LIFE OF SUPERNATURAL WITH THE UNEXPECTED RISKS

2020
Risk management course work 1

CHIEDZA MARIME
BOTSWANA ACCOUNTANCY COLLEGE
10/22/2020
Introduction

This report will save to address on major issues under risk management, firstly on the issue of
arguments for and against foreign currency risk and interest rate risk. Moreover, the issue of no hedge
policy will be addressed, moving on to risk management framework and roles of treasurer. Lastly the
cross-swap approach is also addressed as a major hedging strategy.

Question 1

The unpredictability of foreign currency motion has risen therefore, this has led to challenges in the
forecast of risks and sometimes some will be beyond control. In fact, every company that is dealing
with foreign exchange markets is exposed to these risks of which Letshego is not exempted. Letshego
is a multinational organization based in Botswana whose main duty is to offer unsecured loans to
customers. Its obligation is also to deliver small loans to micro small business. These risks include
transaction, translation, and economic exposures.

Transaction exposure occurs when a company faces contractual financial statements that are fixed in a
foreign currency [ CITATION Lod00 \l 1033 ]. For instance, looking on Letshego Ltd most of its
customers are from outside Botswana and they pay in their home currency therefore, Letshego is
exposed to exchange rate fluctuations.

Translation exposure arises when Letshego’s foreign balance are expressed in terms of the foreign
currency [ CITATION Dum99 \l 1033 ]. Since Letshego has assets and liabilities denominated in foreign
currency as it is shown in the balance sheet that 77% of its assets are not from Botswana. As we all
know at the end of each accounting period companies are expected to consolidate their financial
statements of its subsidiaries therefore, assets and liabilities denominated in foreign currencies must be
translated into their BWP equivalent. Henceforth, due to this translation an accounting gain or loss
may appear since different accounting rules applies to different book.

Economic exposure contains the chances that exchange rates might fluctuate which would adversely
affect the foreign currency [CITATION Edw97 \l 1033 ]. Letshego has almost 82% of its sales
denominated in foreign currency. Suppose the BWP significantly appreciates against other foreign
currencies. The Letsheho is a competitive financial firm and it is highly unlikely that it could increase
the prices of its services outside the parent country. Consequently, Letshego’s financial statements
denominated in BWP will be adversely affected.

There are ways in which the above discussed risks can be hedged. Looking on the positive side of
hedging, meanwhile the aim of hedging currencies is to reduce shortfalls, therefore, it may enable
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Letshego to survive economic recessions [ CITATION Edw97 \l 1033 ] . For instance, if Letshego is
successfully hedged, it will be protected against currency exchange rate fluctuations. In addition, the
removal of insecurity enables Letshego to set precise cost and hold on to the budget because the exact
value of future transaction is known. It allows Letshego to concentrate on activities that increase
profits. Furthermore, hedging using forward contract provides the ability to Letshego to secure in an
exchange rate for a trade that will occur in the future hence, reducing exposure risk [ CITATION Dum99 \l
1033 ]. Letshego should also hedge because it supports rise liquidity as it enables investors to invest in
various asset classes. Meanwhile Letshego is exposed to a translation exposure, it is essential for it to
hedge against translation risk to guarantee that when consolidating financial statements corrects
amounts are reflected, to avoid overstating or understating. These figures attract investors hence, more
investors increase Letshego’s liquidity.

However, hedging usually involves expenses that can reduce Letshego’s profits. For Letshego to be
successful with hedging, it must have enough money to finance its business and be ready to wait for a
longer period before experiencing the profits. Moreover, hedging can be an investment ploy to
Letshego, it can result in massive losses. Hence, before proceeding with hedging strategy, it is
necessary to understand the fundamental concepts for hedging strategy clearly for example, hedging
using option and future frequently require more capital [ CITATION Dum99 \l 1033 ]. Lastly, it fails to
offer sufficient flexibility that enables Letshego to respond rapidly to market subtleties. As we all
know risks and rewards are direct proportion to one another so if Letshego reduce its risks, it is also
reducing its potential profits.

With hedging approaches, people have the advantage of making better informed decisions, while
controlling their losses at the same time, and hedging proves helpful in this regard. Hence, Letshego
should hedge.

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Question 1b

Interest rate risk is the risk of alteration in the price of an currency because of volatility in interest rates
[ CITATION Lin02 \l 1033 ]. Looking at Letshego’s financial statements it indicates interest rates
exposures like pricing, and basic risk that are going to be tackled below and impact of hedging those
risks both negative and positive impact.

Repricing risk is the risk occurs when assets and liabilities have different regular maturities or
different time dates [ CITATION Cyt19 \l 1033 ]. Letshego reconciles its interest rates borrowings at
different dated from when they acquired them. This period difference may cause fluctuations on
interest rates which will have a negative impact on borrowings.

