Exchange Rate Risk Management project

1 | P a g e
C123 Exchange Rate Risk Measurement
DEPARTMENT OF CONSTRUCTION MANAGEMENT
PROJECT COVER SHEET
STUDENT NAME: DC
STUDENT NUMBER: C 123
COURSE/ YEAR DT117/4
SUBJECT: Construction Project Finance
PROJECT TITLE: Exchange Rate Risk Management
LECTURER:
FOR OFFICE USE ONLY:
DATE DUE: 19th
November 2015
DATE RECEIVED:
RECEIVED BY:
REPEAT PROJECT?
MARKS:

2 | P a g e
Contents
Introduction ............................................................................................................................................3
Types of exchange rate risk ....................................................................................................................3
Definition of Hedging..............................................................................................................................4
The Construction Project ........................................................................................................................4
Spot Rate.........................................................................................................................................4
Exchange Risk Graphs .............................................................................................................................6
Quarter 1.................................................................................................................................................7
Natural Hedging..................................................................................................................................7
Quarter 2.................................................................................................................................................8
Forward Market Hedging....................................................................................................................8
Quarter 3.................................................................................................................................................9
FX options contract.............................................................................................................................9
Quarter 4...............................................................................................................................................10
Transfer.............................................................................................................................................10
Quarter 5...............................................................................................................................................11
Natural Hedging................................................................................................................................11
Quarter 6...............................................................................................................................................12
FX Swap.............................................................................................................................................12
Quarter 7...............................................................................................................................................13
FX options contract...........................................................................................................................13
Quarter 8...............................................................................................................................................14
Leading..............................................................................................................................................14
Quarter 9...............................................................................................................................................15
Swap..................................................................................................................................................15
Quarter 10.............................................................................................................................................16
Natural Hedging................................................................................................................................16
Quarter 11.............................................................................................................................................17
Natural Hedging................................................................................................................................17
Quarter 12.............................................................................................................................................18
Transfer.............................................................................................................................................18
Conclusion.............................................................................................................................................20
References ............................................................................................... Error! Bookmark not defined.

3 | P a g e
Introduction
As a company’s financial accountant I will set out a detailed report on the Project ‘Educational
Hub’ that has recently been tendered for and won for the United Kingdom subsidiary using
selective tendering. In this report I will outline different Hedging techniques that will help the
company to hedge the risk of losing its profit due to currency exchange and fluctuation.
Looking at the currency fluctuations over the past years it seem that the economy is on a down
turn and detailed analysis have to be made for keeping some of the profit.
The project background is: ‘Educational Hub’ for the University of London that will have a
total duration of 3 years and the cost of £45,000,000. The project is to start in March 30th
2016.
As taking on project that will be based in Great Britain I will have to deal in GBP, therefore I
must exchange the Pound Sterling back to Euro. I will conduct my studies on current exchange
rate between Euros and GBP.
The definition of foreign exchange risk is ‘the exchange rate will change unfavourably before
the payment is made or received in home currency’. If my company will take on the project in
the UK the UK will not have any effect on the currency but my company will have to take on
the risk associated with fluctuations in the value of the GBP against the Euro.
A way in which I will try to reduce or minimise the risk is by using Foreign Exchange Rate
Hedging. Which is a strategy that can assist and protect our business from uncertainty. As with
risk of treading, hedging can result in low returns but it also lowers the risk of losing
considerable sums of money. My analysis will include comprehensive details of Foreign
exchange rate (FX) risk.
Types of exchange rate risk
The common definition of exchange rate is the unexpected exchange rate changes, defined as
the possible direct loss. In order to manage this, we need to determine the type of current risk
exposed and encountered. The three main types of exchange rate risk are.
1. Transaction risk, is the risk of opposing exchange rate movements occurring from a
normal international day trading. A company receives or pays foreign currency at a
future date, may change due to floating exchange rates
2. Translation risk, is balance sheet exchange rate risk, depending on foreign exchange
rates the asset value of the subsidiary will be reduced in the balance sheet.
3. Economic risk, which reflects the risk of the company’s present value of future cash
flows will change due to exchange rate movements
(Thomas Power, 2005) (Dohring, 2008)

