange rate on the following banking day. However, this determinationprocess has not been transparent and has contained to a large extent elements of thesubjective will of the State Bank of Vietnam. Additionally, the announced average 30
  31. 31. [Tang Huynh Yen Phuong] 2011interbank rate has often appeared rather sticky or even rigid, despite evidence ofrapid developments in the market.Table 1.3- Changes of average inter-bank exchange rates during 2007-2011period. Average inter-bank Exchange rates Change 01/2007 16,100 VND/USD 06/2008 16,500 VND/USD 2.48% 01/2009 17,000 VND/USD 3.03% 11/2009 17,940 VND/USD 5.53% 02/2010 18,544 VND/USD 3.37% 08/2010 18,932 VND/USD 2.09% 02/2011 20,693 VND/USD 9.30%Source: Various Decisions by the State Bank of Vietnam from 2008 to 20112006-2008: During this period, the State Bank of Vietnam pegs Vietnamese Dongto US dollar at an annual devaluation of 1- 2% (mainly to handle the difference ininflation between the two economies). In a stabilizing effort, State Bank of Vietnamraised inter-bank exchange rate by 2.48%, from 16,100 VND/USD to 16,500VND/USD on June, 2008.2009: On December 25th 2008, the State Bank of Vietnam announced a newexchange rate (17,000 VND/USD), with the dong depreciating by 3.03% against theUS dollar as compared to June, 2008. This move contributed to facilitating export,controlling trade deficit, ensuring a sustainable international balance of payments,limiting the expectation of exchange rate hike, hence assisting enterprises toactively develop their stable business plans.Also, in this year, short supplies of foreign currency have characterized the nationaleconomy. The shortage appeared in the second quarter of the year, when exportcompanies held onto foreign currencies and refused to sell dollars to banks.Commercial banks did not have foreign currencies to sell to businesses, but they did 31
  32. 32. [Tang Huynh Yen Phuong] 2011have capital in foreign currencies since no one wanted to borrow in foreigncurrencies for fear of further dollar price increases. To cool the market, in lateNovember, State Bank of Vietnam decided to narrow the foreign currency tradingband to curb the decrease of the dong‟s value and raise the interbank exchange rateby 5.53% from 17,000 VND/USD to 17,940 VND/USD. Meanwhile, the PrimeMinister requested large state-owned groups and corporations to sell dollars tobanks and improve the supply.2010-2011:On February 10th , 2010, Central Bank decided to raise the average interbankforeign exchange rate by 3.37 percent from 17,940 to 18,544 dong per US dollar.Then the foreign exchange rate movements showed the very positive signals whenfree markets foreign exchange rate was closer to the commercial banks.On February, 2011, the State Bank of Vietnam has decided to lift the interbankexchange rate by 9.3% from VND 18,932 to VND 20,693 to the dollar andnarrowed exchange rate amplitude from 3% to 1%. According to State Bank ofVietnam‟s explanation, the adjustment of the exchange rate aims to promote theliquidity of the foreign exchange market. State Bank of Vietnam said that it wouldadjust the interbank average exchange rate flexibly in the near future according tothe foreign currency supply and demand situation, to ensure the liquidity of themarket, contribute to curbing the trade gap and help carry out monetary policiesmore flexibly.In conclustion, the State Bank of Vietnam tends to raise the interbank foreignexchange rate in recent years in order to increase the market liquidity and foreignexchange reserves, and especially to curb trade deficit. However, Vietnamseconomy relies heavily on material imports. A successful processing economy isnot allowed to be dependent on imports. Other countries have to devalue theircurrencies whereby their export products will be more competitive. But theory isnot right as for a developing country like Vietnam. In Vietnam, strategic exportitems such as apparel, footwear have the imported material ratio of over 80-90 32
  33. 33. [Tang Huynh Yen Phuong] 2011percent. So, when devaluing the dong, the prices of material imports as well as theprices of products will be higher, meaning that devaluing the dong will harm theeconomy.1.6.3.2. Allowable trading bandFigure 1.3- Allowable Variations around Official Exchange Rate Mar 1989 -Mar 2011Note: There was no lower band for the periods Aug 91–Sept 94 and Jan 98–Jun 02Source: Various Decisions by the State Bank of Vietnam from 1989 to 2011The trading band, within which commercial quotations are allowed to fluctuate, hasbeen quite narrow except for the periods around the 1997-1998 Asian FinancialCrisis and the 2007-2008 Global Financial Crisis (see Figure 1.3). It would appearthat increases in the width of the allowable trading band have been used mainly torespond to episodes of strong pressure for the VND to depreciate. In particular, therepeated broadenings of the band in 1997 and 2008-2009 allowed the VND/USDexchange rate to be adjusted upward in response to major external shocks. When theimmediate urgency had passed, however, the band tended to be narrowed again.1.6.3.3. Official interventionGiven the operation of administered pricing, through the setting of both the officialexchange rate and the allowable trading band, frequent instances of non-clearance 33
