Statement of the Problem
By holding the debt market instruments, AIBF faces several risk exposures in the international business sense. The first problem the AIBF faces is the foreign exchange risk exposure. This risk exposure comes in three basic forms. The first aspect is the transaction risk, which encompasses the risk of possible variation of value of the French currency that in turn would affect the value of the future cash flows that have already been committed. Due to the great uncertainties in the future of the European current situation, the transaction risk is a real risk that AIBF must be aware of and be prepared to deal with. The second aspect of the risk is the translation risk (or the accounting risk as it sometimes referred to). This risk is a problem that needs to be addressed by AIBF because it stands to cause a variation in the value of debt instruments that AIBF holds and which are denominated in the French currency; or in foreign currency in general. Lastly, a broader economic risk stands in the way of AIBF. This risk accounts for the impact that the variations on exchange rates are likely to affect the competitiveness of the AIBF in the Australian market.
This paper presents the risk management strategies in light of the above risk exposures and problems facing AIBF. While economic risks are general hard to manage, the paper attempts to formulate strategies that can be used to mitigate the other risks effectively in the short-term and presents situations under which the strategies are likely to work well. In light of the numerous hedging strategies available to manage the risk of exposure to foreign exchange risk, the paper argues that domestic currency invoicing is a good strategy that IABF should consider, besides the hedging instruments. This is in line with the views expressed by Döhring, who posits that domestic currency invoicing is a powerful tool that firms which deal in international market can use, while hedging instruments have become instrumental for firms to hedge against the risks that relate to exposure to foreign exchange rates (Döhring, 2008, P. 8).
Strategies to Manage the Problem
There are a number of strategies that AIBF can use to mitigate the risk of exposure to fluctuations of French currency. Given that the problem mainly lies with the debt finance instruments, and the risk involved is of short-term nature, one of the options of managing the risk of exposure to the AIBF is hedging. Given the situation, one of the forecasts that can be deduced from the situation is direction of fluctuation in the currency exchange rate for the French currency (Wei, 1999, p. 1378). Since it is more likely for the French currency to lose value hence the value of the held instruments, an appropriate hedging instrument should be used. Hedging is a good tool to deal with the short-term risk because there is a huge risk of uncertainties that would be involved in the long-term (Muller and Verschoor, 2006, p. 200). Therefore, hedging is an appropriate strategy and the AIBF should approach it as highlighted below.
Using Forward Contracts and Swaps
AIBF can use forward contracts to hedge against the possible exposure to the foreign exchange risk. A forward contract is a hedging instrument that secures companies or trading parties against the depreciation of the receivable currency. The same contract secures the paying party against the risk of currency appreciation. In this type of contract, an agreement would be made between AIBF and French firm that agrees to buy an amount equivalent to what AIBF would expect to get in terms of short periods. For instance, AIBF may decide to estimate that in the next 6 months, it anticipates to get 80 000 dollars. It might decide to go into contract with a foreign firm so that the firm agrees to purchase the amount in 6 months at an agreed exchange rate or forward exchange rate.
On the other hand a swap is a contract involving the foreign currency where “the buyer and the seller exchange equal initial principal amounts of two different currencies at the spot rate” (Döhring, 2008. P. 10). In this case, the buyer exchanges fixed or floating rates of interest payment with the seller in their corresponding swapped currencies as the term of the contract lasts. At maturity of the contract agreement, the principal amount is successfully re-swapped at an exchange rate that was already predetermined so that both parties end up with their initial currencies. The advantages of swaps are manifold for IABF. First, since IABF is a high risk venture, the firm does not have appetite for exchange rate risk and thus can effectively move to a partially or totally hedged position through the mechanism of foreign currency swaps (Wong, 2003, p. 834). On another hand, IABF will still be able to leave the underlying borrowing intact. Apart from offering cover for the exchange rate risk, this type of risk management instrument would also allow IABF to hedge the floating interest rate risk.
Use of Domestic Currency Invoicing
IABF can also consider using domestic currency invoicing. In this case, this strategy would be instrumental for AIBF to guard itself against transaction risk (Sivakumar and sarkar, 2005, p. 10). By invoicing in the Australian currency, AIBF would be able to safeguard its competitiveness in the local market as well as guarding itself against the transaction risks that would arise from uncertainties in the international market transactions.
Having assessed the situation and looked at possible strategies for IABF, it is important to point out that the strategies adopted by the firm need to target mitigation of the three risk exposures. Therefore, in light of the short-term desire to put in place strategies that would help IABF in dealing with the risk, hedging strategies should be used alongside domestic currency invoicing.
Döhring, B., 2008. Hedging and invoicing strategies to reduce exchange rate exposure: a euro-area perspective. European Commission
Muller, A. and Verschoor W., 2006. European Foreign Exchange Risk Exposure, in: European Financial Management, 12(2), 195-220.
Sivakumar, A and Sarkar R., 2005. Corporate Hedging for Foreign Exchange Risk in India. Kanpur, India HYPERLINK “http://www.iitk.ac.in/infocell/announce/convention/papers/Marketing,%20Finance%20and%20International%20Strategy-07-Anuradha%20Sivakumar%20Runa%20Sarkar.pdf” http://www.iitk.ac.in/infocell/announce/convention/papers/Marketing,%20Finance%20and%20International%20Strategy-07-Anuradha%20Sivakumar%20Runa%20Sarkar.pdf.
Wei, J., 1999. Currency hedging and goods trade, in: European Economic Review, 43(7), 1371-1394.
Wong, K., 2003. Currency hedging with options and futures, in: European Economic Review, 47(5), 833-839.