Harvard Case - SaskPower U.S. Debt: Hedging Currency Exposure
"SaskPower U.S. Debt: Hedging Currency Exposure" Harvard business case study is written by Walid Busaba, Saqib A. Khan. It deals with the challenges in the field of Finance. The case study is 12 page(s) long and it was first published on : Jun 19, 2018
At Fern Fort University, we recommend that SaskPower implement a comprehensive hedging strategy to mitigate its exposure to U.S. dollar fluctuations. This strategy should involve a combination of forward contracts, options, and possibly other financial instruments, tailored to SaskPower's specific risk tolerance and financial goals. This approach will ensure that SaskPower can effectively manage its currency risk while maintaining its financial stability and profitability.
2. Background
SaskPower, a Crown corporation responsible for electricity generation and distribution in Saskatchewan, Canada, has significant debt denominated in U.S. dollars. This exposure arises from its acquisition of a U.S. coal-fired power plant. The case study highlights the potential financial risks associated with this exposure, particularly the volatility of the Canadian dollar against the U.S. dollar.
The main protagonists are:
- SaskPower: The Crown corporation facing the challenge of managing its U.S. dollar debt exposure.
- The Board of Directors: Responsible for overseeing SaskPower's financial strategy and risk management.
- The Finance Department: Responsible for analyzing financial data, developing hedging strategies, and managing SaskPower's financial risks.
3. Analysis of the Case Study
The case study presents a classic example of financial risk management, specifically currency risk. SaskPower's exposure to U.S. dollar fluctuations can significantly impact its profitability and financial stability. A weakening Canadian dollar against the U.S. dollar would make it more expensive for SaskPower to repay its debt, potentially leading to a decrease in profitability and a reduction in shareholder value.
To analyze the situation, we can use a framework based on financial analysis and risk assessment:
- Financial Analysis: Analyzing SaskPower's financial statements, including the balance sheet, income statement, and cash flow statement, is crucial to understand the magnitude of the U.S. dollar debt exposure and its impact on SaskPower's overall financial position. This analysis can also reveal SaskPower's risk tolerance and its ability to absorb potential losses from currency fluctuations.
- Risk Assessment: Identifying and evaluating the potential risks associated with SaskPower's U.S. dollar debt exposure is essential. This includes assessing the likelihood and potential impact of different scenarios, such as a significant depreciation of the Canadian dollar.
SaskPower can use various financial tools to manage its currency risk, including:
- Forward Contracts: These contracts lock in a future exchange rate, providing certainty about the cost of repaying the U.S. dollar debt.
- Options: These contracts give SaskPower the right, but not the obligation, to buy or sell U.S. dollars at a predetermined exchange rate. This provides flexibility and protection against unfavorable currency movements.
- Other Financial Instruments: Other instruments, such as currency swaps, can be used to manage currency risk depending on SaskPower's specific needs and risk appetite.
4. Recommendations
SaskPower should implement a comprehensive hedging strategy that includes the following:
- Develop a Clear Hedging Policy: SaskPower should clearly define its hedging objectives, risk tolerance, and the types of hedging instruments it will use.
- Use a Combination of Hedging Instruments: A combination of forward contracts and options can provide a balanced approach to managing currency risk.
- Regularly Monitor and Adjust the Hedging Strategy: SaskPower should regularly monitor the effectiveness of its hedging strategy and adjust it as needed based on changing market conditions and its financial goals.
- Consider Using Internal Expertise: SaskPower can leverage its internal finance department to develop and manage its hedging strategy. However, it may also benefit from seeking external expertise from financial institutions or consultants to ensure a robust and effective hedging program.
5. Basis of Recommendations
These recommendations are based on the following considerations:
- Core Competencies and Consistency with Mission: SaskPower's core competency lies in electricity generation and distribution. Hedging is a financial strategy that supports this core competency by mitigating financial risks and ensuring the long-term sustainability of the company.
- External Customers and Internal Clients: A stable financial position benefits both external customers, who rely on SaskPower for reliable electricity service, and internal clients, such as employees and shareholders. Hedging can help to ensure that SaskPower remains financially sound and able to meet its obligations.
- Competitors: SaskPower operates in a competitive market. By effectively managing its financial risks, SaskPower can maintain its competitive advantage and attract investors.
- Attractiveness ' Quantitative Measures: Hedging can improve SaskPower's financial performance by reducing the volatility of its earnings and cash flows. This can lead to higher profitability and increased shareholder value.
6. Conclusion
SaskPower faces significant currency risk due to its U.S. dollar debt exposure. Implementing a comprehensive hedging strategy is crucial to mitigate this risk and ensure the company's financial stability and profitability. By using a combination of forward contracts, options, and other financial instruments, SaskPower can effectively manage its currency risk while maintaining its financial goals.
7. Discussion
Other alternatives not selected include:
- Doing Nothing: This option carries significant risk and could lead to substantial financial losses if the Canadian dollar depreciates significantly.
- Speculating on Currency Movements: This approach is highly risky and could lead to significant losses if the currency movements are not predicted accurately.
Key assumptions of the recommendation include:
- SaskPower's Risk Tolerance: The recommendation assumes that SaskPower has a moderate risk tolerance and is willing to incur some costs to hedge its currency risk.
- Market Liquidity: The recommendation assumes that there is sufficient liquidity in the currency markets to execute the hedging strategy.
- Financial Expertise: The recommendation assumes that SaskPower has the necessary financial expertise to develop and manage its hedging strategy.
8. Next Steps
SaskPower should take the following steps to implement the recommended hedging strategy:
- Develop a Hedging Policy: This should be done within the next quarter.
- Select Hedging Instruments: This should be done within the next two months.
- Execute the Hedging Strategy: This should be done on a rolling basis, as needed to manage currency risk.
By implementing a comprehensive hedging strategy, SaskPower can effectively manage its currency risk and ensure its financial stability and profitability.
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Case Description
On December 19, 2002, the board of directors of the Saskatchewan Power Corporation (SaskPower) was contemplating the approval of the company's 2003 foreign exchange strategy to manage long-term currency risk exposure in the utility's U.S. dollar debt. SaskPower had borrowed extensively in the early 1990s, with maturities ranging from 10 to 30 years. The U.S. dollar exchange rate against the Canadian dollar had since increased, thereby increasing the effective burden of the debt and reducing the utility's net income. A change in accounting practices implemented in 2001 required SaskPower to recognize as a gain or a loss in the current year any translation differences in the value of its outstanding U.S. dollar debt resulting from fluctuations in the exchange rate during the year. This policy change led to a significant reduction in net income in 2001, followed by a significant increase during the first eight months of 2002. The volatility in earnings had complicated the task of setting rates for electricity and had proved politically difficult to justify. In late 2002, SaskPower had to decide whether and how to hedge its currency exposure in outstanding U.S. dollar debt.
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