  34. 34. [Tang Huynh Yen Phuong] 2011of the market were unavoidable. By default, the State Bank of Vietnam often foundit necessary to intervene in order to manage such market imbalances, aiming atkeeping the exchange rate VND/USD at the required level and within the allowableband.During much of the period under study, the VND was under pressure to depreciate,and there was a persistent excess demand for USD at the commercially quotedexchange rates, which were already pushed to their upper limit. Accordingly, theState Bank of Vietnam had to sell quantities of USD. Due to the need of conservingofficial foreign exchange reserve, however, the State Bank of Vietnam tended tomeet only part of the prevailing excess demand, and to use administrativearrangements to ration some of the available foreign exchange among potentialbuyers. In particular, only those commercial banks with short positions exceeding acertain size could approach the State Bank of Vietnam to buy foreign currency atthe quoted exchange rates. Moreover, the system allowed priority to be given to theimportation of essential goods (such as petroleum, fertilizer and medicine), and tocommercial banks that serve customers engaging in these priority activities. Thismeans that other customers must turn to the parallel black market or other channelsto address their unmet demand for USD.1.7. Overview of Vietnam’s derivatives marketFirst appearing in developed markets in the 1980s, financial derivatives have beenused widely by commercial banks worldwide as risk-prevention tools. However, thesituation is different in Vietnam. Financial derivatives were first used in Vietnamten years ago (2000), but they are still far from popular in the country.In fact, several derivatives products, including forward, swaps, options and futures,have been provided by some prestigious banks such as Vietcombank, BIDV,Techcombank, Eximbank and HSBC. However, the banks still cannot persuadetheir clients to use the products more regularly. 34
  35. 35. [Tang Huynh Yen Phuong] 20111.7.1. Forward transactionForward transaction were first introduced about 10 years ago. This type oftransaction brings many advantages to customers: Suitable for foreign trade settlement, overseas money transfer or investment to hedge the fluctuation of exchange rate. Customers may estimate in advance business expenses and incomes and guarantee ability to make payment to other parties.In forward transaction, Foward rate is caculated according to the formula (Phd TranHoang Ngan, Phd Nguyen Minh Kieu,2008) : (1) ~ F=S F=S+S ~F = S + Forward spreadUsing a direct exchange rate: Home currency price of certain quantity of the foreigncurrency quoted (Home currency/Foreign currency: VND/USD)Rh: Interest rate of Home currency (%)Rf: Interest rate of Foreign currency (%)F: Forward rateS: Spot raten: transaction term(1)Based on the theory of Interest rate parity – IRP.Before 28th May, 2004: according to the Decision 17/1998/QĐ-NHNN7 (10th Jan1998), forward rate consists of two parts: the spot rate and the forward spread (alsoknown as forward points, forward pips, etc). Forward spread is expressed as eitherpremium spread or discount spread. Forward rate was determined as followingformula: F = S + Forward spreadThe Forward spread was determined by Percentage of Spot rate offered by StateBank of Vietnam based on . For example: 35
