international finance assignment spring 2022

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PART 1

1.1 Introduction

The sample of 6 MNEs are chosen randomly, including Fraser & Neave, Ltd (F&N), 3M conglomerate corporation (3M), Samsung Electronics Co., Ltd (Samsung), PepsiCo, Inc (PepsiCo), Honda Motor Co., Ltd (Honda) and Johnson & Johnson corporation (J&J) After examining annual reports in 2020, we can classify all the hedging techniques into 2 main types that we have learned: proactive and strategic management and other techniques that we have not learned The reason is in practice some techniques are customized as a specific need of the firm Each firm is distinguished from others in operation beside sharing the common similarities

In proactive management, the first and the most popular type is contractual technique The financial instruments used are foreign currency forwards, options and foreign exchange swaps Second, beside the instruments introduced in the course, currency swap, J&) uses cross currency interest rate swaps This is the combination of cross currency and interest rate swaps The third one is matching cash flow Due to cost- saving and easily-applying, some firms prefer nature hedging beside currency switching and foreign denominated debt In strategic management, MNEs attempt to manage the cash flows in normal operating, financing and investing activities by its own policies and regulations in business transactions and asset and debt management We also find that net investment hedge, a novel kind of currency risk reduction, is applied by MNEs

To be noted that, none of six firms remain unhedged 100% Since their cash in and out are mainly not made up of its home currency However, they do not hedge on all kinds of non-home currency The policy will depend on the liquidity and contribution of that currency in their cash flow Simply put, MNEs hedge selectively

1.2 Comparison

i Summary of the comparison

swap

2 Fraser & Neave yes

foreign exchange

swaps cross currency interest

tate swaps

Figure 1 Summary of common hedging technique

2 Fraser & Neave hedge ° short Australian dollar, US dollar, Thai bath 2020: gain 7p hedge hort medium | high liquid: J:

3 4M e Be, short, medium high liquid: Japanese 2020: loss speculative long yen, euro

4 Johnson & Johnson hedge long Euro 2020: gain 5 PepsiCo hedge short, medium, | Mexican peso, Russia 2020:

short medium, | US dollar, Euro, Indian

Figure 2 Comparison of hedging technique following four criteria

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rate exposure can affect businesses in three main ways: operating, financing, and investing

Based on the annual reports, the operating activities of the companies are all affected For example, F&N, a Singapore food and beverage group, denominated transactions in foreign currencies had an impact on the company's purchase of raw materials, equipment, and sale of products activities Besides F&N, Honda is affected as they regularly need to import materials from abroad to manufacture products

Regarding financing performance, foreign exchange rate risks have influenced the company's capital raising activities An example is both Pepsi and J&) have foreign currency liabilities in their balance sheet

In addition, some companies are also affected by investing activities, such as F&N, 3M, Samsung and PepsiCo It would be a challenge to control such long in tenor and huge in value investments in overseas subsidiaries, joint ventures and associated companies

iii Similarities and dissimilarities a Purpose:

All companies use financial instruments to hedge foreign exchange risk

Beside that is for trading and speculating Namely, 3M speculates derivatives to generate profit With Samsung, using financial instruments is not only for hedging but also trading on non-Korean currency The leftovers do not want to trade or speculate on these derivatives

b Term

All the MNEs prefer the instrument due in a short period for transaction exposure The longest for maximum maturity is 3 years and the shortest one is 1 year

Maximum

maturity MNE 1 | 12 months Honda

Fraser & 2 | 12 months Neave

Johnson & 3 | 18 months Johnson 4 | 24 months PepsiCo 5 | 36 months 3M

6 | 36 months Samsung

Figure 4 Summary of maximum maturity for short-term hedging

For them, any cash flow that is in longer term is disabled and uneconomical to control However, 3M, Pepsi and J&J still have their approaches listed in the next part.

c Tool

c.1 Proactive management Forward

In general, six companies participating in short-term maturity contracts use the forward contract tool as a principal method

Matching cash flow

It is the next-popular approach Samsung, 3M and Pepsi prefer natural hedging and currency switching For example, Pepsi keeps its account payable mainly in local currency by buying in from domestic suppliers and negotiated foreign suppliers Another one that is applied in many firms is foreign denominated debt Some of them are 3M, J&J This is in net investment hedge of the firm in the long run To take an example, J&J issues euro denominated notes in May 2016 having due dates during 2022 - 2035

Option and cross currency swap

The least popular one in six companies are cross currency swap and option For companies that engage in long-term contracts such as J&J and PepsiCo, using a cross currency swap is an effective method of hedging Cross currency swaps allow companies to manage market volatility by fixing currency exchange rates and interest rates Business decisions can then be made with certainty

