QUESTION
Samoa Tala
Questions
You are a financial risk management consultant hired to advise SPBD on how to best manage its currency risk exposure.
1. Should Micro Finance Institutions take foreign currency loans? If yes should they hedge foreign exchange risk? How will a 5 %
depreciation or appreciation of the Samoan Tala affect the income statement of SPBD? What are the consequences of not hedging?
2. What alternatives are available to hedge foreign currency exposures for SPDB? Is it prudent to leave the Samoa Tal unhedged? If not how much exposure should be hedged?
3. What is the exchange rate regime of Samoa? What can be inferred from the Tala’s exchange rate movements with respect to different currencies?
4. How can the knowledge of the exchange rate regime of Samoa be used to hedge the foreign exchange risk of the Samoan Tala?
5. If borrowing costs are equal in USD, Euro and NZD, how much should SPDB borrow in each currency?
6. Would your hedging recommendation differ if instead of advising SPBD, you were advising the Samoan Sovereign wealth fund fixed income division and the portfolio of that division was composed mostly of USD denominated, NZD denominated and Euro denominated bonds? Would your advice change if you were counseling the equity division of the Samoan Sovereign Wealth fund and it held mostly Euro area, New Zealand and US equities?
FX Quotes
| Exchange Rate Data | ||||||
| USD for | USD for | USD for | AUD for | JPY for | ||
| 1 Tala | 1 NZD | 1 euro | 1 USD | 0.01 USD | ||
| USD Price | USD Price | USD Price | AUD Price | JPY Price | ||
| of 1 Tala | of 1 NZD | of 1 Euro | of 1 USD | of .01 USD | ||
| End of | USD_Tala | USD_NZD | USD_Euro | USD_AUD | USD_JPY | |
| Feb-98 | 0.37 | 0.58 | 1.09 | 0.66 | 0.77 | |
| Mar-98 | 0.36 | 0.57 | 1.09 | 0.67 | 0.8 | |
| Apr-98 | 0.35 | 0.55 | 1.09 | 0.67 | 0.78 | |
| May-98 | 0.34 | 0.54 | 1.11 | 0.65 | 0.76 | |
| Jun-98 | 0.33 | 0.51 | 1.1 | 0.63 | 0.74 | |
| Jul-98 | 0.33 | 0.52 | 1.1 | 0.6 | 0.71 | |
| Aug-98 | 0.32 | 0.5 | 1.1 | 0.62 | 0.71 | |
| Sep-98 | 0.33 | 0.5 | 1.16 | 0.59 | 0.69 | |
| Oct-98 | 0.33 | 0.52 | 1.2 | 0.59 | 0.74 | |
| Nov-98 | 0.33 | 0.53 | 1.17 | 0.62 | 0.83 | |
| Dec-98 | 0.33 | 0.52 | 1.18 | 0.63 | 0.83 | |
| Jan-99 | 0.34 | 0.54 | 1.16 | 0.62 | 0.85 | |
| Feb-99 | 0.33 | 0.54 | 1.12 | 0.63 | 0.88 | |
| Mar-99 | 0.34 | 0.53 | 1.09 | 0.64 | 0.86 | |
| Apr-99 | 0.34 | 0.54 | 1.07 | 0.63 | 0.84 | |
| May-99 | 0.34 | 0.55 | 1.06 | 0.64 | 0.84 | |