  36. 36. [Tang Huynh Yen Phuong] 2011Forward spread= 0,8%*Spot rate (of the signing day) for settlement after 7 days.This way of forward rate determination was different with international practice andcould not keep up with the changes in the market. Also, settlement date was only beat most 6 months after trade date. This did not meet the demand of manycompanies. Thus, not many companies used forward transactions at that time.After 28th May, 2004: According to Desicion No. 648/20 in 2004, Settlement datewas extented to be at most 365 days after trade date. Also, Commercial banks areallowed to set the forward rate VND/USD so that it does not exceed the ratecomputed on the basis of: (i) spot rate; (ii) interest differential between the base rateof the dong and Fed Funds Target Rate of the US dollar; and (iii) forward term.This way of forward rate determination moves closer to international practice.We have the following formula: Forward rate = S+ S*rVND: Base rate of the dongrUSD: Fed Funds Target Rate of the US dollarMany banks provide forward transaction with similar features.EximbankTransaction term: At least 3 days, at most 365 days.Transaction fee: No fee required.Documents: Economic entities, other organizations and individuals deposit VND tobuy foreign currencies from Eximbank have to present documents fully providinginformation on the purpose, quantity and type of payment currency, payment timein accordance with current Foreign Exchange control regulations.Forward rate:Forward rate of USD-VND transaction is the rate calculated on spot rate in the tradedate and the difference between VND basic interest rate of State Bank of Vietnam(on yearly basis) and the USD target interest rate of US Federal Reserve Bank. 36
  37. 37. [Tang Huynh Yen Phuong] 2011Forward rate of VND against foreign currencies (except USD) transaction andforward rate between foreign currencies is based on the negotiation.Table 1.4- Spot rate and forward rate of Eximbank on March 2011 (Forreference) USD/VND Exchange rate nd Date 22 March, 2011 Rate Transaction term Bid Ask Spot rate 20,885 20,890 01 week 20,921 20,926 02 weeks 20,956 20,961 01 month 21,037 21,042 02 months 21,200 21,205 Forward rate 03 months 21,342 21,347 04 months 21,494 21,499 05 months 21,646 21,652 06 months 21,849 21,855 Average interbank exchange rate: 20,683VND/USD Trading band: 3%Note: These statistic can be varied during a day.Source: Eximbank ‘s Treasury DepartmentProcedures:Contact with the Treasury Department to sign a forward contract.3% deposit of the contract value for USD/VND transactions is required.7%-10% deposit of the contract value is required for transactions other thanUSD/VND transactions. Up to the present time, outright forward account for only about five to sixpercent of total foreign exchange trading turnover. Such a share is very small byinternational standard. In addition to low trading volume, the forward segmentappears to have abnormal and immature characteristics. First, the selling-buying structure of forward trading by commercial banks has been exceedingly imbalanced: the turnover of forward-selling by 37
  38. 38. [Tang Huynh Yen Phuong] 2011 commercial banks made up around 75-85 percent of total forward trading (Nguyen Tran Phuc 2009, pp.15). Second, commercial banks have tended to be quite passive in taking the role of market-makers in the forward market. Vietnamese commercial banks generally do not make their quotation ready for forward transactions, in both client and interbank market. Any quotation can be obtained only upon a request. (Luu Minh Ngoc, 2008, as cited in Nguyen Tran Phuc, 2009, pp.15) Third, the determination of forward rate VND/USD still contains administrative elements. According to a guidance in 2004, commercial banks are allowed to set the forward rate VND/USD so that it does not exceed the rate computed on the basis of: (i) spot rate; (ii) interest differential between the base rate of the dong and Fed Funds Target Rate of the US dollar; and (iii) forward term. This way of forward rate determination moves closer to international practice, but the mentioned reference interest rates may not reflect the true market interest rates that market participants realize in their transactions. This suggests that the current guidance has tended to hold back the ability of commercial banks in acting as market-makers as well.( Nguyen Tran Phuc 2009, pp.15).1.7.2. Currency optionsCurrency options were first introduced by Eximbank into Vietnam‟s forex market in2003. Currency Option contract is a contract between buyer and seller of an optionin which buyer has the right (but not the obligation) to buy or sell a certain currencyamount at a predetermined exchange rate at or prior to a certain expiration date. Ifbuyer chooses to exercise the right, seller has a duty to sell or buy that currencyamount at a stated rate as specified in the contract.Some advantages of currency options: To hedge the risk of exchange rate fluctuation as well as to help customers to get profitable opportunities if exchange rate changes appropriately. 38