Not only that, they keep watching the fluctuation to have more effective strategies matching with currency demand For instance, though local finance centers, Samsung oversees foreign exchange rate fluctuation in major regions (United States, United Kingdom, Singapore, China, Brazil, and Russia) and becomes an agent of foreign exchange transactions acting as an agent of foreign exchange transactions In addition, there is no such permission for speculating foreign exchange transactions

d Currency

We can see from the above table, most companies hedge on the US dollar, followed by Euro, Japanese yen, Thai baht, Indian rupee, etc The decision depends on the individual firm Samsung chose the major currencies exposed to foreign exchange risk like US dollar, Japanese yen, Thai baht 3M chooses the one at a high level of liquidity because the less liquid has restricted alternatives for terms and costs more Due to this, 3M uses natural hedging instead Other firms depend on what currency makes up

the common proportion in their cash flow like Euro for Johnson (23% of sale), Malaysia ringgit and Thai baht for F&N (they are two of dairies core markets)

e Result

In 2019, hedging did take effect, bringing additional gain for MNEs In 2020, the pandemic COVID-19 has distorted its positive effect., its abruption in occurrence and impact is out of the control and anticipation All the firms above suffer loss except F&N, J&) and PepsiCo Nevertheless, hedging is not always the cost for the firm

PART 2

2.1 Question (a)

i Reason for the maintenance of unmatched cash flow

The first explanation is the European euro sale (20%) has been nearly matched with European euro cost (30%) Moreover, the position of UK in EU before benefits for Rolls- Royces (RR) According to Single European Act 1986, “Single market" creates the unrestricted movement of goods, services, people and money Since that the mismatch between European euro and British pound is not significant

RR operates in Aerospace, Defense, Energy, Marine industry In which, the story of market switching is not easy for RR when US is RR’s largest consumer, notably aerospace until now (RR, 2022) Its revenue from non-US markets where do not have the most highly-developing aerospace industry like US would definitely drop This is the second reason why it is unavoidable to be unmatched cash inflow with outflow Additionally, the reserve of major foreign currency sources from its revenues A large reserve contributes to the stability of foreign exchange rate and the inflation Therefore, RR is encouraged to export to US in US dollar

The last reason, regarding to its 3-year and 6-year business cycle, RR understands that it will incur fluctuation in cash flow Hence, RR has its own long-term program in 2012 to minimize the impact by using derivative such as currency forward contract It has certainty of its future position when locking at $1.600/pound

ii Reason for the maintenance of manufacture

Actually, the operation of RR outside UK is restricted for these reasons:

Firstly, due to cybersecurity and national security issue, aerospace and defense companies like RR are subject to the regulations in operating and exporting by the government and authorities To be precise, National Institute of Standards and Technology provides cybersecurity standard focusing on aerospace and defense companies and International Traffic in Arms Regulations prohibits the unauthorized access to “defense-related items” (Arvind, 2022) Besides that, many RR’s products are in the controlled items list in Export Control Order 2008 of UK, counting vehicles and their components for military (Tay 611-8 aircraft) and dual-use purpose (T56 engine) (UK Department for International Trade, 2019).

Secondly, Aerospace is "a world-leading industry, driving growth and prosperity across the UK", having “an annual turnover of £35 billion” and 2% of total UK goods exports was from RR (GOV.UK, 2020; Philip, 2017) With the great contribution of this sector to the UK economy There is an enduring partnership established between UK government and this sector such as The Aerospace Growth Partnership which “has published several strategy papers” Means of ascent: The Aerospace Growth Partnership's industrial strategy for UK aerospace 2016 is the latest one (Philip, 2017) RR also supports its industries trade association such as Aerospace, Defense and Security Group in form of member fee (RR, 2022)

Thirdly, recalling about RR’s industries, the consumption of the production line, especially civil and military aircraft is strongly subsidized by the UK government For Research and Development (R&D), it usually requires large source of capital The examples are a mutual investment of £14 million between government, Rolls-Royce and Loughborough University to cutting engine emissions project in 2017 and a total public investment up to 12.5 million pound to R&D in Aerospace Sector deal launched in 2018 (Philip, 2017; GOV.UK, 2020) Therefore, the location for its headquarter and R&D facilities must be in UK Comparing to massive product, Aerospace products contain extremely high level of intelligence and technicality content R&D are determinant for transiting the technologies to which Serial trial being made needs equipment and facilities storing oversized their assembly and supporting the launchers (Britannica, 2021) This, obviously is under the control of human operators, RR’s proficient workers