| Jun-99 | 0.33 | 0.53 | 1.04 | 0.66 | 0.82 | |
| Jul-99 | 0.32 | 0.53 | 1.04 | 0.66 | 0.83 | |
| Aug-99 | 0.32 | 0.53 | 1.06 | 0.66 | 0.84 | |
| Sep-99 | 0.33 | 0.52 | 1.05 | 0.64 | 0.88 | |
| Oct-99 | 0.32 | 0.51 | 1.07 | 0.65 | 0.93 | |
| Nov-99 | 0.32 | 0.51 | 1.03 | 0.65 | 0.94 | |
| Dec-99 | 0.32 | 0.51 | 1.01 | 0.64 | 0.96 | |
| Jan-00 | 0.32 | 0.51 | 1.01 | 0.64 | 0.97 | |
| Feb-00 | 0.32 | 0.49 | 0.98 | 0.66 | 0.95 | |
| Mar-00 | 0.32 | 0.49 | 0.96 | 0.63 | 0.91 | |
| Apr-00 | 0.32 | 0.50 | 0.95 | 0.61 | 0.94 | |
| May-00 | 0.32 | 0.47 | 0.91 | 0.6 | 0.95 | |
| Jun-00 | 0.32 | 0.47 | 0.95 | 0.58 | 0.92 | |
| Jul-00 | 0.30 | 0.46 | 0.94 | 0.59 | 0.94 | |
| Aug-00 | 0.30 | 0.45 | 0.90 | 0.59 | 0.93 | |
| Sep-00 | 0.29 | 0.42 | 0.87 | 0.58 | 0.93 | |
| Oct-00 | 0.28 | 0.40 | 0.85 | 0.55 | 0.94 | |
| Nov-00 | 0.28 | 0.40 | 0.85 | 0.53 | 0.92 | |
| Dec-00 | 0.29 | 0.43 | 0.90 | 0.52 | 0.92 | |
| Jan-01 | 0.29 | 0.45 | 0.94 | 0.55 | 0.89 | |
| Feb-01 | 0.29 | 0.44 | 0.92 | 0.56 | 0.86 | |
| Mar-01 | 0.28 | 0.42 | 0.91 | 0.53 | 0.86 | |
| Apr-01 | 0.28 | 0.41 | 0.89 | 0.5 | 0.82 | |
| May-01 | 0.28 | 0.42 | 0.87 | 0.5 | 0.81 | |
| Jun-01 | 0.28 | 0.42 | 0.85 | 0.52 | 0.82 | |
| Jul-01 | 0.28 | 0.41 | 0.86 | 0.52 | 0.82 | |
| Aug-01 | 0.29 | 0.43 | 0.90 | 0.51 | 0.8 | |
| Sep-01 | 0.28 | 0.42 | 0.91 | 0.53 | 0.82 | |
| Oct-01 | 0.28 | 0.41 | 0.91 | 0.51 | 0.84 | |
| Nov-01 | 0.28 | 0.42 | 0.89 | 0.5 | 0.82 | |
| Dec-01 | 0.28 | 0.42 | 0.89 | 0.52 | 0.82 | |
| Jan-02 | 0.28 | 0.42 | 0.88 | 0.51 | 0.78 | |
| Feb-02 | 0.28 | 0.42 | 0.87 | 0.52 | 0.75 | |
| Mar-02 | 0.28 | 0.43 | 0.88 | 0.51 | 0.75 | |
| Apr-02 | 0.28 | 0.44 | 0.89 | 0.53 | 0.76 | |
| May-02 | 0.29 | 0.46 | 0.92 | 0.54 | 0.76 | |
| Jun-02 | 0.30 | 0.49 | 0.96 | 0.55 | 0.79 | |
| Jul-02 | 0.30 | 0.48 | 0.99 | 0.57 | 0.81 | |
| Aug-02 | 0.29 | 0.46 | 0.98 | 0.55 | 0.85 | |
| Sep-02 | 0.29 | 0.47 | 0.98 | 0.54 | 0.84 | |
| Oct-02 | 0.30 | 0.48 | 0.98 | 0.55 | 0.83 | |
| Nov-02 | 0.30 | 0.50 | 1.00 | 0.55 | 0.81 | |
| Dec-02 | 0.30 | 0.51 | 1.02 | 0.56 | 0.82 | |
| Jan-03 | 0.31 | 0.54 | 1.06 | 0.56 | 0.82 | |
| Feb-03 | 0.32 | 0.56 | 1.08 | 0.58 | 0.84 | |
| Mar-03 | 0.32 | 0.55 | 1.08 | 0.6 | 0.84 | |
| Apr-03 | 0.32 | 0.55 | 1.09 | 0.6 | 0.84 | |
| May-03 | 0.33 | 0.58 | 1.16 | 0.61 | 0.83 | |
| Jun-03 | 0.34 | 0.58 | 1.17 | 0.65 | 0.85 | |
| Jul-03 | 0.33 | 0.59 | 1.14 | 0.66 | 0.84 | |
| Aug-03 | 0.33 | 0.58 | 1.11 | 0.66 | 0.84 | |
| Sep-03 | 0.33 | 0.58 | 1.12 | 0.65 | 0.84 | |
| Oct-03 | 0.34 | 0.60 | 1.17 | 0.66 | 0.87 | |