  39. 39. [Tang Huynh Yen Phuong] 2011 Able to predetermine minimum fee (premium) of a Call Option or minimum profit of a Put Option. To provide customers with an acceptable rate. Have a chance to speculate on F/X fluctuation with a fixed premium and unlimited profit.EximbankStyles:American style: the option can be exercised at any time during its validity.European style: the option can only be exercised at the contract maturity date.Eligible users:Buyer: eligible individuals or entities living or operating in VietnamSeller: EximbankTransaction premium: The amount that buyers have to pay for the bank (sellers) toget the option.Table 1.5- Option transaction premium of Eximbank in March 2011 Reference transaction premium st21 March 2011Style AmericanUSD/JPY (Unit: pips) (strike price 80.90) Call Option Put option 01 week 82 85Transaction period 02 weeks 99 102 01 month 126 130EUR/USD (Unit: pips) (strike price 1.4170) Call Option Put option 01 week 85 89Transaction period 02 weeks 119 121 01 month 197 203GBP/USD (Unit: pips) (strike price 1.6220) Call Option Put option 01 week 95 97Transaction period 02 weeks 128 132 01 month 181 186Transaction period: from 3 days up to 365 daysNote: These statistic can be varied during a day.Source: Eximbank ‘s Treasury Department 39
  40. 40. [Tang Huynh Yen Phuong] 2011Exchange rate: The exchange rate agreed by the two parties and specified in thecontract.Transaction currencies: USD, GBP, CHF, JPY, AUD, CAD, EURAmount: Equivalent to at least USD$100,000 (one hundred thousand US dollars)for each contract.Transaction period: from 3 days up to 365 daysContract validity: The period that option can be done by the requirements of buyersfrom the contract signing date to before 11:00 (Hanoi time) of the contract maturitydate.Documents: No need for any documents certifying the purpose of currency useContract Exercise: When in need of implementing the contract, customers submitthe Request for Contract Exercise to Eximbank.*** In 19th March,2009, the Government has issued a decision under Decree160/2006/NĐ-CP to stop offering option contract between Vietnam dong and otherforeign currency since 23rd March, 2009.1.7.3. SwapForeign exchange swaps have been so far used for the purpose of injecting localcurrency into circulation only. They were first allowed in 1998. However, it was notuntil July 2001 that the first deals were actually done when the State Bank ofVietnam issued a guidance on the implementation of foreign exchange swapsbetween the State Bank of Vietnam and commercial banks to assist the latter inovercoming temporary shortages of fund in local currency. Such specifiedtransactions were popular in years 2001-2002 with transaction volumes of severalhundred million US dollars, helping commercial banks use sources of fund inforeign currency flexibly. Yet, they became quiet in the following years with asmall transaction volume.Some benefits of currency options: Cheaper than cash markets by issuing foreign currency bonds directly. Can select to exchange principal at the start if desired. 40
  41. 41. [Tang Huynh Yen Phuong] 2011 Simple documentation procedure compared to cash markets through issuing a bond or arranging a loan. Customised and can be reversed at any time. Off Balance Sheet. Suitable for hedging long-term transaction exposures. Be fully hedged against foreign exchange risks in terms of both principal and coupons. The obtainment of capital in the required currency, in the necessary volume and with the required due term.EximbankDecription: Cross Currency Swap services include 2 transaction:Spot transaction +Forward transactionForward transaction+ Forward transactionEligible users:Buyer: Entities living or operating in VietnamSeller: EximbankExchange rate: The spot exchange rate at the time of doing the deal determines theprincipal amounts.Transaction term: At least 3 days, at most 365 days.Transaction fee: No fee required.Documents: No need for any documents certifying the purpose of currency useProcedures:Contact with the Treasury Department to sign a forward contract.3% deposit of the contract value for USD/VND transactions is required.7%-10% deposit of the contract value is required for transactions other thanUSD/VND transactions.1.7.4. EvaluationThere are some reasons why Vietnamese companies are quite indiferent toderivatives products: 41
