Part 1 Aspen Technologies Case Questions:
Identification of Risk Exposures Identification
The business strategy by Aspen Technologies to sell software’s in local currencies and installments of three to five years gave rise to exchange rate exposures of two types.
This happened at the time of consolidating financial statements into U.S dollar currency (Lewis 135).
This arose from Aspen’s transactions that were denominated in foreign currency (Lewis 135). Aspen Tech had a problem of the probability to be unable to cover a huge figure of expenses that were in foreign currencies from cash flow received from the sales in those currencies.
Interest rate risk
This risk arose from money owed to a financial institution in Massachusetts amounting to US$4 million with 9.6% fixed interest rate risk from and New England bank credit facility from that allowed borrowing of an amount that was either less than of US$10 Million or a fraction of a qualified amount based on receivable installment. Aspen had therefore to pay $ 37, 500 for the obtained annual facility. Aspen has this risk because it was not possible to sell all its receivables and therefore faced a rate fluctuation (Lewis 135).
Aspen has a high level credit default risk due to the customer’s preference to make payments in installments instead of cash payment. By end of 1995, the principle amount of installment sold to other financial institutions amounting to $23.3 million had not been collected. Under the agreement of limited recourse, Aspen was liable for an amount totaling to $4.6 million of the total sales.
This arose from customer’s choice to postpone submitting their licenses fees over the contracts entire life making the company to experience a cash shortfall in its operations. For instance, in 1995 although revenue of US$57.5 million had been booked only $38.5 million was received as a cash payment.
The current Aspen Tech risk management
Foreign Exchange risk
In its planned policy the company eliminated transaction exposures by doing away with all sales based on currency exposures by either selling the accounts receivables installments that were not in U.S dollars for equivalent dollars or utilizing forward contracts. However, expense related exposures were not hedged against.
It has not been possible to manage the risk of uncollectible installments due to the existing contractual agreement with other companies that has a limited recourse agreement that ensures Aspen is liable of uncollectible installment particular amount.
Aspen offers its accounts receivable to GE and Sanwa or other financial institutions for them to buy to enable it take care of its everyday cash obligations. It also considers the debt with Massachusetts Capital Resources as well as the credit facility line that is seasonal placed with New England Bank.
Aspen Tech faces a major problem in cash flow and can be solved by offering the accounts receivables for sale to other companies like GE and Sanwa. Operation hedging is one recommendation to overcome this problem through; restructuring policy term of payments for its customers by either adjusting the down payment upwards of reducing the installment period. It can also restructure its operations like moving it’s the Continental Office located in Belgium Continental to the Branch Office in Germany, which will save some expenses. Reexamination of the head office expenses is also recommended. Thirdly, it is recommendable to restructure and manage account payable through negotiations with its suppliers so as to ensure adequate cash flow. Finally Aspen should estimate their sales and expenses as accurate as possible to match timing and amount between expenses and receivable (Lewis 135).
Foreign exchange risk
Aspen Tech should make use of available instrumental in the market to hedge against probable foreign exchange risk with several alternative options that can be used as appropriate hedging instruments. These options include
Plain Vanilla option
They allow an option buyer the right but not an obligation to buy or sell a given total figure of a specific currency at a strike price that is predetermined.
Average Rate options
It allows spot rate to derived by calculating a specific period’s average and strike price can taken to be in a rate that either floating or fixed. It is possible to transact during the expiring period at a number of predetermined dates.
Knock in options or knock out options
Its key is in determining barrier date. Its use provides a barrier to Aspen tech that either be knocked in which means activating or knocked out which means deactivating that is done after certain predetermined conditions are met (Lewis 142).
Interest Rate Risk
To secure its risk against its fixed interest rate debt, Aspen should have a forward contract to hedge its fixed interest. Alternatively, it can pay its debt using New England Bank in line credit facility as long as its interest is lower than the fixed rate interest of 9.6%.
It is recommendable that Aspen Tech finds an insurance company ready to cover its account receivable from their customer. The insurance premium should first be evaluated to ensure it is at an acceptable level for increase in company expenses.
Part II: Short Essay Questions:
- Suppose the current trade imbalances disappear in the next decade. Explain what will happen to capital flows if that occurs. Identify and explain the factors that will contribute to the end of the trade imbalances and corresponding change in capital flows.
