Question Tag: Hedging

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  • 5 Marks

AFM – May 2017 – L3 – Q1a – Hedging against financial risk: Non-derivative techniques

Recommendations to mitigate losses on foreign currency transactions due to the depreciation of the Cedi.

In the last couple of years, the Cedi has depreciated substantially against the US Dollar. This has had an adverse effect on the financial performance of most of the multinational companies in Ghana.

Required:
As a Financial Adviser of your organization, a multinational company involved in the export trade, recommend actions to be taken to minimize the loss on foreign currency transactions. (5 marks)

Actions to be taken to minimize the loss on foreign currency transactions include:

  1. The usage of a forward exchange contract: A contract, usually between a bank and its customer, for the purchase/sale of a specified amount of a stated foreign currency at an exchange rate fixed at the time the contract is made for performance at a future date agreed upon at the time of the contract.
  2. To borrow foreign currency: A Ghanaian company that needs to pay a certain amount in US dollars in two months can borrow that amount of US dollars now, avoiding and reducing translation/conversion risks.
  3. Inserting protection clauses: The exporter can incorporate a clause in the contract of sale to adjust the selling price if the exchange rate moves outside an agreed range. Additional charges may be made due to conversion or translation changes which may be agreed to be borne by the importer.
  4. Export factoring: Exporters can raise foreign finance through an international factor.
  5. Operating a domiciliary account: Maintaining an account in a Ghanaian bank denominated in the desired foreign currency allows the company to use proceeds from export sales to settle future commitments.

(Any 5 points for 5 marks)

  • 10 Marks

AFM – May 2018 – L3 – Q5b – Hedging against financial risk: Non-derivative techniques

Explaining exchange exposure and methods for minimizing and hedging against both pre- and post-acceptance exposure.

i) Explanation of Exchange Exposure (2 marks):

Exchange exposure refers to the risk that a company’s financial performance or position may be affected by fluctuations in exchange rates between currencies. For an exporter quoting prices in a foreign currency, there is a risk that the value of the foreign currency may change before payment is received, leading to a gain or loss in the value of that payment when converted into the company’s domestic currency.

Exchange exposure is classified into three types:

  • Transaction Exposure: Risk arising from actual transactions involving foreign currency payments or receipts.
  • Translation Exposure: Risk from converting foreign subsidiaries’ financial statements into the parent company’s reporting currency.
  • Economic Exposure: Risk from the overall impact of exchange rate changes on a firm’s future cash flows and market value.

(2 marks)

ii) Methods for Minimizing Pre-Acceptance Exposure (4 marks):

Pre-acceptance exposure arises in the period between the time an exporter quotes a price in a foreign currency and the time the contract is accepted.

Two methods to minimize pre-acceptance exposure:

  1. Time-Limited Quotes:
    • The exporter can limit the validity period of the quote to a short timeframe, ensuring that the exchange rate does not fluctuate significantly before the contract is accepted.
    • Advantage: This method reduces the period during which the exchange rate risk exists, thus minimizing potential exposure to currency fluctuations.
  2. Forward Contracts:
    • The exporter can lock in a forward contract to sell the foreign currency at a predetermined rate when the quote is accepted. This ensures that the company knows exactly what exchange rate will apply, regardless of fluctuations.
    • Advantage: A forward contract provides certainty about the future exchange rate, allowing the exporter to avoid potential losses due to unfavorable exchange rate movements.

