Enterprise Risk Management Chapter 19 ERM Kilgore Cust

Its 835 Enterprise Risk Managementchapter 19erm Kilgore Custom Mill

Identify the core assignment question and clean the instructions: Remove any rubric, grading criteria, point allocations, meta-instructions to the student or writer, due dates, and any lines that are just telling someone how to complete or submit the assignment. Also remove obviously repetitive or duplicated lines so that the cleaned instructions are concise and non-redundant. Only keep the core assignment question and any truly essential context.

Analyze the case of Kilgore Custom Mill as described, focusing on their enterprise risk management strategies related to currency risk amidst their new contract with a Japanese manufacturer. Discuss how Kilgore's management can assess and mitigate financial risks associated with currency fluctuations, including evaluating the options of long-term swap contracts, short-term forward contracts, and currency options. Explain which risk mitigation strategies would be most suitable considering the company's context, knowledge level, and objectives, and provide recommendations based on best practices in enterprise risk management (ERM).

Paper For Above instruction

In the contemporary manufacturing landscape, especially for companies engaged in international trade, enterprise risk management (ERM) plays a crucial role in safeguarding against financial uncertainties, such as currency fluctuations. Kilgore Custom Milling, a small private manufacturer based in southern Ontario, Canada, exemplifies this challenge. The company's recent pursuit of a lucrative contract with a Japanese manufacturer presents significant currency risk, especially given past international contracts resulted in losses due to currency volatility. This paper assesses Kilgore's strategic options for managing currency risk, evaluates the suitability of various hedging instruments, and offers recommendations aligned with principles of ERM.

Understanding Kilgore's background is essential. The company specializes in power window assemblies, and its core management team comprises experienced professionals with diverse roles, including the owner and CEO Steve MacLinden, who intends to retire within the next decade. The company's primary financial concern revolves around cash flow stability amid currency fluctuations, which can significantly impact profitability, especially given the contract's proceeds in U.S. dollars and Kilgore's Canadian base. The potential for exchange rate volatility, particularly between the U.S. dollar and the Canadian dollar, introduces a substantial risk that could negate the benefits of increased sales and growth prospects.

Financial Risks in Context

Currency risk, also known as exchange rate risk, affects companies engaged in cross-border transactions. For Kilgore, the main exposure exists as they expect to receive proceeds in U.S. dollars. If the Canadian dollar appreciates relative to the U.S. dollar, Kilgore’s revenue in Canadian dollar terms diminishes, impacting cash flow and profitability. Conversely, a depreciating Canadian dollar could benefit the company but introduces unpredictability into financial planning.

In this context, Kilgore must adopt a comprehensive ERM framework that involves identifying, assessing, and mitigating financial risks. The goal is to ensure that the company's strategic objectives—such as sustaining cash flow, avoiding losses from adverse currency movements, and maintaining competitiveness—are achieved despite currency market volatility.

Hedging Strategies and Instruments

The company’s management has identified several instruments to manage currency risk: long-term swap contracts, short-term forward contracts, and currency options. Each instrument offers specific advantages and limitations, influenced by the company's familiarity with these tools, risk appetite, costs, and operational capacity.

Forward Contracts

Forward contracts are agreements to buy or sell a specified amount of foreign currency at a predetermined rate on a future date. They are straightforward, provide certainty over transaction costs, and are widely used for hedging currency risk. For Kilgore, entering into short-term forward contracts for the expected U.S. dollar proceeds could lock in exchange rates, minimizing future cash flow variability. However, managers' lack of understanding of these instruments may hinder execution. Proper education and consultation with financial experts are essential for effective use.

Long-term Swap Contracts

Currency swap contracts involve exchanging principal and interest payments in different currencies over an extended period. Although beneficial for managing ongoing currency exposures, swaps are complex and require sophisticated understanding and infrastructure. Given Kilgore's size and management team's limited familiarity, engaging in swap contracts could introduce additional risk if not properly managed. Nonetheless, for large and predictable cash flows, swaps could stabilize revenue streams over extended periods.

Currency Options

Options give the right, but not the obligation, to buy or sell foreign currency at a specified rate before a certain date. They provide flexibility, allowing a company to benefit from favorable currency movements while hedging against adverse ones. However, options are typically more expensive than forward contracts or swaps due to premium costs. The management’s current lack of understanding further complicates their use, increasing the importance of seeking expert advice.

Evaluating the Most Suitable Hedging Strategy

Given Kilgore’s size, resource constraints, and management's limited knowledge about complex financial instruments, a pragmatic approach is advised. Short-term forward contracts are often the most suitable for small to medium enterprises entering specific international transactions because of their simplicity, cost-effectiveness, and clarity. These instruments would allow Kilgore to lock in exchange rates for the contract duration, reducing cash flow uncertainty with manageable complexity.

In parallel, there should be an investment in capacity-building, including training and engaging financial professionals specializing in FX risk management. Building internal expertise or external partnerships can enhance decision-making and the proper execution of hedging strategies.

Long-term swaps and options could be considered as the company matures and gains more financial sophistication. For now, their use should be cautious and possibly limited to strategic or high-value transactions, with comprehensive risk assessments performed beforehand.

Recommendations for Kilgore Custom Milling

  • Adopt short-term forward contracts for imminent international sales to lock in currency rates and mitigate cash flow risk.
  • Invest in training and consult with currency risk management experts to improve understanding and execution of financial instruments.
  • Explore building a diversified hedging approach, combining forward contracts with cautious use of options where flexibility is needed.
  • Develop comprehensive ERM policies that integrate currency risk management into the broader strategic planning process.
  • Regularly monitor currency markets and adjust hedging strategies to respond to evolving market conditions and company needs.

Conclusion

In conclusion, Kilgore Custom Milling's expansion through a significant international contract underscores the importance of effective currency risk management within an enterprise risk management framework. While complex instruments like swaps and options offer advanced risk mitigation, their appropriate use requires expertise and resources that the company currently may lack. Therefore, pragmatic use of straightforward tools such as short-term forward contracts, complemented by capacity-building efforts, represents the most viable pathway. Implementing a structured ERM approach will enhance Kilgore's resilience to currency volatility, safeguard profitability, and support sustainable growth.

References

  • Costa, P., & Swavely, G. (2017). Currency risk management: Strategies and tools for effective hedging. Journal of International Business, 8(3), 112-130.
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  • World Bank. (2020). Currency exchange and risk mitigation in international trade. Retrieved from https://www.worldbank.org/en/topic/financialsector/brief/currency-exchange-and-risk-mitigation

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