Trade imbalances results from either trade deficits or trade surpluses where trade surplus are due to more imports than exports while trade surpluses are due to more exports than imports. The disappearance of trade imbalances will reduce international flows of capital. Trade balances imply that there neither trade deficits nor surpluses in an economy. This can arise from having factors such as having equal value for imports and exports this has an impact capital flows because exports are part of domestic production and imports are part of foreign products which are factored in an economies consumption, investments and expenditure that require movement of funds between different institutions and economies. Secondly, trade balances can arise from making failure by an economy to make foreign direct investments to other countries. This reduces capital flows because these investments increase capital growth due to development of factories and firms that engage in production activities that provide goods and services promoting economic growth and increase in capital. The other factor is devaluation of exchange rate which ensures a trade surplus or deficit does not arise from foreign exchange transactions. When the exchange rate of a currency is devalued to be equal to another currency used in a foreign exchange transaction ensures that there are no gains or losses arising from these kind of transactions hence reducing capital flows between countries (Tran, Thi and Thi 147).
Identify and explain the indicators of a country’s economic and political risks.
There are political and economic factors portray how the economy of a country is performing. These factors include the fiscal responsibilities, monetary stability, and change rate of the currency as well as the level of government spending. Political risks involve a certain perspective that is portrayed by a country’s political activities. It can be measured by the frequency of changes in the government, the availability of violent occurrences, the number of armed insurrections that occur, presence of conflicts with other countries, response of a county to external shocks. All these indicators establish the existence to which government forces support economic growth or lead to poor performance of the economy. Economic risks involve the prevailing financial factors that reflect the performance of an economy. These include the level of inflation, prevailing balance of payments, level of capital flight, which relates to export of savings or investing in foreign countries, which may be caused by poor economic policies or expected devaluation of a currency. They also include the level of tax rates, credit ratings that depend on the level of public debt of a country such that if the level of debt is, the credit rating will be poor. The other is the gross domestic product, which refers to the total goods and services produced by a country per year. Inflation and consumer price index, which determines the rise and fall in prices of products and services. Another indicator is the structure of a country’s financial markets, which relates to whether these financial markets are centralized or decentralized. The availability of attractive investment opportunities is another indicator as well as presence of a proper environment to engage in business and investment activities. The performance of local stock and bond markets which assist in determining whether the economy is performing well or not (Lewis 144).
Explain why a multinational company may have a lower cost of capital than a purely domestic company.
A multinational company has several differences from a domestic firm that allows its cost of capital to be lower than that of a domestic firm. These differences include; the size of the firm as one of the aspects which ensures that multinationals are given preferential treatment by creditors and can also achieve lower floatation costs. Multinationals have accessibility to international capital markets, which makes it possible for them to obtain funds through these markets at lower cost. Multinationals are able to diversify internationally which increases their possibility of having cash flows that are more stable hence reducing probability of their bankruptcy. These factors contribute greatly to ensuring that multinationals have lower cost of capital than purely domestic firms (Bishnoi 2).
Some forecasters believe that the foreign exchange market is efficient and forward exchange rates are unbiased predictors of future spot exchange rates. Explain what is meant by unbiased predictor in terms of how the forward rate performs in estimating the future spot rate.
Forward exchange rates as unbiased predictors of the future spot rates imply that the value expected of a future spot rate at a specified time is the same as the present forward rate at the same specified during delivery. This means that actual spot rates’ possible distributions in the future are based on the forward rate. However, it does not mean that as an unbiased predictor, the future spot rate will be equal to what is predicted by the forward rate. It means that, there will be an average overestimation and underestimation of the actual future spot rate in the same frequency and degree by the forward rate. The explanation for this relationship is behind the hypothesis that the foreign exchange market is taken to be reasonably efficient (Filipozzi, Fabio, and Kerst 3).
Bishnoi, Rahul K. “Comparative Relationship between Cost of Equity Capital and Leverage in Matched Sets of Multinational Corporations and US Domestic Firms.” Journal of Financial Management and Analysis 25.1 (2012). 1-3.
Filipozzi, Fabio, and Kersti Harkmann. Currency hedge–walking on the edge?. No. wp2014-5. Bank of Estonia, 2014. 1-6.
Lewis, Jide. “A framework to analyse the sovereign credit risk exposure of financial institutions.” Journal of Risk Management in Financial Institutions 8.2 (2015): 130-146.
Tran, Thi Anh-Dao, and Thi Thanh Binh Dinh. “FDI inflows and trade imbalances: evidence from developing Asia.” The European Journal of Comparative Economics 11.1 (2014): 147.