  42. 42. [Tang Huynh Yen Phuong] 2011 Most Vietnamese companies did not have good understanding of complicated operations of how to use these derivatives products. For example, It took HSBC Vietnam six months to explain and negotiate with a client before a swap contract was reached. The turnover from derivatives products is not big enough for Vietnamese banks to spend more time and money to attract clients. The policy on stabilising the VND/US$ exchange rate has also led to the fact that companies do not pay appropriate attention to these products. Currently, the official VND/USD exchange rate has followed a gradual upward trend with very little volatility except for the periods of the Asian Financial Crisis and the recent World Financial Crisis. This gives rise to a high degree of predictability and an expectation among market participants that the State Bank of Vietnam will frequently intervene to limit volatility in the official rate. The low volatility of the exchange rate, coupled with the one-way nature of most daily movements, means that businesses generally perceive little foreign exchange risk. As a result, there is little incentive for market participants to develop greater sophistication in terms of ability to form views regarding the future paths of the exchange rate, or to manage exchange rate risks. Most credit loans on the market apply fixed interest rates (90%), and with fixed interest rates, borrowers do not need derivatives products to minimize risks from interest rate fluctuations.In conclusion, we can say that there is little need for derivative products as a meansof risk management during normal times. However, when exchange rates didbecome more volatile (for example, during the recent World Financial Crisis),hedging devices would have been very useful means to manage exchange rate risks. 42
  43. 43. [Tang Huynh Yen Phuong] 2011 CHAPTER 2- RISK ANALYSIS OF TRANSACTION EXPOSURE2.1. Profile of CNT2.1.1. IntroductionEstablished: 1976Name in Vietnamese: CÔNG TY CỔ PHẦN XÂY DỰNG VÀ KINH DOANHVẬT TƯName in English: CONSTRUCTION AND MATERIALS TRADING JOINTSTOCK COMPANYDirector: Mr Pham Anh TuanCharter Capital: VND 100,150,690,000Registered and Corporate Office: 9-19 (Floor 6) Ho Tung Mau Street District 1Ho Chi Minh CityWebsite: www.CNT.com.vnTable 2.1- List of shareholders holding over 5% as of May 14, 2010 Number Owner Name of Shareholders Address of percentage SharesConstruction Corporation 111 Pasteur P. Ben Nghe 3,450,000 34.50%No.1 Ward, Dist 1, HCM cityVietNam Property TMS Building, Floor 12, 172 1,939,975 19.39%Holding Hai Ba Trung, Dist 1 HCM citySource: Prospectus 2010 43
  44. 44. [Tang Huynh Yen Phuong] 20112.1.2. Establishment and historyFigure 2.1-Establishment and history of CNT 28/05/1976 Established with initial name Transport Materials Supply Enterprise directly under Construction Corporation No.1 26/05/1981 Ministry of Construction signed Decision to change Transport Materials Supply Enterprise to Transport Materials Supply Company. 24/02/1990 The company was renamed Construction and Materials Supply Company. 15/01/2003 The Ministry of Construction promulgated decision concerning equitizing the company with the new name Construction and Materials Trading Joint Stock Company (C&T). 04/03/2003 Department of Planning and Investment of Ho Chi Minh city issued the business registration certificate No 4103002148. 28/07/2008 C&T was the 155th company officially listed in Ho Chi Minh City‟s Stock Exchange under the code CNT. 01/01/2009 Vietnam Steel Association certified C&T as official member. 44
  45. 45. [Tang Huynh Yen Phuong] 20112.1.3. Vision and missiona. VisionUntil 2015, CNT continues to be a diversified company with the leading position inthe fields of construction, materials trading and real estate business; maintaining thesteady growth in infrastructure construction, industrial production and real estateinvestment.b. MissionStrive to provide customers with the high quality products and good services at thecompetitive price, making a significant contribution to the national economicgrowth.Strengthen management system, increase efficiency of capital utilization andtransparency in business activities.Concentrate on raising employees‟ salaries and creating surplus values toshareholders.Build up the specific characteristic of the company culture: Grow up together.Link the individual success with the growth of the company and be dedicated tonational community development.2.1.4. Scope of Business2.1.4.1. ConstructionWith experienced engineers and over 2000 skilled workers, CNT has performedcivil, industrial projects, foundation and infrastructure projects which have been inhighest rank and project progress completion on time. Since 2000, CNT hasinvested lots of machinery, manpower, and applied new technology in constructionfield. As a result, CNT becomes one of the best construction companies ofConstruction Corporation No.1.2.1.4.2. InvestmentCNT has been carrying out many investment projects since 2003, especially realestate investment and industrial production. At present, CNT is concentrating allfinancial efforts on investing and building the complex commercial office- 45