| Nov-03 | 0.35 | 0.63 | 1.17 | 0.69 | 0.91 | |
| Dec-03 | 0.35 | 0.65 | 1.23 | 0.72 | 0.92 | |
| Jan-04 | 0.36 | 0.67 | 1.26 | 0.74 | 0.93 | |
| Feb-04 | 0.37 | 0.69 | 1.26 | 0.77 | 0.94 | |
| Mar-04 | 0.36 | 0.66 | 1.23 | 0.78 | 0.94 | |
| Apr-04 | 0.36 | 0.64 | 1.20 | 0.75 | 0.92 | |
| May-04 | 0.35 | 0.62 | 1.20 | 0.74 | 0.93 | |
| Jun-04 | 0.35 | 0.63 | 1.21 | 0.7 | 0.89 | |
| Jul-04 | 0.35 | 0.65 | 1.23 | 0.69 | 0.91 | |
| Aug-04 | 0.35 | 0.66 | 1.22 | 0.72 | 0.91 | |
| Sep-04 | 0.36 | 0.66 | 1.23 | 0.71 | 0.91 | |
| Oct-04 | 0.36 | 0.68 | 1.25 | 0.7 | 0.91 | |
| Nov-04 | 0.37 | 0.70 | 1.30 | 0.73 | 0.92 | |
| Dec-04 | 0.37 | 0.71 | 1.34 | 0.77 | 0.96 | |
| Jan-05 | 0.37 | 0.70 | 1.31 | 0.77 | 0.96 | |
| Feb-05 | 0.37 | 0.71 | 1.30 | 0.77 | 0.97 | |
| Mar-05 | 0.38 | 0.73 | 1.32 | 0.78 | 0.95 | |
| Apr-05 | 0.37 | 0.72 | 1.29 | 0.78 | 0.95 | |
| May-05 | 0.37 | 0.72 | 1.27 | 0.77 | 0.93 | |
| Jun-05 | 0.37 | 0.71 | 1.21 | 0.77 | 0.94 | |
| Jul-05 | 0.36 | 0.68 | 1.21 | 0.77 | 0.92 | |
| Aug-05 | 0.37 | 0.70 | 1.24 | 0.75 | 0.89 | |
| Sep-05 | 0.36 | 0.70 | 1.22 | 0.76 | 0.9 | |
| Oct-05 | 0.36 | 0.70 | 1.20 | 0.77 | 0.9 | |
| Nov-05 | 0.36 | 0.69 | 1.18 | 0.75 | 0.87 | |
| Dec-05 | 0.36 | 0.69 | 1.19 | 0.74 | 0.84 | |
| Jan-06 | 0.36 | 0.69 | 1.21 | 0.74 | 0.84 | |
| Feb-06 | 0.36 | 0.67 | 1.19 | 0.75 | 0.87 | |
| Mar-06 | 0.35 | 0.64 | 1.20 | 0.74 | 0.85 | |
| Apr-06 | 0.34 | 0.62 | 1.23 | 0.73 | 0.85 | |
| May-06 | 0.36 | 0.63 | 1.28 | 0.74 | 0.85 | |
| Jun-06 | 0.36 | 0.62 | 1.27 | 0.76 | 0.89 | |
| Jul-06 | 0.35 | 0.62 | 1.27 | 0.74 | 0.87 | |
| Aug-06 | 0.36 | 0.63 | 1.28 | 0.75 | 0.86 | |
| Sep-06 | 0.36 | 0.65 | 1.27 | 0.76 | 0.86 | |
| Oct-06 | 0.36 | 0.66 | 1.26 | 0.76 | 0.85 | |
| Nov-06 | 0.36 | 0.67 | 1.29 | 0.75 | 0.84 | |
| Dec-06 | 0.37 | 0.69 | 1.32 | 0.77 | 0.85 | |
| Jan-07 | 0.36 | 0.70 | 1.30 | 0.79 | 0.85 | |
| Feb-07 | 0.36 | 0.69 | 1.31 | 0.78 | 0.83 | |
| Mar-07 | 0.36 | 0.70 | 1.33 | 0.78 | 0.83 | |
| Apr-07 | 0.37 | 0.74 | 1.35 | 0.79 | 0.85 | |
| May-07 | 0.38 | 0.73 | 1.35 | 0.83 | 0.84 | |
| Jun-07 | 0.38 | 0.76 | 1.34 | 0.82 | 0.83 | |
| Jul-07 | 0.38 | 0.78 | 1.37 | 0.84 | 0.82 | |
| Aug-07 | 0.38 | 0.73 | 1.36 | 0.87 | 0.82 | |
| Sep-07 | 0.37 | 0.72 | 1.39 | 0.83 | 0.86 | |
| Oct-07 | 0.39 | 0.76 | 1.42 | 0.85 | 0.87 | |
| Nov-07 | 0.39 | 0.76 | 1.46 | 0.9 | 0.86 | |
| Dec-07 | 0.39 | 0.77 | 1.45 | 0.9 | 0.9 | |
| Jan-08 | 0.39 | 0.77 | 1.47 | 0.87 | 0.89 |
ANSWER
Question 1