(2 marks for each method, 4 marks total)

iii) Hedging Methods for Post-Acceptance Exposure (4 marks):

Post-acceptance exposure arises after the contract has been accepted but before the payment has been received. There are several methods for hedging this exposure:

  1. Borrowing in the Foreign Currency:
    • The exporter can borrow the foreign currency equivalent of the receivable immediately and repay the loan once the foreign customer pays. This hedges the risk of adverse currency movements.
    • Advantage: This method is relatively simple and cheap. It also provides immediate cash flow in the foreign currency and eliminates exchange rate risk.
  2. Forward Contracts:
    • The exporter can enter into a forward contract to sell the expected foreign currency receipt at a specified rate on the date payment is due. This locks in the exchange rate and eliminates the uncertainty associated with currency fluctuations.
    • Advantage: Forward contracts offer certainty about the amount of the domestic currency that will be received, providing security and allowing for better financial planning without committing cash resources upfront.

i) Explanation of Exchange Exposure (2 marks):

Exchange exposure refers to the risk that a company’s financial performance or position may be affected by fluctuations in exchange rates between currencies. For an exporter quoting prices in a foreign currency, there is a risk that the value of the foreign currency may change before payment is received, leading to a gain or loss in the value of that payment when converted into the company’s domestic currency.

Exchange exposure is classified into three types:

  • Transaction Exposure: Risk arising from actual transactions involving foreign currency payments or receipts.
  • Translation Exposure: Risk from converting foreign subsidiaries’ financial statements into the parent company’s reporting currency.
  • Economic Exposure: Risk from the overall impact of exchange rate changes on a firm’s future cash flows and market value.

(2 marks)

ii) Methods for Minimizing Pre-Acceptance Exposure (4 marks):

Pre-acceptance exposure arises in the period between the time an exporter quotes a price in a foreign currency and the time the contract is accepted.

Two methods to minimize pre-acceptance exposure:

  1. Time-Limited Quotes:
    • The exporter can limit the validity period of the quote to a short timeframe, ensuring that the exchange rate does not fluctuate significantly before the contract is accepted.
    • Advantage: This method reduces the period during which the exchange rate risk exists, thus minimizing potential exposure to currency fluctuations.
  2. Forward Contracts:
    • The exporter can lock in a forward contract to sell the foreign currency at a predetermined rate when the quote is accepted. This ensures that the company knows exactly what exchange rate will apply, regardless of fluctuations.
    • Advantage: A forward contract provides certainty about the future exchange rate, allowing the exporter to avoid potential losses due to unfavorable exchange rate movements.

(2 marks for each method, 4 marks total)

iii) Hedging Methods for Post-Acceptance Exposure (4 marks):

Post-acceptance exposure arises after the contract has been accepted but before the payment has been received. There are several methods for hedging this exposure:

  1. Borrowing in the Foreign Currency:
    • The exporter can borrow the foreign currency equivalent of the receivable immediately and repay the loan once the foreign customer pays. This hedges the risk of adverse currency movements.
    • Advantage: This method is relatively simple and cheap. It also provides immediate cash flow in the foreign currency and eliminates exchange rate risk.
  2. Forward Contracts:
    • The exporter can enter into a forward contract to sell the expected foreign currency receipt at a specified rate on the date payment is due. This locks in the exchange rate and eliminates the uncertainty associated with currency fluctuations.
    • Advantage: Forward contracts offer certainty about the amount of the domestic currency that will be received, providing security and allowing for better financial planning without committing cash resources upfront.
  • 5 Marks

AFM – May 2016 – L3 – Q2b – Hedging against financial risk: Non-derivative techniques, Hedging against financial risk: Derivatives

Describe four approaches that a company can use to hedge against foreign exchange risk.

b) As a trading company, Joewoka exports and imports merchandise in many countries for which it receives and makes payment in foreign currency. This exposes the company to foreign exchange risk.

