Table of Contents

Introduction.................................................................................................................................................3
Types of Exchange Rate Risks......................................................................................................................4
Managing Exchange Rate Risks....................................................................................................................5
Hedging Strategies – Pros and Cons........................................................................................................5
Discussion of Risk Profiles............................................................................................................................6
Conclusion...................................................................................................................................................7
References...................................................................................................................................................8
Introduction

Every firm that engages in exchange rates is exposed to some level of exchange rate risk and
should assess the level of risk it will be exposed to. This risk forms an integral part of the foreign
currency transaction the firm undertakes.

As noted from the case study, AstraZeneca PLC is selling commercial rights of its heart drugs
Atacand and Atacand Plus to CHEPLAPHARM Arzneimittel GmbH for Euro 400 million
(AstraZeneca to sell Atacand rights to Cheplapharm for $400M, 2021). Under the terms of this
agreement, the usage of drugs is permissible in more than seventy countries. The buyer
Cheplaparm, a German pharmaceutical company, will pay Euro 250 million for the deliberation
on the transition process. In contrast, it will pay the balance of the monies in the first year
(AstraZeneca to sell Atacand rights to Cheplapharm for $400M, 2021). Atacand is used for
treating heart failure and hypertension, whereas Atacand Plus is a fixed-dose combination of
hypertension medicines. In 2019, the drugs made $148 million in sales in the countries included
in the deal (AstraZeneca to sell Atacand rights to Cheplapharm for $400M, 2021). The reason
AstraZeneca is selling these drugs is that they want to focus on developing new medicine.

As AstraZeneca is a pharmaceutical company based in the UK, and Cheplapharm is a German

company, the transaction will require currency exchange between Euro and Pound Sterling
(GmbH, 2021). In this context, hedging comes into play as currency risk hedging is a process of
eliminating or mitigating this risk. The selection of a suitable hedging strategy is a cumbersome
process. There are multiple complexities involved, such as the accurate measurement of the risk
exposure and the extent to which this exposure should be covered. Multinational companies such
as AstraZeneca have a dedicated risk committee to evaluate the company's exchange rate risk
when undertaking transactions with currencies other than those they normally do business in.

This report will discuss the measures of exchange rate risk, evaluate the best methods available
to manage this risk, and analyze the pros and cons of the various hedging approaches. The
discussion will also encompass the alternate risk profiles under different circumstances of the
deal between AstraZeneca and Cheplapharm. In conclusion, the report will summarize and
provide recommendations on the most suitable method to mitigate the foreign currency exchange
rate risk.

Types of Exchange Rate Risks

An exchange rate risk is created when there is an unexpected fluctuation in the value of a
currency, which can affect the firm's value. The risk is the direct loss that can occur due to the
fluctuation in the currency exchange rate when a firm's exposure to such risk is not hedged or the
indirect loss which can occur and affect the firm's value (Bereslavska, 2021). Exchange rate risk
is inherent in foreign exchange transactions. To mitigate or eliminate this risk, a firm should
understand the extent of its exposure to such risk, the strategy to hedge, and the availability of
different instruments to manage this risk (Hagelin and Pramborg, 2001). A company like
AstraZeneca is subjected to exchange rate risk due to their international operations. In order to
measure to what extent is the company is exposed to such risk, also known as the implied value-
at-risk (VaR), from exchange rate fluctuation, the company's exposure to the type of risk should
be assessed (Bereslavska, 2021). In this report, three main types of exchange rate risks will be
discussed as follows.

Transaction risk – Transaction risk is at the level of transactions of the company and affects the
cash flow. When the exchange rate fluctuates, the transactional accounts become exposed to this
risk. Transactional accounts are balance sheet accounts related to payables and receivables. A
fluctuation in the exchange rate in the currency's relative value to the denomination currency
heightens this risk for the company (Hagelin and Pramborg, 2001).

Translation risk – Translation risk exists at the balance sheet level and is caused due to the
variation in the value of a foreign subsidiary being consolidated to the parent company's
statement of financial position. This risk persists at the foreign subsidiary level and is measured
considering the exposure of the net assets to the potential exchange rate fluctuation. To mitigate
this risk, at the time of consolidation, the foreign currency translation to the local currency
should be undertaken either at the period end exchange rate or by using an average of the entire
period's exchange rate (Hagelin and Pramborg, 2001). This also depends on what accounting
body regulates the financial reporting where the parent company operates. Therefore, the profit
and loss statements are translated using an average exchange rate and balance sheet exposures
using the exchange rate at the time of the consolidation (Hagelin and Pramborg, 2001).

