Financial Risk Management – Case Memo

Financial Risk Management – Case Memo

1. The calculation of investing in the Brazil facility, without any hedging is shown in the spreadsheet attached (Appendix 1).

The net present value of the 25 years investment is -30,837,069 BRL.

We use the spot rate of 1.7950 as a rough estimate for the following 25 years. The discount rate is 10.68%, composed of the U.S. Treasury bond yield of 4.18% and risk premium of 6.5%.

The NPV does not depend on whether the cash flow forecast is expressed in USD or BRL, otherwise there will be a chance for arbitrage.

2. The risks Nodal faces if it goes unhedged include inherent risks for REIT industry, currency risk and operational risk.

(1) Inherent risks for REIT industry

a. Demand volatility: Because Nodal’s profits come from leases and rents, the business performance is totally determined by the demand of industrial property.

b. Reinvestment issue: Because Nodal distributes at least 90% of its current-period profits to its shareholders, there is no reinvestment in this way.

c. Exchange rate risk: Nodal earned rents in BRL and it would convert the rents back to USD each and every period to meet REIT requirements for profit distributions. The fluctuation of foreign exchange would cause the fluctuation of incomes measured in dollars.

(2) Currency risk

Because of high inflation in Brazil, its currency had experienced different stages of succession, from cruzeiro to real. Under these circumstances, foreign exchange rates or the implied volatility of real value would change. So the Brazilian economy and its currency were synonymous with risk.

(3) Operational risk

Operational risk is the risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events. In this case, committing fixed assets invested by Nodal subjects the firm to Brazilian economic conditions. The value of the assets would affected by the change of economic environment.

From the above analysis, the main...