  46. 46. [Tang Huynh Yen Phuong] 2011apartment (Green Pearl City) at An Phu Ward, District 2, Ho Chi Minh City. Thisproject is regarded as CNT‟s key investment and trading project from 2010-2012.2.1.4.3. Industrial and construction material productionCNT has produced the industrial products and construction materials as follows: - Various kinds of construction stones - Reinforced concrete pile and others such as centrifugal round drains, box drains, girders, etc. - Various kinds of PP packing (for Baltic – Europe)2.1.4.4. Import - export tradeWith skilled staff in foreign trade activities, full of prestige in mandating importexport services, CNT has won the contracts to supply the imported materials andequipment for many large projects and raw materials for the construction materialproduction factories such as clinker, rough steel, etc. The company has had therepresentative office in Ukraine, China since 2003 and business promotion in theU.S.2.1.4.5. Local product tradeCNT has much experience for many years in the material and equipment supply tothe large projects of Construction Ministry and Construction Company No. 1 suchas Tri An Hydroelectric Plant, Thac Mo Hydroelectric Plant, Vung Tau Petroleum,Da My Ham Thuan Hydroelectric Plant, Sao Mai Hon Chong Cement Factory,National road No.1 upgrading contract R.100, Xuyen A Highway, Dong TayBoulevard, water environment projects, etc. 46
  47. 47. [Tang Huynh Yen Phuong] 20112.1.5. Organizational structureFigure 2.2- Organizational structureSource: Prospectus 2010 47
  48. 48. [Tang Huynh Yen Phuong] 20112.1.5.1. General Shareholder’s MeetingGeneral Shareholders Meeting is the body with highest decision power of CNTincluding all shareholders with voting right and held at least once a year. GeneralShareholders Meeting decides on the issues regulated by the Laws and the Articlesof Association of CNT such as Passing annual financial statements of CNT andfinancial budget for the subsequent year; electing, dismissing or releasing membersof the Management Board, Supervisory Board2.1.5.2. Board of managementBoard of Management has 05 members, two of which are independent ofmanagement. Board of Management is the body managing of the Company, whichis entitled to act on behalf of the Company in exercising all the rights andobligations, except those falling under the authority of the Shareholders Meeting.2.1.5.3. Board of supervisorsThe chief supervisor of the Company has expertise in accounting, workingindependent of finance and accounting department.2.1.5.4. Board of directorsFull names Position Appointing date1. Mr. Pham Anh Tuan General Director December 20062. Mr. Do Đuc Minh Vice General Director December 20063. Mr. Hoang Ngoc Minh Vice General Director May 20044. Mr. Phan Trung Huy Vice General Director January 20105. Mr. Phung Dat Duc Vice General Director June 20056. Mr. Tran Cong Quoc Bao Vice General Director October 20062.1.5.5. Functional departments Administration Department Finance and accounting Department Planning and investment department General department Construction department 48
  49. 49. [Tang Huynh Yen Phuong] 2011 Sale department2.1.6. Human resourcesTable 2.2-Staffs and employees (2010) Quantity Percentage Level (People) (%) University and postgraduate 161 28% College 16 3% Genaral employees 405 69% Total 582 100%Source: Annual report 2010.Figure 2.3- Staffs and employees Staffs and employees (2010) University and postgraduate 28% College Genaral 3% employees 69%As Table 2.1 shows, employees with college, and university and postgraduateeducation makes up approximately 31% of total employees. The general employeesare around 69% of all the employees. In general, most of the employees in CNThave enough qualification to take on important responsibilities and carry out large-scale projects. In some cases, there are not enough employees to meet demand ofthe company, especially when the company has to carry out big projects. The mainreason is because the company does not have many recruitment programs andtraining programs to attract more qualified employees. Moreover, in the contextwhere the market in general lacks highly qualified human resources, humanresources for Construction and International business become more difficult.2.1.7. Business performance2.1.7.1. Profit structure 49
