BC Hydro like any other organization or company is exposed to financial risks, the firm faced movements in different areas of related to finances like rates of exchange, interests and also prices of different commodities in the firm. From the case study there are several issues that are identified in relation to the organization and that have potential impacts in the organizations success. These factors include but not limited to the following;
Financial exposures, the financial structure of the organization was not very much complex but easy to understand. The revenues for the organization were basically from sales of power to both residential as well as business enterprises. On the other hand cost structure was not complex since it only included the debt service. The organization further experienced great challenges because of the debt issues and this was greatly triggered by strength of U.S dollar and the Canadian interest rates. Also use of different currencies placed the organization in disclosure of financial viability of the organization. (Currency exposure, 2008)
The firm called in for help in solving the issue whereby the main agenda was to point out the main risks associated with finance after which possible solutions were to be identified. In aid of solving the problem two main questions were to be addressed. First “does BC Hydro aim at reducing all financial risks or to look for a way of managing it? Second is whether the firm is engaged in provision of power and in business of trading or contemplating in the financial markets.” (Currency exposure, 2008)
The case further discusses the financial exposure issues that included financial price risks and what contributed much to the increased financial risks in the firm. Also the issues of currency exposure are highly discussed and factors underlying its increase are discussed.
Interest rate exposure
Interest rate exposure refers to the risks that a business organization is exposed to in regards to the interest rates. This is usually as a result of use of loans for business organizations to finance operations. Interest rates keep on fluctuating and at ties they fluctuate to favor the business organization while in most cases the rates increases exposing the business organization to challenges of interest payment. (Sohnke et al, 2008)
Interest rate exposure is caused by changes in rates and is assumed to be the gap between assets that bear interest and the liabilities of the firm. This is the main contributor to the interest rate exposure in most of the business organizations. (Sohnke et al, 2008)
Interest rate risks for business are in most cases experienced when for instance the loan that has been obtained by the firm matures for payment and there is no shortcut it has to be repaid. When the interest rates increase it becomes challenging to obtain a loan in future and costs for maintaining the loan increase. This means that the loans obtained by business organization should be re-paid within the scheduled period of time since if the period expires then the cost of financing the loans will have increased. (Millan, 1990)
For the BC Hydro firm it experienced interest rate exposure, this was as a result of the power sales of the firm. The residential consumers of the power were stable hence they were not sensitive to the movements in interest rates. This meant that most of the revenues that were collected were not equivalent to the changes in interest rates. Because of this at times when the interest rates changed drastically there were no enough finances to support or payback the interest rates hence resulting to great exposure of the firm to interest rates exposure. (Beato, 2007)
The other thing is that the cost structure of the firm was based on debt service, 55 percent of the total operating costs for the firm were based on debt service. The kind of strategy adopted by the firm, it is possible for the costs in firms to move directly with interest rates but because of the strategy adopted this was not possible. This increased chances of interest rate exposure for the firm. The strategy used was the one for maintaining fixed assets with debts that last for long period of time at rates that are fixed. This blocked movement in shorter cycles of interest rates. (Currency exposure, 2008)
Based on the case study the BC Hydro firm experienced currency exposure, currency is said “to be exposed to changes in exchange to a degree that is used to perform transactions with external markets. The greater the proportion of the inter-currency exchanges to monetary transactions in the market, the higher the chances in exchange rates. (Beato, 2007)
This means that currency exposure is mostly associated with the use of another currency apart fro the main currency used in that country. Chances of having great currency exposure risks are associated with the frequency or the more times a business firm uses the foreign currency. In order to avoid the currency exposure risks it is important that the trading business organization uses its own main currency since in most cases it will favor the firm and also reduce so many transactions that are involved with the use of foreign currency. (Eliot, 2008)
The BC Hydro firm faced great challenges in its operations in regards to foreign exchange exposure. This was because the firm was Canadian and its used foreign currency in obtaining finances for its operations, the firm had four billion of the total long term debt that was U.S dollar dominated. The difference in currency used in one or another may have caused confusion since total of 95 percent of the revenues earned were in Canadian dollar while the debt was in U.S dollar. This kind of transactions using different currencies exposed the firm to great currency risks. (Eliot, 2008)