4 | P a g e
Definition of Hedging
Company’s use hedging to protect themselves against uncertainty. It is like insuring money,
when a company decides to hedge they are making uncertain outcomes certain. Specifically,
in the case of exchange rate risk the results of hedging is that the business is not influenced
by the movement in currency exchange rate. (Investopedia, 2015)
If this event happens and the company has properly hedged the impact is reduced. In other
words it won’t make the company money but it will reduced the potential loss (Investopedia,
2015)
The Construction Project
As recently tendered for and successively won a contract for their UK construction subsidiary
to build Educational Hub for University of London.
This, three year project is expected to generate receipts in the region of £45,000,000 at today’s
Foreign exchange spot rate.
Spot Rate
£1 → € 1.401 (8/11/15) (X-rates.com)
Equating to: € 63’045’000 (45,000,000 x 1.401)
€ 1 → £ 0.713 (8/11/15) (X-rates.com)
In the following report I will focus on:
 A Graphical representation of the Spot FX rate in relation to Historic FX rates over the
past 3 years from January 2012 – December 2015.
 A Graphical representation of the Spot FX rate in relation to Historic FX rates over the
past 3 years from November 2015 – December 2018.
In addition, detailed calculations of the following for each Quarter, which include:
 FX rate Risk based on Historic FX rates & its effect on expected Receipts from January
2012 – end 2015
 FX rate Risk based on forecasted FX rates which are based on the above Historic FX
rates and their effect on forecasted Receipts from November 2015 – December 2018
 Hedging calculations.
 FX rate Risk & the Net effect on Receipts after Hedging FX rate risk.

5 | P a g e
Figure 1. Risk based on Historic FX rates & its effect on expected Receipts (this will not be outlined any further in the report)
Table 2: FX Risk based on forecasted FX rates & its effect on forecasted Receipts (6th November 2015.)
Table 1: FX Risk based on Historic
FX rates & its effect on expected
Receipts
Q1 Q2 Q3 Q4 Q5 Q6 Q7 Q8 Q9 Q10 Q11 Q12 Totals
31/03/2012 30/06/2012 30/09/2012 31/12/2012 31/03/2013 30/06/2013 30/09/2013 31/12/2013 31/03/2014 30/06/2014 30/09/2014 31/12/2014
Expected Receipts GB£
3,750,000 6,500,000 6,000,000 3,000,000 4,500,000 4,500,000 2,000,000 5,000,000 1,000,000 3,750,000 2,000,000 3,000,000 45,000,000
Today's FX rate (Spot Rate) GB£ → €
1.401 1.401 1.401 1.401 1.401 1.401 1.401 1.401 1.401 1.401 1.401 1.401
Expected Receipts at the current spot
rate €
5,253,750 9,106,500 8,406,000 4,203,000 6,304,500 6,304,500 2,802,000 7,005,000 1,401,000 5,253,750 2,802,000 4,203,000 63,045,000
Historic FX rate GB£ → €
1.198 1.24 1.257 1.233 1.186 1.169 1.195 1.203 1.21 1.249 1.284 1.287
Expected Receipts at Historic FX
Rates €
4,492,500 8,060,000 7,542,000 3,699,000 5,337,000 5,260,500 2,390,000 6,015,000 1,210,000 4,683,750 2,568,000 3,861,000 55,118,750
Historic receipts - Expected Receipts
(761,250) (1,046,500) (864,000) (504,000) (967,500) (1,044,000) (412,000) (990,000) (191,000) (570,000) (234,000) (342,000) (7,926,250)
Table 2: FX Risk based on forecasted
FX rates & its effect on forecasted
Receipts
Q1 Q2 Q3 Q4 Q5 Q6 Q7 Q8 Q9 Q10 Q11 Q12 Totals
31/03/2016 30/06/2016 30/09/2016 31/12/2016 31/03/2017 30/06/2017 30/09/2017 31/12/2017 31/03/2018 30/06/2018 30/09/2018 31/12/2018
Today's FX rate (Spot Rate) GB£ → €
1.401 1.401 1.401 1.401 1.401 1.401 1.401 1.401 1.401 1.401 1.401 1.401
Expected Receipts GB£
3,750,000 6,500,000 6,000,000 3,000,000 4,500,000 4,500,000 2,000,000 5,000,000 1,000,000 3,750,000 2,000,000 3,000,000 45,000,000
Expected Receipts at today's FX rate
(Spot Rate) €
5,253,750 9,106,500 8,406,000 4,203,000 6,304,500 6,304,500 2,802,000 7,005,000 1,401,000 5,253,750 2,802,000 4,203,000 63,045,000
Forecasted FX rate GB£ → € (based
on self-assumptions)
1.366 1.36 1.359 1.351 1.348 1.345 1.355 1.361 1.366 1.369 1.372 1.375
Actual Receipts based on forecasted
FX rates €
5,122,500 8,840,000 8,154,000 4,053,000 6,066,000 6,052,500 2,710,000 6,805,000 1,366,000 5,133,750 2,744,000 4,125,000 61,171,750
Expected Receipts less forecasted
Receipts €
(131,250) (266,500) (252,000) (150,000) (238,500) (252,000) (92,000) (200,000) (35,000) (120,000) (58,000) (78,000) (1,873,250)

