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 (Loderer, 2000). 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 (Dumas, 1999). 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 (Edward, 1997). 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
Letshego to survive economic recessions (Edward, 1997). 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 (Dumas, 1999). 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 (Dumas, 1999). 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.
Question 1b

Interest rate risk is the risk of alteration in the price of an currency because of volatility in interest rates
(Linsmeier, Danie, Thornton, & Mohan, 2002). 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 (Cytonn, 2019). 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 (Loderer, 2000). 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 (Loderer, 2000). 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 (Senior Supervisors Group,
2009). For instance, if interest rates decrease, Letshego will not benefit from it.

Although there are costs involved for hedging interest rate, but the benefits outweigh the costs hence,
Letshego should hedge.
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 (Jensen, 2019).

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 (Dumas, 1999).

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 (Cytonn, 2019).

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 (Edward, 1997).

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 (Loderer, 2000).

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
(Dumas, 1999).

Based on the above discussed arguments Letshego can be advised to take into consideration the policy
of no hedge.
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) (Linsley & Shrives, 2006). 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 (Gordon and Betty
Moore Foundation., 2018). 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 (Joseph, 2013). For instance, Barclays bank risk
identification criteria will vary depending on the nature of activities that are considerably exposed
(IvyPanda, 2019). This helps it to know where, when and how the risk is going to affect the health of
the bank (Drury & Mike, 2005).

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 (Joseph, 2013). 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).
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 (Drury & Mike, 2005).
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 (Jensen, 2019).

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 (Cytonn, 2019). 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 (Cytonn, 2019). 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.