As a Financial Consultant to the company, suggest FOUR approaches that the company can use to hedge against foreign exchange exposure. (5 marks)

Approaches to Hedge Against Foreign Exchange Risk:

  1. Forward Contract
    • A contract made with a bank to buy/sell currency at a predetermined rate on a specific future date. This method fixes the exchange rate, thus providing certainty.
      (1 mark)
  2. Future Contract
    • Similar to forward contracts, but futures are standardized and traded on exchanges. They help companies hedge currency risk by locking in exchange rates for specific future transactions.
      (1 mark)
  3. Lead/Lag Payments
    • Payments for goods/services can be expedited (lead) or delayed (lag) to benefit from favorable exchange rate movements. By adjusting payment timing, companies can minimize currency losses.
      (1 mark)
  4. Currency Options
    • Provides the right, but not the obligation, to buy (call) or sell (put) a currency at an agreed rate within a set time. It allows companies to hedge risks while benefiting from favorable rate movements.
      (1 mark)
  5. Natural Hedging
    • Involves offsetting foreign currency exposures by matching foreign currency revenues and costs. For example, revenues in one currency can be used to pay liabilities in the same currency.
      (1 mark)
  • 10 Marks

AFM – May 2016 – L3 – Q1b – Hedging against financial risk: Non-derivative techniques, Hedging against financial risk: Derivatives, The use of financial derivatives to hedge against interest rate risk

Explain how to hedge a foreign exchange risk exposure using forward and money markets with calculations.

b) A Ghanaian Food and Beverage company has recently imported raw materials from China with an invoice value of US$264,000 payable in three months’ time. Due to the company’s efficient production capacity, it has finished production and exported finished products to Germany. Consequently, the German customer has been invoiced for US$75,900 payable in three months’ time. Below is the current spot and forward rates for the transactions:

  • USD/GHS Spot: 0.9850 – 0.9870
  • 3 Months Forward: 0.9545 – 0.9570

Current Money Market rates per annum are as follows:

  • US$ (USD): 11% – 13.2%
  • Gh¢ (GHS): 12.7% – 14.3%

Required:
i) Demonstrate with relevant calculations how the Ghanaian company can hedge its exposure to foreign exchange risk using the Forward Markets. (3 marks)
ii) Demonstrate with relevant calculations how the Ghanaian company can hedge its exposure using the Money Markets. (4 marks)
iii) Determine which of the above markets is the best hedging technique. (3 marks)

i) Forward Market Hedge
Offset USD264,000 – USD75,900 = USD189,000 (1 mark)
Buy USD189,000 3 months forward.

Cost = USD189,000 ÷ 0.9545 = GH¢198,009 payable in 3 months (1 mark)

ii) Money Market Hedge

  • The company has a US$ liability, so it needs to create a matching US$ asset.
  • Place USD on deposit for 3 months at an interest rate of 2.7%.
  • Accumulate capital at the end of 3 months to the USD189,000 required.

Step 1:
Deposit USD189,000 needed in 3 months.

Amount to deposit now:
USD189,000 ÷ 1.027 = USD184,390 (1 mark)

Step 2:
The Ghanaian company will have to buy USD184,390 on the spot market.

Cost = USD184,390 ÷ 0.9850 = GH¢187,198 payable now (1 mark)

iii) Best Hedge Market
Now vs. 3 months:

  • Forward Market Hedge: GH¢198,009              (0.5 mark)
  • Money Market Hedge: GH¢187,198 (0.5 mark)

Compound cost of the Money Market Hedge = GH¢187,198 × (1 + 0.0325) = GH¢193,282 (1 mark)

  • 6 Marks

CR – Nov 2019 – L3 – Q2a – Foreign currency

Analyze foreign currency transactions, their impact on financial statements, and the application of hedging instruments.

a) Nyinahini Ltd (Nyinahini) is a company reporting under IFRS. Nyinahini normally operates only within the country where its buildings are physically located. Recently, it entered into a contract to supply its products to a new client based in South Africa. All the work was completed in the period October to November 2018. The (fixed) contract price of 100 million Rand has been agreed upon as denominated in South African Rand. The full amount was invoiced on 1 December 2018 when the exchange rate was GH¢1 = 10.1889 Rand. The new client paid 50 million Rand in advance on 1 November 2018 when the exchange rate was GH¢1 = 9.9783 Rand. The balance will be paid in two equal instalments on 31 March 2019 and 30 June 2019. The exchange rate at 31 December 2018 was GH¢1 = 10.5037 Rand.

