Advanced Corporate and International Finance

Introduction

Unilever is an Anglo-Dutch consumer products manufacturing and distributing giant with its headquarters located in London, the United Kingdom and another one in Rotterdam, Netherlands. The products of Unilever include food, beverages and different types of cleaning and personal care items. In 2012, Unilever was named as the biggest consumer goods producing company measured according to its revenue accumulated (Unilever, 2018). On Oct 13, 2016, the company decided to pull out 200 products from Tesco including Martime, Pot Noodles, etc. after the value of pound was affected due to the impact of Brexit (As excerpted from the case study). The government’s resolution towards Brexit led to uncertainty and currency risks for the company (As excerpted from the case study). Moreover, Unilever assured Brandtone to invest $5 million in its venture of digital marketing. The company also decided to make a onetime lumpsum investment rather than multiple cash flow. This report intends to study the currency risks that Unilever might face in its attempt of investment and provide useful insights to the company regarding its hedging strategies to provide a defence against the risks.

Currency Risks exposed by Unilever

In the first example, the company took an initiative in investing in its digital marketing by investing in Brandtone and decided to make the entire investment one time, thus giving rise to transaction based risk (Campbell, Serfaty-De Medeiros and Viceira, 2010).

The second example of Unilever pulling out its products of Tesco suggests that it is a type of economic risk exposure, which is caused as a result of fluctuations in the currency of a company and effects its long term elements such as cash flow and the market value of a product. The impact of economic risk is severe, as the changes in the exchange rate affect the company’s competitive position. In this case, due to the effect of Brexit, the value of pound endured a substantial plunge and fails to show any sign of recovery in the recent future (Campbell, Serfaty-De Medeiros and Viceira, 2010).

Types of hedging tools

The hedging tools used by Unilever to encounter the situations are currency forward hedging tools and money market hedging strategies. The hedging strategies are discussed as under:

Currency Forward Contracts– These types of foreign currency contracts are used when the investor is under the obligation of making a payment in foreign currency at any point of time in future (Aretz and Bartram, 2010). This type of hedging tool keeps the exporter totally protected even if the level of currency depreciates below contract level in the future. Moreover, the seller of forward rate is entitled to unlimited cost generation, if in future there is appreciation in the currency. (Aretz and Bartram, 2010).

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Money Market Hedging– Money Market hedging is the technique used for hedging of the foreign risk with the use of money market and short term and liquid instruments such as Treasury bills, bank acceptance and other commercial papers (Ruf, 2013). Money market may not be the most effectual and cost-effective method of hedging for large organizations such as Unilever, but it is the most convenient method to protect the company against fluctuations in the currency.

Pros and cons of hedging strategies

The exchange for future transactions for the money market is fixed like the forward markets. Although the rate is fixed and the company can forecast the future, the fluctuations in the currency can affect the firm doing the transaction (Hull and Basu, 2016). In currency forward hedging, the one doing the transaction is aware of the currency the person needs to buy, and therefore, can plan the budget in an effective manner depending upon his forecast. However, in money markets, this customization is available to a greater scope and the transactions can be conducted in precise amounts. Money market hedging is lot more complicated than currency forward hedging, as money market is a process of step-by-step deconstruction (Aretz and Bartram, 2010). Moreover, there are more chances of logistic constraints such as arrangement of a loan amount or deposit of foreign currencies in money market hedging than in currency forward. Money market hedging is used as an alternative tool to mitigate the risk that has aroused and cannot be solved by using tools of forward and futures contract (Hull and Basu, 2016).

Hedging strategies of Unilever

Figure 1: Fluctuations in GBP and USD

(Source: DailyFX, 2018)

In 2018, Unilever wants to make a lumpsum investment in Brandtone in the US. Figure 1 represents the current market fluctuations between Sterling and the US Dollars. The value of sterling has depreciated since the last one month from December 2017 to January 2018 (DailyFX, 2018). Due to fluctuations in sterling, Unilever would like to invest $5 million in Brandtone and achieve 100% currency exposed risk hedging.

Figure 2: Spot and forward rate of Sterling against Dollar

 (Source: Investing, 2018)

Figure 2 represents the forward rate of sterling against dollar, which is 1.3529, indicating that the value of currency forward of dollar against sterling is 0.3529 more. The spot price of both the currencies is 1.35. Therefore, Unilever to hedge the market using currency forward rates needs to apply the following formula (Wong, 2013):

Forward Price- Spot Price/ Spot Price * 12/Number of months * 100%

= 1.3529-1.351.35*126*100%

= 0.4296 (Forward hedging rate).

For money market hedging, the foreign currency needs to be borrowed at the present value. Then the currency should be converted into the domestic currency at spot exchange rate. The third step involves placing the domestic currency, in this case, sterling, on deposit for the ongoing interest rate. Finally, from the first step, after the receivable of foreign currency comes in, the loan is repaid including the interest.

Due to the fluctuations in the currency of sterling, Unilever should attempt to use the currency forward strategies, as it being one of the largest consumer goods producers can create an impact on the market by taking advantage of the fall in price of sterling and investing in US Dollars to reap benefits in future. In addition, with the impact of Brexit, it is less likely for sterling to have a substantial improvement in future, until December 2018, instating high probability of the company to achieve higher returns if it invests in Brandtone (As excerpted from the case study).

The involvement of transaction costs can lead to fluctuations in the revenue of Unilever. The transaction costs reduce the impact of hedging and leads to optimization of the company portfolio (Dolinsky and Soner, 2014).

Future’s Contract and its implications

In the second example, the value of sterling has dropped from $1.48 to $1.29 and with the impact of Brexit, there is possibility of a further drop in the recent future with no sign of recovery (As excerpted from the case study). This type of risk is economic exposure of currency risk affecting the company. It is difficult to hedge currencies with economic exposure, as it deals with the unprecedented changes in the foreign exchange rates, which are the pillars for forecasting and determining the corporate budgets. However, the economic exposures of a particular contract can be hedged using the futures contract, as it is a tool that is normally used to hedge the depreciation of currencies. According to Hull and Basu (2016), the futures contract is a legal contract that is made in the trading room of a futures market for the purpose of buying or selling of a financial commodity at a price determined earlier to be paid in future. The futures contract can involve both physical asset and cash as settlement. These contracts are referred to as a few specific characteristics of the underlying assets that are being traded. The two participants of future contracts in the market are hedgers and the speculators. The producers of an asset usually hedge the commodity, which is to be sold or purchased while portfolio managers bet on the underlying asset’s price movements. These contracts require a minimum initial outlay and can result in a significant quantity of money with effect from fluctuations in price (Hull and Basu, 2016). In the above example, with the drop in the value of sterling, Unilever can make lump sum investment in its digital marketing venture so as to get heavy returns in future with the rate appreciating.

Conclusion

Unilever made investment in Brandtone, giving rise to transaction based risk and economic risk by removing the products of Tesco. To counter the situations, the company decided to use the currency forward and money market strategies. The study of both the strategies indicates that the currency forward strategy is more beneficial to the company than money market and with the sudden drop in the currency of sterling, it is advised to the firm to implement the currency forward strategy.