Economic risk – The economic risk of the foreign exchange rate arises from the present value of
the future cash flows resulting from the fluctuation of the exchange rate. Therefore, economic
risk is on the income statement level as it has an imminent effect on the sales arising locally and
internationally and operating expenses related to the sales (Hau, 2009).

Managing Exchange Rate Risks

AstraZeneca is faced with a transaction level risk and an economic risk that can arise from the
fluctuation of the Pound Sterling rate in relation to the Euro. Suppose AstraZeneca wants to
hedge these risks, the decision of selecting which strategy to use to mitigate this risk is pertinent
(Hau, 2009). From the literature review of past and current practices, it is evident that corporate
treasury departments use various strategies solely dependent on the type of risk and the
company's size to absorb the risk.

Hedging Strategies – Pros and Cons

A business's corporate treasury department views the future movements of the business and
decides to hedge the transaction risk to sustain the cash flows. This strategy also depends on the
type of currencies involved in the transaction and their fluctuation trends. Depending on the
treasury's measurement of the risk, the business may decide to use tactical hedging or strategic
hedging (Bereslavska, 2021). Strategic hedging is used for transactions resulting in over a long
period. In contrast, tactical hedging is used to mitigate the fluctuation risk of exchange rates in
the short term, mainly resulting from receivables and payables (Bereslavska, 2021).
Nevertheless, some businesses use passive hedging, using a stable currency value, and not
considering any fluctuations (Hau, 2009). By using passive hedging, the business does not
consider currency fluctuations.

Translation risk is hedged only depending on circumstances, which may be infrequent (Hau,
2009). Hedging for this risk is undertaken only when sudden movements in the currency value
can potentially impact the net assets (Bernoth and Herwartz, 2019). As this risk arises from long-
term foreign currency exposure resulting from international investments or subsidiary valuations,
the main impact of this risk is on the balance sheet items, making it less important for the
management to hedge against (Bereslavska, 2021).

While the main risk exists in consolidating a parent and subsidiary's balance sheet in different
currency zones, hedging a firm's debt profile is also imperative (Hau, 2009). As foreign currency
debt matures, the firm's net equity and income become prone to exchange rate risks. An
optimization model of hedging strategies may be used to mitigate this risk (Bereslavska, 2021).
Nevertheless, hedging the balance of the currency exposure even though optimal hedging
strategies are used is not an easy task. The business may opt to use tactical hedging to reduce this
risk to a lower level (Lee, 2009). Furthermore, if currency exchange rates do not go as expected,
the business cash flow and income may become volatile (Bereslavska, 2021). Therefore, it is
imperative to compare hedging costs against the cost of not hedging to realize the optimal
benefits.

It is difficult to quantify and measure economic risk as it involves the valuation of the fluctuation
of an exchange rate on the present values of future cash flows (Lee, 2009). As corporate
treasuries use a benchmark rate developed from observing exchange rate trends, measuring
economic risk will require them to predict the deviation of the costs and revenues from the
benchmark over some time (Bernoth and Herwartz, 2019). A possible line of action is to net off
the deviation's impact on different product lines and markets (Bernoth and Herwartz, 2019).
Consequently, the net risk will become small due to offsetting.

There is a wide number of hedging instruments available, and they are simple as well as complex
in nature. The number of hedging instruments has increased dramatically due to the increasing
complexities of modern-day business transactions (Bernoth and Herwartz, 2019). These
instruments include both over the counter and exchange-traded products. The ones ich are most
commonly used are currency forward contracts and cross-currency swaps. Currency forward
contracts enable the buying and selling of a currency at a future date using the current day rate
(Bernoth and Herwartz, 2019). When using forward contracts, the transaction is fully hedged
against risk; however, there is a risk of the exchange rate moving adversely and the high cost of
forwarding contracts execution (Lee, 2009).
Discussion of Risk Profiles

AstraZeneca is faced with an exchange rate risk exposure when it will receive the first payment
instalment of Euro 150 million exposure in the first year. There are few options that AstraZeneca
has as an alternative to the risk exposure, which is discussed below.