Nyinahini decided to eliminate exchange rate differences on the final two payments and entered into two forward rate agreements on 1 December 2018 to sell the appropriate amount of Rand on 31 March 2019 and 30 June 2019, and set up the relevant documentation to treat them as fair value hedges of the recognized receivables. At 31 December 2018, the two contracts for settlement on 31 March 2019 and 30 June 2019 were valued at GH¢148,000 collectively, as an asset from Nyinahini’s point of view.

Required:
Set out and discuss the accounting treatment of the above items, including relevant calculations, as the information provided permits, in the financial statements of Nyinahini for the year ended 31 December 2018.

(6 marks)

  1. Accounting for Foreign Currency Transactions (IAS 21)
    • Initial recognition of the sale: The full contract price of 100 million Rand is recognized as sales revenue and a receivable at the exchange rate on 1 December 2018, i.e., GH¢9,814,602 (100 million / 10.1889).
    • Advance payment accounting: The advance payment of 50 million Rand is initially recorded as deferred income at GH¢5,010,874 (50 million / 9.9783). Upon invoicing on 1 December 2018, an exchange gain of GH¢103,573 (GH¢5,010,874 – GH¢4,907,301 [50 million / 10.1889]) is recognized in profit or loss when 50 million Rand of the total receivable is derecognized.
  2. Remeasurement of the Receivable at Year-End:
    • The remaining 50 million Rand receivable is retranslated at the year-end (31 December 2018) at the prevailing exchange rate of GH¢1 = 10.5037 Rand. This gives a retranslated value of GH¢4,760,227 (50 million / 10.5037). An exchange loss of GH¢147,074 (GH¢4,907,301 – GH¢4,760,227) is recognized in profit or loss.
  3. Hedging the Receivable:
    • Nyinahini has entered into forward rate agreements to hedge the final two payments, and these contracts are designated as fair value hedges of the recognized receivable. The forward contracts are recognized at their fair value of GH¢148,000 at the year-end, recorded as an asset. Since the hedge is classified as a fair value hedge, the gain of GH¢148,000 is credited to profit or loss to offset the exchange loss on the retranslated receivable.

Summary of Journal Entries:

  • On 1 December 2018:
    • Dr. Receivables: GH¢9,814,602
    • Cr. Sales Revenue: GH¢9,814,602
    • Dr. Deferred Income (advance payment): GH¢5,010,874
    • Cr. Receivables: GH¢5,010,874
    • Dr. Exchange Gain: GH¢103,573
    • Cr. Profit or Loss: GH¢103,573
  • At 31 December 2018:
    • Dr. Exchange Loss: GH¢147,074
    • Cr. Receivables: GH¢147,074
    • Dr. Forward Contract Asset: GH¢148,000
    • Cr. Profit or Loss: GH¢148,000
  • 10 Marks

AT – May 2017 – L3 – Q3b – Business income – Corporate income tax

Compute allowable financial cost on hedged transactions and provide management advice on the tax implications.

b) XYZ Ltd runs a business with a basis period from January to December each year. The following information is relevant to its business operations for 2016 year of assessment:

Item Amount (GH¢)
Chargeable Income from business operations 40,000
Financial cost incurred on hedged transactions 150,000
Financial gain from hedged transactions 60,000

Required:

i) Compute the financial cost to be allowed in 2016 year of assessment. (6 marks)

ii) Advise management on the above results. (4 marks)
(Total: 10 marks)

b) XYZ Ltd

COMPUTATION OF CHARGEABLE INCOME FROM OPERATION
Y/A OF ASSESSMENT: 2016

Item GH¢
Chargeable income (given) 40,000
Add Financial Cost from hedging 150,000
190,000
Less Financial gain from hedging 60,000
Income from operation 130,000

