Chap 10 Ifm
Chap 10 Ifm
Chap 10 Ifm
1 P & G India
Proctor and Gamble’s affiliate in India, P & G India, procures much of its toiletries product line from a Japanese company. Because of the
shortage of working capital in India, payment terms by Indian importers are typically 180 days or longer. P & G India wishes to hedge a 8.5
million Japanese yen payable. Although options are not available on the Indian rupee (Rs), forward rates are available against the yen.
Additionally, a common practice in India is for companies like P & G India to work with a currency agent who will, in this case, lock in the
current spot exchange rate in exchange for a 4.85% fee. Using the following exchange rate and interest rate data, recommend a hedging strategy.
Assumptions Values
180-day account payable, Japanese yen (¥) 8,500,000
Spot rate (¥/$) 120.60
Spot rate, rupees/dollar (Rs/$) 47.75
Implied (calculated) spot rate (¥/Rs) 2.5257 (120.60 / 47.75)
180-day forward rate (¥/Rs) 2.4000
Expected spot rate in 180 days (¥/Rs) 2.6000
180-day Indian rupee investing rate 8.000%
180-day Japanese yen investing rate 1.500%
Currency agent's exchange rate fee 4.850%
P & G India's cost of capital 12.00%
Spot Risk
Hedging Alternatives Values Rate (Rp/$) Assessment
If spot rate in 180 days is same as current spot 3,365,464.34 2.5257 Risky
If spot rate in 180 days is same as forward rate 3,541,666.67 2.4000 Risky
If spot rate in 180 days is expected spot rate 3,269,230.77 2.6000 Risky
Evaluation of Alternatives
The currency agent is the lowest total cost, in CERTAIN future rupee value, of all certain alternatives.
Problem 10.2 Siam Cement
Siam Cement, the Bangkok-based cement manufacturer, suffered enormous losses with the coming of the
Asian crisis in 1997. The company had been pursuing a very aggressive growth strategy in the mid-1990s,
taking on massive quantities of foreign currency denominated debt (primarily U.S. dollars). When the Thai
baht (B)was devalued from its pegged rate of B25.0/$ in July 1997, Siam’s interest payments alone were
over $900 million on its outstanding dollar debt (with an average interest rate of 8.40% on its U.S. dollar
debt at that time). Assuming Siam Cement took out $50 million in debt in June 1997 at 8.40% interest, and
had to repay it in one year when the spot exchange rate had stabilized at B42.0/$, what was the foreign
exchange loss incurred on the transaction?
Assumptions Value
US dollar debt taken out in June 1997 $ 50,000,000
US dollar borrowing rate on debt 8.400%
Initial spot exchange rate, baht/dollar, June 1997 25.00
Average spot exchange rate, baht/dollar, June 1998 42.00
At the time the loan was acquired, the scheduled repayment of dollar
and baht amounts would have been as follows:
Scheduled Repayment:
Repayment of US dollar debt: Principal $ 50,000,000
Repayment of US dollar debt: Interest 4,200,000
Total repayment $ 54,200,000
Actual Repayment:
Repayment of US dollar debt: Principal $ 50,000,000
Repayment of US dollar debt: Interest 4,200,000
Total repayment $ 54,200,000
Brent Bush, CFO of a medical device manufacturer, BioTron Medical, Inc., was approached by a Japanese
customer, Numata, with a proposal to pay cash (in yen) for its typical orders of ¥12,500,000 every other month
if it were given a 4.5% discount. Numata's current terms are 30 days with no discounts. Using the following
quotes and estimated cost of capital for Numata, Bush will compare the proposal with covering yen payments
with forward contracts.
How much in U.S. dollars will BioTron Medical receive 1) with the discount and 2) with no discount but fully
covered with a forward contract?
Assumptions Values
BioTron's 30-day account receivable, Japanese yen 12,500,000
Spot rate, ¥/$ 111.40
30-day forward rate, ¥/$ 111.00
90-day forward rate, ¥/$ 110.40
180-day forward rate, ¥/$ 109.20
Numata's WACC 8.850%
BioTron Medical's WACC 9.200%
Desired discount on purchase price by Numata 4.500%
Brent Bush should compare two basic alternatives, both of which eliminate the currency risk.
