PHANG YU SHANG 17WBR11339 RFI4

Individual written report

Determine derivative instrument used by company

According to Annual Report of TOP GLOVE CORPORATION BERHAD (Topglove)

in 2019, most of the debt borrowed by Topglove was majority denominated in United States
Dollar (USD). Topglove consists of borrowing of USD borrowing exchange to Ringgit
Malayisa approximately RM1.3 billion (Appendix 1), when USD strengthen against MYR in
future, Topglove will face a loss as they need to pay more for the interest cost after convert
MYR to USD. In order to hedge the foreign exchange rate risk, the group has used currency
forward contract to reduce the risk. (Appendix 2) Based on the sensitivity analysis, we know
that strengthen of USD is bad for Topglove, if USD appreciate by 5%, Topglove need to
suffer RM 11,062,000 loss, vice versa.

Currency forward contract is a binding agreement entered between two

counterparties which allow them exchange specific amount of currency for another currency
on a fixed future date at a fixed exchange rate. This instrument is popular as all the terms can
be negotiated between two counterparties such as volume, price and maturity date to match
the unique needs of both counterparty. Moreover, currency forward contract is less costly
compare to other derivative instruments. (Rambo, et al., 2011)

How the company use the derivative on financial management

For example, Topglove expects to pay an interest payment of USD 3million after
3months. Before they pay the interest payment, they will need to convert MYR into USD and
they will expose to exchange rate risk as the exchange rate will fluctuate over time. Assume
Topglove predicts USD will be strengthening after 3 months, they can lock in certain
exchange rate first to reduce the risk of exchange rate fluctuation. Assume exchange rate
today is 1 USD = 4.10 MYR, but Topglove predicts USD will appreciate to 1 USD = 4.20
MYR after 3months. Topglove can now enter into a currency forward contract to exchange 3
million MYR into USD after 3months at a fixed exchange rate of 1 USD = 4.15 MYR to
reduce the risk of fluctuation in exchange rate.

Assume that the actual exchange rate after 3months is 1 USD = 4.20 MYR. Without
using currency forward contract, Topglove would have paid RM12.,600,000 [ USD 3million
x 4.2 ] by exchanging to USD 3 million at the market exchange rate.
 Since Topglove has entered into currency forward contract at the rate of 1 USD = 4.15
MYR, Topglove should pay only RM12,450,000 [USD 3million x 4.15] after 3 months. By
entering into currency forward contract, it has helped Topglove reduced loss of RM150,000
[ RM12,600,000 – RM12,450,000 ] payment for the interest cost. Under the terms of the
contract, Topglove will get compensation from the other counterparty equivalent to the
difference between the exchange rate that they have locked in previously and the current
exchange rate.

However, if the actual exchange rate after 3months is 1 USD = 4.00 MYR, which
USD depreciate, Topglove would have pay RM12,000,000 [ USD 3million x 4.00 ] by
exchanging USD 3million at the market exchange rate. Since Topglove has entered into
currency forward contract, Topglove now need to pay more as the current market rate is
lower than the contract rate. Topglove can actually pay less without hedging, which is RM
450,000 lower [(4.15-4.00) x USD 3 million], but is it important to take note the purpose of
hedging is not to eliminate all risk or maximise our profit, its main function is to help us
reduces risk. By using hedging, Topglove will be able to lock in certain exchange rate which
allow them to know the exact proceeds and cost will be, so that they will not suffer infinite
loss.

Recommendation on other derivative instrument

Other than forward currency contract, Topglove can use currency option to hedge
exchange rate risk. Currency option is an instrument that give holder right but not obligation
to buy or sell certain amount of exchange rate at specific date and specific exercise price. The
benefit of currency option is it could provide flexibility to holders which holders can choose
to exercise or not to exercise the currency at maturity date so it will be much more expensive
compare to other derivative instruments. (Kamau, Inanga and Rwegasira, 2015) Currency
option can be divided into call option and put option. Call option is bought when holders
expect the exchange rate will appreciate in future. In opposite, holders will buy put option if
they expect the exchange rate will depreciate in future. (Maurer and Valiani, 2007)

Since Topglove is worried about USD appreciated due to their borrowing are mostly
denominated in USD, it is suggested for Topglove to buy either call option on the USD or put
option on the MYR. If USD strengthens against MYR after 3months, Topglove should
exercise the option, they will enjoy unlimited potential gain from the currency option to
offset the loss generated from transactions denominated in USD. If USD weaken against
MYR after 3months, Topglove will profit from transactions denominated in USD but will
suffer limited loss in currency option. In this case, Topglove should not exercise the option
and the loss will only limited to the cost which is premium.

Besides that, Topglove can use currency future contract to hedge the exchange rate
risk. Currency future contract is a legal agreement entered between two counterparties which
allow them to buy or sell standardized amount of currency for another currency at certain
currency at a future date. The difference between currency future and currency forward is it
trades in standardized form in terms of volume, maturity date and price. The benefit of
currency future is it could provide transparency to counterparties as private information is
required to publish to them and it could help counterparties to reduce default risk and
improve efficiency. (Kamau, Inanga and Rwegasira, 2015) (Kharbanda and Singh, 2018)

There will be 2 position involve in currency future contract which are long position
and short position. Long position will benefit when USD appreciated against MYR in future
while short position will make profit when USD depreciated against MYR in future.
Topglove would hold the long position as majority of borrwoing of Topglove are
denominated in USD and they worry about USD appreciated against MYR. If USD
appreciated against MYR after 3months, Topglove will make profit. In opposite, if USD
depreciated against MYR, Topglove will suffer loss. There is always a cost for future contract
which holder will lose part of the profit if the currency move in unfavourable direction.

(1059 Words)
Reference

Kamau, P., Inanga, E.L. and Rwegasira, K., (2015). The usage of currency derivatives in
multilateral banks. Management Research Review, 38(5), pp.482-504 <.https://www-
emeraldinsight-com.tarcez.tarc.edu.my/doi/pdfplus/10.1108/MRR-10-2013-0248 >

Kharbanda, V. and Singh, A., (2018). Futures Market Efficiency and Effectiveness of Hedge
in Indian Currency Market. International Journal of Emerging Markets, (just-
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com.tarcez.tarc.edu.my/doi/pdfplus/10.1108/IJoEM-08-2017-0320 >

Maurer, R. and Valiani, S., (2007). Hedging the exchange rate risk in international portfolio
diversification: Currency forwards versus currency options. Managerial
Finance, 33(9), pp.667-692. < https://www-emeraldinsight-
com.tarcez.tarc.edu.my/doi/pdfplus/10.1108/03074350710776235 >

Rambo, R.G., Main, D. and Beaubien, L., (2011). Reducing reporting risk: Designating
foreign currency forward contracts as cash flow hedges. Journal of Accounting
Education, 29(4), pp.284-294. <https://ac-els-cdn-
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Hartalega, (2018), Annual Report 2018, viewed 17 November 2018,

<https://harta.irplc.com/investor-relations.html>
Appendix

Appendix 1: Loan and borrowing by Top Glove Corporation Berhad

Appendix 2: Derivatives used by Top Glove Corporation Berhad

Appendix 3: Sensitivity analysis for foreign currency risk of Top Glove Corporation Berhad