COMPUTATION OF FINANCIAL COST ALLOWABLE
Y/A – 2016

Item GH¢
Financial Gain from hedging 60,000
Add 50% Chargeable Income from operation (50% * 130,000) 65,000
Financial cost allowable ceiling 125,000

ii) ADVISE TO MANAGEMENT

The cost incurred from hedging was GH¢150,000. The allowable ceiling on the cost incurred is GH¢125,000. The excess of GH¢25,000 (GH¢150,000 – GH¢125,000) will be carried over for five years. The financial cost carried forward shall be allowed in five years following. It is granted in the order in which they occur.

Management should in future be mindful of the implication of cost on derivatives as they are not allowed wholesale but are restricted in accordance with section 16 of Act 896 Act 2015 and its amendment.

  • 5 Marks

FM – May 2021 – L2 – Q4b – Treasury Management

Explain interest rate risk and suggest two ways of managing an entity’s exposure to it.

b) Most large companies maintain a treasury department to handle some specialized functions in finance. One of such functions is the management of financial risk, which includes interest rate risk.

Required:

Explain interest rate risk and suggest two ways of managing an entity’s exposure to interest rate risk. (5 marks)

Interest Rate Risk Explanation:

Interest rate risk is the risk of uncertainty and potential loss that could arise due to movements or changes in interest rates. If interest rates rise, the value of bonds or financial assets drops and vice versa. Borrowers at fixed interest rates tend to suffer or lose when interest rates rise, as they may face higher interest expenses on new borrowing or may find that their existing fixed-rate liabilities are now more costly compared to prevailing market rates.

Ways of Managing Interest Rate Risk:

  1. Interest Rate Matching:
    • This strategy involves matching the interest type on the borrowing with the interest type on the investment to be financed. For example, an investment that will return constant cash flows can be financed with a fixed-rate loan. This ensures that the interest expenses are predictable and aligned with the cash flows generated by the investment.
  2. Interest Rate Smoothing:
    • This method involves balancing the amount of fixed-rate loans with variable-rate loans. By maintaining a balanced proportion of fixed-rate and variable-rate loans, any movement in interest rates will result in both losses and gains of fairly equal amounts, which would net off. This approach reduces the volatility in interest expenses due to fluctuations in interest rates.

External Strategies:

  1. Interest Rate Swap:
    • This involves swapping fixed interest payments for variable interest payments, or vice versa. By engaging in an interest rate swap, the entity can achieve a desired interest rate profile that better matches its exposure, thereby reducing the risk of adverse movements in interest rates.
  2. Forward Rate Agreement (FRA):
    • An FRA involves hedging the interest rate exposure with a forward contract with a bank. This allows the entity to lock in an interest rate for a future period, thereby providing certainty over borrowing costs and mitigating the risk of interest rate fluctuations.

Marks Allocation:

  • Explanation of interest rate risk: 2 marks
  • Each management strategy: 1.5 marks
  • 6 Marks

FM – Nov 2020 – L2 – Q5b – Foreign exchange risk and currency risk management

Identify and explain four internal techniques to hedge exchange rate risk.

Identify and explain FOUR (4) techniques that can be used internally to hedge exchange rate risk.

1. Matching:
Matching involves aligning the currency of the company’s revenue with the currency of its costs. For example, if a company earns revenue in a foreign currency, it should try to match this by incurring expenses in the same currency. This reduces the exposure to currency fluctuations.

2. Netting:
Netting is a method where a company offsets receivables and payables in the same foreign currency, reducing the need to exchange currencies. This is commonly used in multinational companies where different subsidiaries owe and are owed in the same currency, and the net amount is transferred rather than gross amounts.

3. Leading and Lagging:
Leading and lagging refer to the timing of payments and receipts. If a currency is expected to depreciate, the company may decide to delay payments (lagging) or expedite receipts (leading) to minimize losses. Conversely, if a currency is expected to appreciate, the company might expedite payments or delay receipts.