Basis risk is most allied with floating rate and occurs when credits are priced in one index and are
financed with liability that is valued in diverse index [ CITATION Lod00 \l 1033 ] . Letshego’s overdrafts
and bank loans are priced based on LIBOR and are funding in BWP. This may expose Letshego to the
risk spread between the two index rates, because the use of different indexes has the potential for rates
on index to change differently, despite that the instruments may reprice with the same frequency as
monthly or quarterly.

Hedging the interest rate risk is more comfortable for Letshego as it provides the ability to obtain
finances more affordable and flexible. This means that it can be arranged for any amounts and any
duration especially when forward approach is used. More so, it gives admission to Letshego as it is
hard to borrow directly. Like, companies that has little credit rating may be limited in terms of access
to certain fixed rates markets hence, they decide to pay it by swaps [ CITATION Lod00 \l 1033 ].
Moreover, there is a chance of efficiently rearrange Letsego’s cash flows by changing the type of
interest obligations, not including converting old debt or announcing new interest-bearing liabilities
for instance, changing fixed interest to floating rate. Lastly, hedging protects the net worth as this is a
essential figure to investors. Mitigating these risks will guards against the increase in the cost of its
borrowings that impacts the organization’s net worth.

Looking at the side effects of hedging interest risk, options consist of the payment of a premium, often
upfront which is payable irrespective that the option shall be exercised or not. Hence, there is a
possibility that the premium cost may be relatively expensive. In addition, if Letshego decide to take
floating rate obligation, it might prone to adverse changes in interest rates. Also, if it choose to take
fixed rate obligation, it will fail to take full advantage of favorable changes in rates [ CITATION Sen09 \l
1033 ]. For instance, if interest rates decrease, Letshego will not benefit from it.

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Although there are costs involved for hedging interest rate, but the benefits outweigh the costs hence,
Letshego should hedge.

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Question 1c

Before considers some additional argument, which are sometimes set forth to try and support a ‘’no
hedge’’ policy. It is important to take into consideration the formula for Kelly which might be useful
for Letshego when applying no hedge policy. The basic concept of this method is that the sheer
amount of the wager must be a particular purpose of how big your benefit is. Therefore, when there is
no edge you should risk nothing [ CITATION Kam19 \l 1033 ].

Looking on currency, they do not have long term return because they are not an economic, although it
is a risk exposure. Hence, long-period for the currency reverts are anticipated to be zero. Hedging
must, hence, have no impact on long-term on the reverts and only impact the fluctuations. Since,
fluctuations in the decrease from hedging can be diverted more effectively by expanding exposure to
economic assets where a risk premium occurs. Therefore, no hedge [ CITATION Dum99 \l 1033 ].

Moreover, in sighting on the prediction of currency movements, The Kelly formula emphasis that if
a company can predict the currency movements with profound precision, then it will be able to
manage currency exposures. Hence no hedging [ CITATION Cyt19 \l 1033 ].

The mean reversion is an impression that whenever currency fluctuate, they will come a time where
it will revert to a mean level over a long period limit. This means that in a stable economy when
currency fluctuate instead of hedging Letsogo can apply no hedge police since the currency rate will
come back to where it was [ CITATION Edw97 \l 1033 ].

Furthermore, currency offers uncorrelated risk, this method was derived from the mean-variance
framework of modern portfolio theory where it was explained how good it was. Foreign assets are not
supposed to be hedged to improve diversification. Hence, accumulation of currency risk to Letsego’s
collection would enhance the portfolio’s overall risk. Therefore, no need to hedge foreign assets to
insure diversification [ CITATION Lod00 \l 1033 ].

Lastly, looking at the fair value markets theory. At the end of accounting period, the market value of
the purchase or sales will be converted into parent currency. If the foreign currency has appreciated
during the purchase and sales period and the spot is unhedged, the cost is more than anticipated.
Hence, hedging the transitional foreign currency risk is excessive because the price paid is constantly
reasonable [ CITATION Dum99 \l 1033 ].

Based on the above discussed arguments Letshego can be advised to take into consideration the policy
of no hedge.

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Question 2a

Corporates can constantly experience unexpected risk. So, does that imply that the company is
vulnerable against undetermined risk? No! because risk management has managed to come up with a
approach of risk management framework (RMF) [ CITATION Lin06 \l 1033 ]. A risk management
framework is the regulated procedure used to identify potential threats to banks and to identify a
strategy for reducing the effect of the risks, as well as monitoring and evaluating the strategy
[ CITATION Gor18 \l 1033 ]. However, there are many processes of RMF depending on the organization,
hence, this research will focus on Barclays bank RMF that shows six processes which are going to be
explained below (see Appendices fig 1).

Identify Risk is the process of determining risks that could potentially prevent the bank from
achieving its objectives and this process differ with the banks [ CITATION Jos13 \l 1033 ] . For instance,
Barclays bank risk identification criteria will vary depending on the nature of activities that are
considerably exposed [ CITATION Ivy19 \l 1033 ] . This helps it to know where, when and how the risk is
going to affect the health of the bank[ CITATION Dru05 \l 1033 ].

