A hedge refers to an investment position which is intended at offsetting gains/losses which may be incurred from a companion investment (Jorion, 2009). In other words, a hedge is used for reducing any substantial gains or losses suffered by an individual or organization. Hedges can be constructed by use of several types of financial instruments (Gorrod, 2004). These include stocks, insurance, exchange traded funds, swaps, options, forward contracts, futures contracts and many types of both derivative and over –the- counter products. Available strategies for hedging include currency future contracts, forward exchange contract, money market operations and future contracts for interest.
There is a Telecommunications Company which our holding company (Michcom solutions) hopes to make in Africa. We wish to use the following 5 step process so as to manage the exchange risk involved in the acquisition. Risk management in the context of foreign exchange is normally designed in order to preserve the value of investments, currency inflows and loans while at the same time helping international businesses to compete fairly abroad (Gorrod, 2004). Although it is possible to eliminate all the involved risks, it is possible to anticipate and manage negative exchange outcomes effectively. This can be done by both corporate entities and individuals (Hopkin, 2012). Businesses such as ours can do this by ensuring they are familiar with the normal foreign exchange risks, proper diversification, hard currency demands and employment of hedging strategies.
The first step that we have to take is to look at the value of our domestic currency in terms of the South African rand where we hope to make our acquisition. This is because our domestic currency may undergo adverse exchange movements to the detriment of our new acquisitions. Therefore, we have to consider all the likely factors which may influence the exchange rates. In this regard, we will use the fundamental approach to exchange rate forecasting (Hopkin, 2012). Through this method, we will forecast the exchange rate after giving due consideration to the factors which give rise to the long term cycles. We will use of South Africa’s elementary data in relation to inflation rates, GDP, productivity indices, unemployment rate and balance of trade. Our approach is based upon the premise that the currency’s true worth will be realized. Therefore, this approach is the best for our long-term investment.
Assessment of our strategic Plan’s Impact
After estimating the future ranges in interest rates, we will carry out projections for earnings and cash flows. Then we will compare these by use of the alternative exchange rate scenarios such as a weak rand versus a strong pound. We will use a five year cumulative basis instead of the year after year basis (Gorrod, 2004). The rationale for this is that five year cumulative results can result in more useful information on the exchange exposure in relation to our company’s long term plans.
Decision on Hedging
We have realized that hedging is essential if we are to be cushioned against any potential losses from our new acquisition. As a result, we opted for a prime property in London with guaranteed returns which can either equal or surpass possible exchange rate losses from our South African acquisition (Hopkin, 2012). The company’s financial strategists are of the opinion that the chance that both investments post a loss is almost zero (Gorrod, 2004). In addition, because adverse cash flows can affect the laid down strategies for the new acquisition, there was a need for hedging to ensure that regardless of the new acquisition’s financial outcomes, wealthy maximization for shareholders is assured (Eun and Resnick, 2011). The money to be used in the acquisition of the property in London will be availed by reducing expenditure incurred in research and development (R&D) whose budget will be kept at minimal until the South African acquisition breaks even.
Selection of the Instruments for Hedging
The company’s top strategists realized the importance of selecting the most cost effective tool for hedging. Special emphasis was placed on accommodation for company’s risk preference. Therefore, prime real estate and currency options were more appealing. With the currency options, it will ensure that incase the pound depreciates; we will enjoy gains from our South African operations (Eun and Resnick, 2011). On the other hand, the chosen property is projected to offset any adverse financial occurrences at our South African operations as soon as it is securely in the hands of our real estate agents.
Hedging program construction
After our board of directors agreed with company strategists that currency options and real estate acquisition are the way to go, we agreed on a six year implementation plan, percentage of income to be covered and the strike price (Eun and Resnick, 2011). After looking at potential outcomes by use of different implementation strategies by considering different profitability and exchange rate scenarios, we decided to work on a multi year hedging strategy as well as hedging on a partial basis with the rest of our new investment remaining self insured (Hopkin, 2012). This was essential to ensure accountability and initiative on the part of the staff in our new acquisition. Although we are optimistic that our new investment will do well, we had to take all the necessary caution to ensure that our shareholders financial wellbeing is assured regardless of our new acquisition’s performance.