The SPBD is a not for profit organization, which provides financial services to the women of Samoa. The organization does not receive that much of donation and to provide financial services to its member it is required to take loan. The loan rates in Samoa is pretty high and if they take the loan from Samoa it would burden its members. Therefore, they are required to take loan from foreign countries. Hedging or not is highly dependent on the economic conditions of the country. If the economy of the country is strong than the currency would appreciate in the future and vice versa. But most of the time it is not known what the movement of the currency will be therefore it is always suggested to hedge the exposure.
5% appreciation will reduce the expenses and 5% depreciation will increase the expenses. Refer to appendix for further.
Consequences of not hedging would, if currency depreciates, result into losses.
Question 2
There are lots of traditional method of hedging which includes buy derivative such as forwards, futures and options. But the problem with these derivatives is that, the size of the economy of Samoa is small and thus there is no market for such products. There are other options such as back to back lending and letter of credit but both of these options come with their own limitations.
Given the size of the organization, SPBD can take the risk of going unhedged, as hedging in itself cost a lot of money to the organization and requires expertise in that particular field.
Question 3
The currency of Samoa, Tala follows a pegged exchange rate regime, in which the rate is determined by pegging the currency against a basket of key trading partner country’s currency. So it follows a fixed Currency Composition scheme, in which weights is assigned to every currency (which centre bank decides) and the rate of the local currency is calculated.
When it comes to USD the currency has appreciated in past 10 years, but when compared to the other two currency, we can safely conclude that Tala has depreciated and the rate of depreciation against Euro has been higher than that of NZD.
Question 4
The knowledge of the exchange rate regime can help an organization a lot in deciding the hedging strategy for the future. Suppose in the given case, Tala is pegged to a basket of foreign currency. We as an organization knows that the change in the following currency will impact the movement of our currency. Therefore, we would be already hedged against the movement of those currency.