Risk assessment and evaluation requires considering the cause of risk, the effects of these risks and
the likelihood to assess the consequences of those risks without controls in place [ CITATION Jos13 \l
1033 ]. For example, Barclays uses the risk assessment matrix that is intended for obtaining
information to identify mitigation requirement to allow the bank to develop policies that will guarantee
better risk response (Gorrod, 2004).

Risk response and decision implementation are stages of developing a cost-effective method for
reducing founded risks implementing controls and recording the discoveries, moreover, risks will be
dealt with in different ways (see Appendices 2,). For example, for Barclays to reduce the impact of
risks, the bank administration performs staff training to generate risk awareness and acceptance
(Gorrod, 2004).

Monitoring is the last stage after risks has been addressed, it is essential for the management team to
understand that the notion of risk is extremely dynamic and thus constant review of the risk is
necessary to provide a guarantee that risks that is being administered as anticipated. For example, in
Barclays the evaluation of risk-management plan is constantly evaluated to determine its efficacy
when dealing with risks and ensure consistence with bank’s objectives. (Alexander & Sheedy, 2005).

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Question 2b

Treasurers oblige as financial risk manager that hunt down to safeguard a company's efficacy from the
financial risk it faces from its business activities (Gordon and Betty Moore Foundation., 2018). This
topic will be focusing on the roles and significance of a treasurer discussed on paragraphs to follow.

Looking on cash and liquidity, the treasurers are predominantly on safeguarding that the financial
requirements of the bank are met with the most effective approach (Joseph, 2013). Moreover, they
ensure that large puddles of money that are not efficiently implemented are avoided (Joseph, 2013),
for instance, avoid keeping puddle of cash without investing it (Akreeyk, 2013).

Moving on to capital markets and funding, treasurers encompasses on finances that are there for the
cooperate, ways to raise those finances and on what terms are those finances acquired (Cytonn, 2019).
For instance, this helps in deciding on the terms of acquiring assets, that is, whether to buy in cash or
hire purchase.

Exploring on corporate financial management, treasurers makes sure that the company is consistency
with its objectives and that policies are properly affiliated (Akreeyk, 2013). For example, they make
sure that the following questions are addressed, thus, what is the best applicable investment structure?
How are potential investments appraised? Is an asset giving them the specified profit and if not, would
it be disposed? (Gordon and Betty Moore Foundation., 2018).

The process of risk management is whereby treasurers are identifying risk type, measuring it, defining
financial risk policies, and reporting it as conveyed by (AICPA, 2019). This might involve exploring at
the impact of interest and exchange rate moves and putting the appropriate hedges on-site such as
using forward contract when hedging economic and translation exposures (Gordon and Betty Moore
Foundation., 2018).

Lastly but not least treasury operations and controls. Treasurers will be placing the previous four
elements into practice in a consistent and suitably way (AICPA, 2019). For example, whenever a bank
issues a tender with foreign currency content with foreign currency costs the treasurer should realize
the risks involved such as translation risk [ CITATION Dru05 \l 1033 ].

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Question 3

Swaps have remained one of the quickest expanding type of hedging, and the reasons are going to be
discussed later so as the problem encountered. Looking on the scenario of Chobe holdings, it was
difficult to find African investors who would take up bond issues and as a solution it decides to hedge
with cross swaps. Cross-currency swap is the contract between both parties to swap interest payments
and principal denominated in two different currencies in this case the contract is between Chobe and
Bank [ CITATION Kam19 \l 1033 ].

There are numerous benefits from the swap made between Chobe company and bank in South Africa.
Both the parties are going to benefit with comparative advantage. For example, Chobe is now able to
borrow on more favorable terms in foreign country because it has considered the issue of currency
swap. In other words, it is difficult to have direct borrowing hence, because of swap it allows Chobe to
obtain long-term foreign currency financing at reduced costs than might not been possible with direct
borrowing [ CITATION Cyt19 \l 1033 ]. In addition, Chobe company is attaining a better rate at 5%
compared to 6%. Therefore, this supports Chobe’s borrowing as it will pay only fixed rate to the bank.
Lastly, transfer and convertibility risk are eliminated.

However, before entering into any agreement, Chobe should have a clear understanding on negative
impacts that associate with swap. The pertinent issues include credit risk. If the value of the swap
becomes positive, then the pension fund has a credit-risk exposure to the counterparty of the swap, in
this case the bank. This may result in default payment of interest and principal in both parties. In case
if there is early termination of swap, it might lead to brokerage cost. More so, hedging under swaps
can limit Chobe to take advantage of any favorable movements of interest rates in the market
[ CITATION Cyt19 \l 1033 ] . Lastly, although this swap might appear to be beneficial to Chobe, but Chobe
will have to pay short of 0.5% interest rate to the bank.

Conclusion
In conclusion the above report was based of managing risk arises from fluctuation of currency and
interest rate risk. More so the no hedging policy was addressed using both theories and arguments.
Moreover, Barclays risk management framework was used to explain the RMF. In addition, the roles
of a treasurer and the impact of hedging with swaps was discussed.

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Appendices

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