4. Invoicing in local currency:
Invoicing in the company’s home currency eliminates exchange rate risk as it transfers the risk to the other party. By insisting that all sales and purchases are invoiced in the home currency, the company avoids the need to hedge foreign exchange risk.

  • 7 Marks

FM – Nov 2020 – L2 – Q3b – Futures and hedging with futures | Hedging with options

Explain intrinsic value of an option and calculate the intrinsic value for USD/GH¢ call options over several months.

i) Explain the term intrinsic value of an option. (1 mark)

ii) DUU Ghana Ltd bought USD/GH¢ call options from KASA Ltd. The table below shows the various spot rates and strike prices for the various tenors.

Month Spot Rate USD/GH¢ Exercise Rate/Price USD/GH¢
1 5.1 4.8
2 5.3 5.0
3 5.5 5.4
4 5.8 5.8
5 5.7 6.0
6 6.0 6.4

Required:

Determine the intrinsic value of the option for each trading month and clearly indicate the months in which the option is in-the-money, at-the-money, or out-of-the-money. (6 marks)

i) Intrinsic value of an option:
The intrinsic value of an option is the amount by which the option is in-the-money. It is the positive value or gain that would be realized if the option were exercised immediately. An option has intrinsic value when it is in-the-money, meaning that for a call option, the spot price is above the exercise price.

(1 mark)

ii) Intrinsic value calculation:

Month Spot Rate USD/GH¢ Exercise Rate USD/GH¢ Intrinsic Value (Spot Rate – Exercise Rate) Comments/Interpretation
1 5.1 4.8 0.3 In-the-money
2 5.3 5.0 0.3 In-the-money
3 5.5 5.4 0.1 In-the-money
4 5.8 5.8 0 At-the-money
5 5.7 6.0 (0.3) Out-of-the-money
6 6.0 6.4 (0.4) Out-of-the-money

Interpretation:

  • DUU Ltd was in-the-money for months 1, 2, and 3.
  • The option was at-the-money in month 4.
  • The option was out-of-the-money in months 5 and 6.
  • 10 Marks

FM – May 2020 – L2 – Q3b – Hedging with options

Calculate the variable and fixed interest payments under an interest rate swap agreement and determine if the strategy is an effective hedge.

Asanka Ghana Ltd is a medium-sized business in Ghana that is currently borrowing GH¢1,000,000 from North East Bank at a floating or variable interest rate basis at Ghana Reference Rate (GRR) plus 3% margin which is market determined on a monthly basis. This makes their monthly interest payment volatile depending on where GRR is at the end of the month. They are rather interested in fixed interest payment at the end of the month to manage this volatility.

OTI Bank Ghana Ltd has agreed to do an Interest rate Swap with Asanka where OTI Bank Ghana Ltd pays the variable rate to Asanka but Asanka pays them a fixed rate of 21% per annum paid monthly.

The table below shows the GRR for the last 6 months:

Month GRR (%) Variable Interest (C) Fixed Rate (D) Fixed Interest (E) Net Settlement (F)
1 16% 21%
2 18% 21%
3 20% 21%
4 19% 21%
5 18% 21%
6 17% 21%

Required:

i) Calculate the variable interest, fixed interest, and net settlement under columns (C), (E), and (F) in the table above.
(8 marks)

ii) Will you describe this strategy as an interest rate hedge? Explain.
(2 marks)

i) Calculation of Variable Interest, Fixed Interest, and Net Settlement:

ii) Interest Rate Hedge Explanation:

Yes, this strategy can be described as an interest rate hedge. The variable rate that Asanka will receive under the swap agreement compensates for the variable rate it has to pay to its original lender, North East Bank. This effectively leaves Asanka with a fixed interest payment of 21%, thereby removing the uncertainty and volatility in its monthly interest payments.
(2 marks)

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