Question 5
The main consideration before borrowing the money is interest rate of that particular country. But if the interest rates are constant than the organization has the option to borrow from anywhere it wants but than it has to think about the exchange rate risk which is dependent on its foreign exchange regime. As per the current regime we assume that the basket is made of only three currencies which are USD, Euro and NZD. Solving through the regression equation given in the question, we arrive at the following weights
| Currency Weights | |
| USD/Tala |
30.56% |
| USD/NZD |
39.93% |
| USD/Euro |
15.09% |
These are the weights the company should borrow in three currencies.
(for regression results please refer appendix)
Question 6
When it comes to the hedging for investment firms, historically the firms would hedge their bonds and leave the equities unhedged. This is what should be done by the Samoa Sovereign Wealth fund, they should hedge their fixed income investment and leave the equities investment unhedged. This is because they are investing in economically sound countries where the chances of currency depreciation are low.
Appendix 1
Example of 5% of appreciation or depreciation
| USD per Tala | |||
| Spot Rate |
0.4 |
||
| Loan Taken in USD | 1,00,000 | ||
| Loan Taken in Tala | 2,50,000 | ||
| After 1 year | Rate | Repayment in USD | Repayment in Tala |
| 5% Appreciation |
0.42 |
1,00,000 | 2,38,095 |
| 5% Depreciation |
0.38 |
1,00,000 | 2,63,158 |
Appendix 2
Regression
Equation 2
| SUMMARY OUTPUT | ||||||||
|
Regression Statistics |
||||||||
| Multiple R |
0.96583 |
|||||||
| R Square |
0.932828 |
|||||||
| Adjusted R Square |
0.93168 |
|||||||
| Standard Error |
0.008543 |
|||||||
| Observations |
120 |
|||||||
| ANOVA | ||||||||
|
|
df |
SS |
MS |
F |
Significance F |
|||
| Regression |
2 |
0.118571 |
0.059286 |
812.3956 |
2.46E-69 |
|||
| Residual |
117 |
0.008538 |
7.3E-05 |
|||||
| Total |
119 |
0.127109 |
||||||
|
|
Coefficients |
Standard Error |
t Stat |
P-value |
Lower 95% |
Upper 95% |
Lower 95.0% |
Upper 95.0% |
| Intercept |
0.148496 |
0.006549 |
22.67526 |
1.23E-44 |
0.135526 |
0.161466 |
0.135526 |
0.161466 |
| X Variable 1 |
0.186401 |
0.024397 |
7.640359 |
6.54E-12 |
0.138084 |
0.234717 |
0.138084 |
0.234717 |
| X Variable 2 |
0.069882 |
0.016453 |
4.247302 |
4.36E-05 |
0.037297 |
0.102467 |
0.037297 |
0.102467 |
Equation 3
| SUMMARY OUTPUT | ||||||||
|
Regression Statistics |
||||||||
| Multiple R |
0.827093 |
|||||||
| R Square |
0.684082 |
|||||||
| Adjusted R Square |
0.678636 |
|||||||
| Standard Error |
0.009533 |
|||||||
| Observations |
119 |
|||||||
| ANOVA | ||||||||
|
|
df |
SS |
MS |
F |
Significance F |
|||
| Regression |
2 |
0.022825 |
0.011412 |
125.5922 |
9.45E-30 |
|||
| Residual |
116 |
0.010541 |
9.09E-05 |
|||||
| Total |
118 |
0.033366 |
||||||
|
|
Coefficients |
Standard Error |
t Stat |
P-value |
Lower 95% |
Upper 95% |
Lower 95.0% |
Upper 95.0% |
| Intercept |
-0.00094 |
0.000881 |
-1.07277 |
0.2856 |
-0.00269 |
0.0008 |
-0.00269 |
0.0008 |
| X Variable 1 |
0.399312 |
0.03613 |
11.05212 |
7.79E-20 |
0.327752 |
0.470872 |
0.327752 |
0.470872 |
| X Variable 2 |
0.150934 |
0.044767 |
3.371558 |
0.001016 |
0.062268 |
0.2396 |
0.062268 |
0.2396 |
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