6 | P a g e
Exchange Risk Graphs
Figure 3. Shows a representation of spot exchange rate in relation to historical exchange
rates.
Figure 4. The figures taken above are used as the forecasted exchange rates taken from data
tables on figures 1 and 2
0.000
0.500
1.000
1.500
Q1 Q2 Q3 Q4 Q5 Q6 Q7 Q8 Q9 Q10 Q11 Q12
GB£ → €
Quarter
GB£ → € FX Rates
Spot FX Rate
Historic FX Rate
1.300
1.320
1.340
1.360
1.380
1.400
1.420
Q1 Q2 Q3 Q4 Q5 Q6 Q7 Q8 Q9 Q10 Q11 Q12
GB£ → €
Quarter
GB£ → € FX Rates
Spot FX Rate
Forecasted FX Rates

7 | P a g e
Quarter 1
Table 2: FX Risk based on forecasted FX rates & its effect on forecasted
Receipts
Q1
31/03/2016
Today's FX rate (Spot Rate) GB£ → € 1.401
Expected Receipts GB£ 3,750,000
Expected Receipts at today's FX rate (Spot Rate) € 5,253,750
Forecasted FX rate GB£ → € (based on self-assumptions) 1.366
Actual Receipts based on forecasted FX rates € 5,122,500
Expected Receipts less forecasted Receipts € (131,250)
Figure 5. FX Risk based on forecasted FX rates & its effect on forecasted Receipts.
Natural Hedging
A method of reducing financial risk by investing in the currency of Great Britain where the
transaction will take place. By doing so the expenses will cancel each other out. However,
natural hedging is imperfect, and do not eliminate risk completely as the company will still
have £500,000 to be exchanged. (Investopidia.com 2015) (PWC, 2014)
Sales in one country holds a natural hedge on its currency risk if it also generates expenses in
that currency
Our company could match GB£ receipts with their GB£ Expenses by buying for Q 1.
Expected receipts = GB£ 3,750,000
Expected Expenses = GB£3,250,000 for Q1.
3,750,000 – 3,250,000 = GB£500,000
It shows now that the company is only exposed to GB£500,000 in relation to currency
exchange.
Table 3: FX Risk & the Net effect on Receipts after Hedging FX risk Q1
31/03/2016
Today's FX rate (Spot Rate x-rates.com) GB£ → € 1.401
Expected Receipts GB£ 500,000
Expected Receipts at today's FX rate (Spot Rate) € 700,500
Forecasted FX rate GB£ → € 1.366
Actual Receipts based on forecasted FX rates € 683,000
Net Expected Receipts less forecasted Receipts after Hedging € (17,500)
The table above shows that the expenses are reduced with its potential FX rate loss by:
€ 131,250 – 17,500 = € 113’750 (saving)

8 | P a g e
Quarter 2
Receipts
Q2
30/06/2016
Forward Market Hedging
By using FX forward will mean that The Company will go in contract with the bank to
exchange the amount of £6,500,000 at a certain period of time in the future. This will mean
that the currency will be € 1.401 as the forward rate (x-rates.com)
This is a contract to buy FX rate security at a price that is fixed today.
In 2nd
quarter it is forecasted to make one of its biggest losses in relation to FX rate risk,
therefore our company could enter into a contract with the Bank to fix the interest rate in
advance at today’s spot rate of 1.401 GB£ → €
This provides the protection of a known FX rate should the spot rate in Q2 not go in their
favour.
It should be noted that the Banks charge a fee for this service.
For the purpose of this report, bank charges are assumed to be €15,000.
Table 3: FX Risk & the Net effect on Receipts after Hedging FX risk
Q2
30/06/2016
Agreed FX rate GB£ → € 1.401
Bank charges € 15,000
€ 266,500 – 15,000 = € 251’500 (saving)