  50. 50. [Tang Huynh Yen Phuong] 2011Table 2.3- Profit structure of CNT during 2006-2010 (Unit: Million VND) 2006 2007 2008 2009 2010 Items Value % Value % Value % Value % Value % Net operating profit 11,958 79% 21,802 94% 21,720 78% 24,313 47% 16,138 63% Profit from sale 31,332 38,404 85,161 58,469 81,073 Financial profit (loss) -19,374 -16,602 -63,441 -34,156 -64,935 Profit in business concerns - - - - 2,962 11% 26,370 51% 5,997 24% and joint venture Other profit 3,270 21% 1,396 6% 3,207 11% 751 2% 3,281 13% Total accounting profit 15,228 100% 23,198 100% 27,889 100% 51,434 100% 25,416 100% Profit after tax 13,208 100% 20,040 100% 21,498 100% 45,889 100% 21,099 100% Change in 2007 Change in 2008 Change in 2009 Change in 2010 compare with 2006 compare with compare with compare with Items 2007 2008 2009 Value % Value % Value % Value % Net operating profit 9,844 182% -82 100% 2,593 112% -8,175 66% Profit from sale 7,072 123% 46,757 222% -26,692 69% 22,604 139% Financial profit (loss) 2,772 - -46,839 - 29,285 - -30,779 - Profit in business concerns - - - - 23,408 890% -20,373 23% and joint venture Other profit -1,874 43% 1,811 230% -2,456 23% 2,530 437% Total accounting profit 7,970 152% 4,691 120% 23,545 184% -26,018 49%Source: Financial report 2007-2009 50
  51. 51. [Tang Huynh Yen Phuong] 2011Figure 2.4- Profit structure of CNT during 2006-2010 Chart Profit structure of C&T during 2006-2010 60000 50000 Total accounting profit Million VND 40000 Net operating profit 30000 20000 Profit in business concerns and joint venture 10000 Other profit 0 2006 2007 2008 2009 2010Based on these data, The Total accounting profit is increasing year-by-year,reflecting the efforts to expand operation and increase profit. Net operating profitmakes up a relatively large proportion of Total accounting profit of the company.In 2007, the value of Net operating profit stood at VND 21,802 million, up 82percent compared with 2006. In that year, foreign direct investment continuouslygained extremely good results. This investment mainly focused on industry andconstruction sector. Therefore, the increasing demand of building materials gaverise to revenue and profit from sale of the company.In 2008, CNT showed similar performance with 2007. Especially, the Profit fromsale, which is a major part of net operating profit, climbed to VND 85,161 Millionor 122 percent year-on-year increase thanks to the joining of Vietnam into theWorld Trade Organisation (WTO) and the positive situation of material market inthe beginning of the year. In that year, the Financial cannot compensate thefinancial expenses which mostly consists of loan interest expenses and exchangeloss...Exchange rate fluctuations in 2008 resulted in an Financial loss of VND63,441 Million which affected negatively the Net operation profit.In 2009, the value of Net operating profit represents VND 24,313 Million, up 12percent against the same period in 2008. The profit from sale decreased by VND26.6 billion (down 31 percent in comparison with that of the previous year) due tothe decrease of the sales from iron and steel. That year, we saw a sharp increasing in 51
  52. 52. [Tang Huynh Yen Phuong] 2Profit in business concerns and joint venture which leaded to a significant change inprofit structure. The main reason for this change is because the company‟s financialincome of the current year has increased considerably in comparison with that of theprevious year due to the interest from transferring 50% of share capital in itssubsidiary (An Phuc Construction and House Trading Limited Company).One general trend that can be seen from this table is that the value of Financialloss always causes decreasing in operating profit. Specifically, the loan interestexpenses is much higher than financial income. The main reason is that CNT‟strading activities are frequently funded through loan finance. Therefore, the increaseof inflation rate and loan interest as well as the tight monetary policies ofVietnamese Government can have adverse impacts on CNT‟s financial situation.Even though the company has increased the charter capital to 80 billion VND, thiscannot meet the demand for development of the company.In 2010, the Net operating profit was approximately 16,138 million VND, declined44 percent in turnover. In recent year, the construction materials market is growingstrongly alongside rapid urbanization. Also, Vietnams building materialsmanufacturers have been unable to meet the demand from contractors for a largeamount of materials. Therefore, the profit from sale soar nearly 22,604 MillionVND to 81,073 Million VND in 2010. However, the net operating profit in thisperiod suffered from a sharp decrease. The rapid increase of financial loss is themain reason for this problem. In this year, we saw a sharp increase in financial loss,mainly from the loss of financial income (Interests on capital transfer) comparedwith the same period in 2009. 52

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