 Remain uncovered: Uncovered exchange rate risk is a form of risk that involves
switching from a domestic currency that is cheaper in relation to a foreign currency that
is more expensive (Ramirez, 2015). If AstraZeneca takes up this option, their transaction
will not be covered through a forward or futures contract, and the risk will remain
unhedged.

 Cover the entire exposure with forward contracts: Forward contracts are the most
common way to hedge foreign currency risk (Ramirez, 2015). Suppose AstraZeneca uses
forward contracts to cover the entire risk. In that case, it will lock the exchange rate today
to sell the currency on the predefined future date, hoping that Euro will depreciate against
the Pound Sterling.

 Cover half of the exposure, leaving the remaining balance uncovered: By undertaking
this option, AstraZeneca will be exposing Euro 75 million to risk while covering the
remaining amount with a forward contract at some predefined date.

 Cover the exposure with money market hedge: The money market hedge works
similarly as a forward exchange but is different somehow (Ramirez, 2015). The money
market hedge is not the optimal way to privet foreign currency translation exposure
because it is more complex than a forward contract. AstraZeneca is better off not using
this option due to the high risk and complications of the transaction.

 Speculate and conduct the currency exchange at the due time: If AstraZeneca opts to
speculate and conduct the currency exchange of Euro 150 million in a year, it will face a
higher risk due to high uncertainty levels. There is no saying whether the Euro will
depreciate or appreciate against the Pound Sterling in the future, and AstraZeneca may be
exposed to higher risk if it selects this option.
Conclusion

Mitigating risk arising from foreign currency exchange rate fluctuations can be managed using
different options, as discussed in the report. In order to reduce a company's susceptibility to
exchange rate fluctuations, it is imperative to measure and manage currency risk exposure. A
company's susceptibility can result from international transactions (Wu and Carr, 2006), as in the
case of AstraZeneca. In managing currency risk, multinational firms use different strategies
depending on the specific currency risk involved in the transaction. These strategies have
become very intricate as they attempt to discourse the transaction, translation and economic risks
altogether (Wu and Carr, 2006). AstraZeneca can mitigate foreign currency exchange rate risk by
covering the entire exposure of Euro 150 million with forward contracts. This way, AstraZeneca
can keep an eye on the current currency rate and lock it, hoping that it will not go adversely in
the future.

References

Bereslavska, O., 2021. DERIVATIVES AS CURRENCY RISK HEDGING

INSTRUMENTS. Market Infrastructure, (51).
Bernoth, K. and Herwartz, H., 2019. Exchange Rates, Foreign Currency Exposure and Sovereign
Risk. SSRN Electronic Journal,.
Corporate Finance Institute. 2021. What is a Forward Contract? - Corporate Finance Institute.
[online] Available at: <https://corporatefinanceinstitute.com/resources/knowledge/finance/
forward-contract/> [Accessed 30 June 2021].
GmbH, f., 2021. AstraZeneca To Divest Atacand In 70 Countries To Cheplapharm In $400 Mln
deal. [online] markets.businessinsider.com. Available at:
<https://markets.businessinsider.com/news/stocks/astrazeneca-to-divest-atacand-in-70-
countries-to-cheplapharm-in-400-mln-deal-1029745105> [Accessed 30 June 2021].
Hagelin, N. and Pramborg, B., 2001. Hedging Foreign Exchange Exposure: Risk Reduction from
Transaction and Translation Hedging. SSRN Electronic Journal,.
Hau, H., 2009. The Exchange Rate Effect of Multi-Currency Risk Arbitrage. SSRN Electronic
Journal,.
Lee, J., 2009. Currency Risk and Volatility Spillover in Emerging Foreign Exchange
Markets. SSRN Electronic Journal,.
Ramirez, J., 2015. Accounting for Derivatives. Hoboken: Wiley.
Spglobal.com. 2021. AstraZeneca to sell Atacand rights to Cheplapharm for $400M. [online]
Available at: <https://www.spglobal.com/marketintelligence/en/news-insights/latest-news-
headlines/astrazeneca-to-sell-atacand-rights-to-cheplapharm-for-400m-61022172>
[Accessed 30 June 2021].
Wu, L. and Carr, P., 2006. Theory and evidence on the dynamic interactions between sovereign
credit default swaps and currency options. SSRN Electronic Journal,.