9 | P a g e
Quarter 3
Receipts
Q3
30/09/2016
FX options contract
This is the purchase of a currency option from, for example, a Bank, which gives the buyer the
right but not the obligation, for a specified period of time, to exchange an agreed amount of
one currency for another. (T.M. Kenneddy, 1995)
The company could enter into a contract with the bank, to fix the FX Rate in advance at today’s
(6/11/15) spot rate of 1.401 GB£ → € (x-rates.com 2015)
This measure provides the protection of a known FX rate should the spot rate in Q3 turn out to
be not in favour.
However, if the spot FX rate in Q3 turns out to be better that the agreed FX rate, under the FX
options contract of 1.401 GB£ → €, The company can allow this contract to lapse and take
their money at the preferred Q3 spot FX rate when the time comes.
It should be noted that banks charge a higher fee for the security of an FX options contract
when compared with forward market hedging.
For the purpose of the report it is assumed the Bank will charge €20,000 for the FX options
Contract.
Q3
30/09/2016
Bank Charges FX option contract € 20,000
€ 252,000 – 20,000 = € 232’000 (saving)

10 | P a g e
Quarter 4
Receipts
Q4
31/12/2016
Transfer
US subsidiary for Q4 is forecasted to receive Net receipts of US$ 470,000 at a forecasted FX
rate of US$ → € = 0.933 (X-Rates.com, 2014)
Equating to: US$ 470,000 * 0.933 = € 429,290
This can be used to off-set some of the FX rate losses that are forecasted in the UK for Q4.
€ (504,000) + € 429,290 = € (74,710)
Q4
31/12/2016
Transferee from the US subsidiary € 429,290
Net expected receipts less forecasted receipts after hedging (74,710)
€ 150,000– 74,710 = € 75’290 (saving)

11 | P a g e
Quarter 5
Receipts
Q5
31/03/2017
Natural Hedging
Natural Hedge is a simple concept which is to offset future sterling payments against future
sterling receivables. To do this we require to have certain know receivables and payments
which coincide exactly. If the exchange rate decreases then then reduction in the value of the
sterling receivables, an income is offset by the decrease in value of the sterling payments, an
outgo and vice versa. This is the most efficient way to hedge. (PWC, 2014)
The ability to natural hedge payments is constrained by the availability of future payments and
receivables. We can only use Natural Hedging to hedge the proceeds of the construction project
the extent we have future sterling payments to make. (PWC, 2014)
The company could match receipts GB£ receipts with their GB£ Expenses for Q 5.
Expected receipts = GB£4,500,000
Expected Expenses = GB£4,300,000 for Q5. 4,500,000 – 4,300,000 = GB£200,000
The result is that the company is now only exposed to GB£200,000 in relation to FX rate risk.
Q5
31/03/2017
€ 238,500 – 10,600 = € 227’900 (saving)

12 | P a g e
Quarter 6
Receipts
Q6
30/06/2017
FX Swap
A swap is binding contract with a bank in which we receive a schedule of fixed known
payments in EURO and make fixed known payments in £. The fixed EURO amounts we
receive will be less than the expected amount using the forecast rates; the bank won’t give full
value of the expected EURO payments – the reduction is used to cover the bank’s costs and
profits. Costs will reflect the company’s credit worthiness, if the company defaults then the
bank will suffer a loss. The bank’s charge will increase with time as uncertainty, and so the
bank’s risk increases with time. (T.M. Kennedy, 1995)
For Q the company could approach the Bank and make arrangements to swap currencies with
a British company (GB£) trading in the Euro currency zone (€)
However, banks do charge fees for facilitating this exchange.
For the purpose of this report The Company will assume €2,000.
Q6
30/06/2017
Amount to be swapped GB£ 4,500,000
Bank Fees 2,000
Net after hedging (2,000)
€ 252,000 – 2,000 = € 250’000 (saving)