As discussed before, none of final process can be finished without them RR cannot leave behind over 23,000 workers working under the company to unemployment After leaving, UK can no more enjoy freedoms in moving people while UK and EU did not reach any agreements On 29% March 2019, “Britain leaves the EU without a deal” (Chemical Watch, 2019) So if the movement carries out before or after, it’s not a saying when moving that amount of worker outside UK to EU or US

Fourthly, RR operates in the industries where the production is not massive The word “craft” in aircraft and spacecraft has expressed that Process for only aerospace final goods are complex in nature For example, there are approximately millions part to form a flight vehicle When being connected, transportation is complex for 1 product as the working and maintenance of vehicle need the support system (Britannica, 2021) In $224 million-defense service contract with US, complete logistics assistance of US Marine Corps KC-130) aircraft made up $59.5 million Normally, RR contract consists not only 1 vehicle but also a fleet Namely, Norway's C-130) fleet were agreed to deliver to US in the same contract (RR, 2015)

It becomes even more complex for its assembly What will happen if one of them is postponed Storage would be built in case of unexpected lag in shipping We do not need to image how many facilities needed for that number of component as it is probably unacceptable.

Lastly, assuming that these factor above are dismissed, the budgeted cost for this strategy still increase There is nothing to ensure that the cost will be lower than the loss from forward and this will be more effective than using forward While the loss has effect in short run, the change has effect in long run Therefore, this demands deeper analysis and approval at higher level

First, assembling in customer country - US cannot be completed in a flash It is to build infrastructure, enter into contracts, work out the global logistic from zero Another factor is worker Many US firms choose to move out US to China where supplies low- cost labor Even though in 2018 Trump tried to shift US firms from China to US, they shift their operation to Asian country like Vietnam (VnExpress, 2020) Not only that, labor demand of RR is highly-skilled worker who requires well-paid salary

Second, component production does not stand alone and heavily link with the supplier network, assembly suppliers located nearby, labor resources Looking at the supplier network only, Mary Creagn, the chair of UK Environmental Audit Select Committee, affirmatively stated that it is not just switching easily from one supplier to others in a strictly modulated industry like aerospace (Chemical Watch, 2019) The ideal to bring all components to US to have the finished product is not cost-effective, making RR less competitive than before This adjustment has significant effect on long-standing business ecosystem

To sum up, due the unique characters of the industry that RR is operating: the customer base, the supply chains, the business ecosystem the suggestion of completing the final good in customer country is theoretically possible rather than practically

While contractual instrument seems useless since it hedges for the something that is uncontrollable The increasing uncertainty and risks are accumulated and go along with the length of the time Further, it is feasible to predict the future It reflects in the forward rate: the longer the time, the higher forward premium Forward contract is not suitable for the case of RR RR would better to choose policies recommend in the last part.

Looking at the part 1, in reality, MNEs see that it is unreasonable and uneconomical to care about the foreign exchange risk for such a long term and to use the contractual agreement The term of contracts is limited up to 36 months (3 years) This equals only a half of the RR’s contract

Part b will be externally causal factors Nevertheless, RR is over-confident and let it pass or not consider it cautiously

b From outside

Forward contact now is called forward in short Comparing to pure hedging, forward is characterized to be certain in delivery date and rate Forward rate is predetermined at present This also means whatever the ending spot rate is RR has to use the forward rate The beauty of the forward contract that you do not really pay out the money until the maturity now becomes the disadvantage for RR It cannot end the contract at earlier time when the rate has not reach the bottom If RR had hedged purely, when pound started its historical-dropping period it would have sold the US dollar without delay

The currency hedge is performing poorly during the six-year period, the value of the British pound was extremely low, the main reason being caused by the abruptness of referendum RR brought a long position hoping that the British pound would appreciate against the US dollars Since the pound was depreciated, the hedging program did not occur in favor of RR Until May 2016, it expected, at least pound is at the average of $1.4400/£ This loss would be covered The pound has enjoyed a long period of relative weakness against the US dollar and Euro But the recent referendum seems to have pushed it down to a level not seen in the past quarter-century against the US dollar, as well as approaching the historical lows versus the Euro Now this loss is out of coverable capacity, equaling £4.4 million

The $/£ rate had been relatively stable in 2016 Technical analysis of in 5-first month shows that RR has the chance of improving the profit before tax by £40 million pound (Telegraph, 2016) However technical analysis did not work for the case of RR since 6/2016 marked the historical down trend of the pound By August, the pound had fallen by more than 12% against the dollar Since a weakening home currency against the dollar in late June is an advantage for exporter RR evidenced by the increase in RR share price following the referendum and its first-half year results, regardless its long position at high purchasing price And that had led to a loss on its currency hedging program

Companies often plan for a long run Aston Martin is a car manufacturer who is not in the same industry but like RR it had announced “a multi-year strategy”, “to go from