Since the firm only earned five percent of its revenues in US dollar it was a challenge for the firm to obtain enough foreign currency to service the huge debt it had. The firm continued to experience great losses in regards to payment of the debt. From the case study it is clear that there are certain factors that contributed much to increased risks associated with currency exposure. The first one is the exchange rates movement between the two currencies, if the U.S dollar continues to increase it means that the risk will continue to increase since the Canadian dollars needed to cover one U.S dollar may be very high. (Trewin, 2005)
Business firms and organizations operating using foreign currencies should be careful to design strategies that enable the firms to minimize the risks associated with currency exposure. This is the only way business firms can survive since it is challenging to transact completely using one’s own currency. (Trewin, 2005)
Strategies for risk management
Because of the kind of risks that the firm faced in regards to currency exposure as well as interest rate exposure there are certain strategies that were put forth to help the firm overcome the risks and gain an advantage out of every situation. The strategies provided solutions to the revenue-cost risks and the foreign currency risks. (Watkins et al, 2008)
To increase the proportion of short-term debt
The first solution was focused on the issue of revenue-cost mismatch whereby they were not matching hence high debts being recorded. The strategy to address this problem was to increase in the proportion of short-term debt. When the proportion of the short term debt would be increased it will mean that the revenues earned by the firm will match the debts or the costs that are there. This will help in limiting huge amounts of long term debts that increase risks for the firm. (Watkins et al, 2008)
On the other hand the strategy when applied in the firm it will help in decreasing the risks associated asset-liability maturity matching. It will ensure that by the time the loan matures there are enough revenues to repay the loans and the interests involved. (Jennifer, 2005)
To buy the U.S dollars forward
This was created to solve the risk associated with foreign currency exposure. The firm would be engaged in a process whereby they would buy the U.S dollars in their current rates and forward them for payment at a future date. This will enable the firm to accumulate enough funds and be able to pay back the debt. (Jennifer, 2005)
To move al sinking fund capital out of Canadian dollars bonds into similar risk category of US dollar-dominated securities
This kind of a strategy would enable the firm to deposit all of its sinking-fund capital from the Canadian bond to the U.S dollar dominated securities. This will mean that the funds of the firm are in the same currency hence the amounts that the funds will gain from the U.S dollar securities will enable the firm to offset the debt of the firm. The reason for this is that the funds will grow hence the amounts gained will be used to offset the interest rates expected out of the debt hence the firm will not struggle much to pay the debt and the interest rates. (Watkins et al, 2008)
On the other hand the strategy may place a challenge on the firm since it will have opened foreign currency position that at one point may go the opposite and cost the fir much by loosing all the funds deposited.
Interest rate swap
Interest rate swap refers to use of substitute or change of the interest rates excepted to be paid. This is usually done with clear association with the corporation or organization to which the debt belongs to. Is there is corporation between the two corporations then it is an easier strategy of solving the problem of interest rate exposure. But there may also be challenges to this strategy since the other organization may not be ready to corporate on swapping the interest rates. (Fernando, 2005)
After analysis of the strategies the best strategy to use for the corporation is to ensure that the ratio is increased for short term debt. The reason being that it helps in avoiding the high service debts as well as balancing the costs and debts such that there is enough to pay for the debts. The strategy does not cost the firm more resources. (Fernando, 2005)
The BC Hydro firm does not need to eliminate completely all the financial risks instead it needs to manage the risks because risks are normal part of business operations. The reason is that the risks increased because of the poor management in the firm concerning use of foreign currency and debts. The firm is only engaged in provision of power but not in financial market speculation. The only thing is that the firm used debts in form of U.S dollars to cater for its needs. In conclusion the firms should be careful when engaging in use of foreign currencies since they may affect the operations of the firms through the foreign currency exposure risks and the interest rates exposure. Also financial institutions should ensure that there are strategies to cater for this. (Millan, 1990)
List of references
Beato P, 2007, Foreign currency exposure and project finance. Web.
Currency exposure, 2008, growth in foreign currency exposure. Web.
Eliot R. 2008, Currency risk management. Web.
Fernando R.M, 2005, Managing foreign exchange risk, United Nations capital development fund, microfinance.
Jennifer M, 2005, “Tapping Financial Markets for Microfinance” Grameen Foundation USA Publication Series.
Millan G. J, 1990, The floating battlefield; corporate strategies in the currency wars, New York, AMACOM.
Sohnke M.B, Natasha B, Jean H, 2008, Foreign currency exposure and hedging: Evidence fro foreign acquisitions, University Library of Munich Publishers Germany.
Trewin D. 2005, Foreign Currency exposure. Web.
Watkins T, Valley S, Alley T, 2008, Corporate strategies toward foreign currency transaction risk. Web.