13 | P a g e
Quarter 7
Receipts
Q7
30/09/2017
FX options contract
Bank guarantees to convert GB£ to € amount but the company is under no obligation to exercise
the option and convert the £ at that rate. This allows the company to protect against downside
currency movements. Options are more expensive compared to swaps and forward contracts
as a result and banks will charge an upfront fee for it (Dohring, 2008) (PWC, 2014).
The fee will reflect the guaranteed GBP->EUR exchange rate and how close that is to the
expected rate and how volatile the future exchanges are deemed to be. The company could
enter into a contract to with the bank to fix the interest rate in advance at today’s (08/11/15)
spot rate of 1.401 GB£ → € (X-Rates.com)
This provides the protection of a known FX rate should the spot FX rate in Q7 not be in favour.
However, if the spot FX rate in Q7 turns out to be better that the agreed FX rate under the FX
options contract of 1.401 GB£ → €, this can allow contract to lapse and take their money at the
preferred Q7 spot rate.
It is assumed the Bank will charge €6,000 for the FX options contract.
Q7
30/09/2017
€ 92,000 – 6,000 = € 86’000 (saving)

14 | P a g e
Quarter 8
Receipts
Q8
31/12/2017
Leading
This is where we enter into agreement with the client to receive the purchase price now, instead
of in instalments each quarter. The client will need to be offered a discount as an incentive to
pay the instalments now. As we receive the payments now we can convert to EUR using the
current known spot rate. The table below shows the value of these payments today. (T.M.
Kennedy, 1995)
The discount required by the client is negotiated. The client will only accept paying now if the
amount of that payment is less than the NPV of the payment in the future. (PWC, 2014)
The company could make arrangements with its debtors to for-go its 3 month credit period and
pay them on the 30/09/2016 at the preferred forecasted spot FX rate of 1.361 GB£ → €.
However, The Company will have to give its debtors an incentive by way of a discount.
For the purposes of this report The Company will offer an early payment discount of 2 %.
Q8
31/12/2017
Discount (0.2%) 100’000
Expected Receipts GB£ - Discount 4,900,000
€ 200,000 – 196,000 = € 4’000 (saving)

15 | P a g e
Quarter 9
Receipts
Q9
31/03/2018
Swap
The Company could again, approach the Bank and make arrangements to swap currencies
with a British company (GB£) trading in the Euro currency zone (€)
However, Banks do charge fees for facilitating this service.
For the purpose of this report The Company will assume Bank charges of €2,000.
The British company swaps €1,366,000 with other company for GB£1,000,000 at a cost to
The Company of €2,000
Resulting in a Net expected receipts for Q8 of € (2,000)
Q9
31/03/2018
Amount to be swapped GB£ 1,000,000
Bank Charges € 2,000 2,000
Net after Hedging € (2,000)
€ 35,000 – 2,000 = € 33’000 (saving)

16 | P a g e
Quarter 10
Receipts
Q10
30/06/2018
Natural Hedging
The Company could again, match receipts GB£ receipts with our GB£ Expenses for Q 10
Expected Expenses = GB£3,500,000 for Q10
3,750,000 – 3,500,000
= GB£ 250,000
The result is that the company is now only exposed to GB£ 250,000 in relation to FX rate
risk.
Q10
30/06/2018
€ 120.000 – 8,000 = € 112’000 (saving)

17 | P a g e
Quarter 11
Receipts
Q11
30/09/2018
Natural Hedging
The company could again, match forecasted GB£ receipts with its forecasted GB£ Expenses
for Q 11.
Expected Expenses = GB£1,000,000 for Q11.
2,000,000 – 1,000,000
= GB£ 1,000,000
The result is that the company is now only exposed to GB£ 1,000,000 in relation to FX risk.
Receipts
Q11
30/09/2018
€ 58,000 – 29’000 = € 29’000 (saving)

18 | P a g e
Quarter 12
Receipts
Q12
31/12/2018
Transfer
The company’s US subsidiary for Q12 is forecasted to receive Net receipts of US$50,000 at a
forecasted (Cited: 06/11/15) FX rate of:
US$ → € = 0.933 (X-Rates.com, 2015)
Equating to US$ 50,000 * 0.933 = € 46,650
The Company can use some these monies to off-set some of the forecasted FX losses that
may be incurred in the UK for Q12
€46,650 + € (78,000) = € (31,350)
Q12
31/12/2018
Transfer from the US subsidiary € 46,650
€ 78,000 – 31,350 = € 46,650 (saving)

19 | P a g e
Figure 5. Representation of forward hedging in relation to the project and how each part of the hedging used impacted the overall savings in
comparison to doing nothing option as seen in figure 2.
Table 3: FX Risk & the
Net effect on Receipts
after Hedging FX risk
Q1 Q2 Q3 Q4 Q5 Q6 Q7 Q8 Q9 Q10 Q11 Q12
Totals
31/03/2016 30/06/2016 30/09/2016 31/12/2016 31/03/2017 30/06/2017 30/09/2017 31/12/2017 31/03/2018 30/06/2018 30/09/2018 31/12/2018
Today's FX rate (Spot
Rate) GB£ → €
1.401 1.401 1.401 1.401 1.401 1.401 1.401 1.401 1.401 1.401 1.401 1.401
Expected Receipts GB£ 500,000 6,500,000 6,000,000 3,000,000 200,000 4,500,000 2,000,000 4,900,000 1,000,000 250,000 1,000,000 3,000,000 32,850,000
Expected Receipts at
today's FX rate (Spot
Rate) €
700,500 9,106,500 8,406,000 4,203,000 280,200 6,304,500 2,802,000 6,864,900 1,401,000 350,250 1,401,000 4,203,000 46,022,850
Forecasted FX rate GB£
→ €
1.366 1.401 1.401 1.351 1.348 1.345 1.401 1.361 1.366 1.369 1.372 1.375
Actual Receipts based on
forecasted FX rates €
683,000 9,106,500 8,406,000 4,053,000 269,600 6,052,500 2,802,000 6,668,900 1,366,000 342,250 1,372,000 4,125,000 45,246,750
Net Expected Receipts
less forecasted Receipts
after Hedging €
(17,500) (15,000) (20,000) (74,710) (10,600) (2,000) (6,000) (196,000) (2,000) (8,000) (29,000) (31,350) (776,100)
Natural
Hedging of
3,250,000
resulting in
FX exposure
of 200,000
Giving bank
a charge of
15,000
(Forward
Market
Hedging)
Given FX
options
contract
bank
charges
assumed to
be 20,000
Transfer of
429,290
from US
subsidiary
Natural
Hedge of
GB £
4,300,000
Swapped
resulting in
FX Bank
Exposure
charges of
200,000
Swapped for
by Bank and
charged
Charges of €
2,000
Agreed FX
rate with the
bank under
an FX
option
contract.
Bank
charges of
€6,000
The
Company
made
arrangement
s to its
debtors to
fore go their
90 day
credit period
in order to
get paid at
(30/09/16)
forecasted
rate of €500
GB$ to euro
(Leading)
The
Company
approached
the bank in
order for
them to
attain
currency
swap with
UK
company
trading in
the Euro
currency
zone. The
bank
charged a
fee of €
2,000 for
facilitating
the Swap
Natural
Hedging of
£ 3,500,000
resulting in
FX exposure
of £ 250,000
Natural
Hedging of
£1,000,000
resulting in
FX exposure
of € 29,000
Transfer of
Euro
46,650
from The
Company’s
US
Subsidiary

20 | P a g e
Conclusion
As can be seen from the preceding report, the risk in relation to FX has been reduced from an
expected loss of € 1,873,250 to a loss of € 776,100 which is a saving of € 1’097’150
I should be noted that the savings are based on FX rate predictions which are subject to often
volatile markets, meaning the rates can go down as well as up.
For a three year project overseas it is often difficult to predict with great certainty, forecasted
FX rates. However, to do nothing and run the risk could result in potentially catastrophic losses
as can be seen in quarter 4 and 8 respectively.
Therefore, it is important that Companies make reasonable, calculated assumptions and
decisions, generally, based on previous market trends and drawing on their own experience in
order to reduce their exposure to FX rate risk and in turn maximise their profit potential in
overseas ventures.

Exchange Rate Risk Management project

More Related Content

What's hot

Viewers also liked

Similar to Exchange Rate Risk Management project

More from Davis Ciprikis

Recently uploaded

Exchange Rate Risk Management project