2. Not offer any discounts for early payment and cover exposure with forwards
Brent Bush should politely decline Numata's offer to pay cash in exchange for the requested discount.
Problem 10.4 Embraer of Brazil
Embraer of Brazil is one of the two leading global manufacturers of regional jets (Bombardier of Canada is the other).
Regional jets are smaller than the traditional civilian airliners produced by Airbus and Boeing, seating between 50 and 100
people on average. Embraer has concluded an agreement with a regional U.S. airline to produce and deliver four aircraft one
year from now for $80 million. Although Embraer will be paid in U.S. dollars, it also possesses a currency exposure of inputs –
it must pay foreign suppliers $20 million for inputs one year from now (but they will be delivering the sub-components
throughout the year). The current spot rate on the Brazilian real (R$) is R$1.8240/$, but it has been steadily appreciating
against the U.S. dollar over the past three years. Forward contracts are difficult to acquire and considered expensive. Citibank
Brasil has not explicitly provided Embraer a forward rate quote, but has stated that it will probably be pricing a forward off the
current 4.00% U.S. dollar eurocurrency rate and the 10.50% Brazilian government deposit note.
Assumptions Values
Receivable due in one year, US dollars $80,000,000
Payable due in one year, US dollars $20,000,000
Spot rate, reais per dollar (R$/$) 1.8240
One-year US dollar eurocurrency interest rate 4.00%
One-year Brazilian govt deposit note 10.50%
Implied one year forward rate = spot x ( 1 + iR$ ) / ( 1 + i$ ) 1.9380
Risk
Analysis Values Assessment
This is a net long position, meaning, Embraer will be receiving US dollars on net. Given the history of the Brazilian reais, that
it has traditionally suffered from rapid depreciation and occasional devaluation, a net long position in dollars by most Brazilian
companies is considered a very good thing.
Brazilian reais in one year at one year forward rate R$ 116,280,000.00 Certain
In this case, however, because the reais is selling forward at a considerable discount, the net long position -- if sold forward --
yields considerably more reais than the current spot rate. It should also be noted, however, that if the reais were to fall
considerably over the coming year, by remaining unhedged Embraer would enjoy greater reais returns.
Problem 10.5 Vizor Pharmaceuticals
Vizor Pharmaceuticals, a U.S.-based multinational pharmaceutical company, is evaluating an export sale of its
cholesterol-reduction drug with a prospective Indonesian distributor. The purchase would be for 1,650 million
Indonesian rupiah (Rp), which at the current spot exchange rate of Rp9,450/$, translates into nearly $175,000.
Although not a big sale by company standards, company policy dictates that sales must be settled for at least a
minimum gross margin, in this case, a cash settlement of $168,000. The current 90-day forward rate is Rp9,950/$.
Although this rate appeared unattractive, Vizor had to contact several major banks before even finding a forward
quote on the rupiah. The consensus of currency forecasters at the moment, however, is that the rupiah will hold
relatively steady, possibly falling to Rp9,400/$ over the coming 90 to 120 days. Analyze the prospective sale and
make a hedging recommendation.
Risk
Alternatives Values Assessment
1. Remain Uncovered.
Analysis
The Indonesian rupiah has been highly volatile in recent years. This means that during the 90-day period,
any variety of economic or political or social events could lead to an upward bounce in the exchange rate,
reducing the dollar proceeds at settlement to an unacceptable level.
Unfortunately, the forward contract does not result in dollar proceeds which meet the minimum margin.
The cost of forward cover, 20.1%, is indicative of the "artificial interest rates" used by some financial
institutions while pricing derivatives in emerging, illiquid, and volatile markets.
In the end, Vizor will have to decide whether making the sale into this specific market is worth breaking a
company policy on minimum proceeds (forward cover) or taking significant currency risk by not using
a forward cover.
Problem 10.6 Mattel Toys
Mattel is a U.S.-based company whose sales are roughly two-thirds in dollars (Asia and the Americas) and one-third in euros
(Europe). In September Mattel delivers a large shipment of toys (primarily Barbies and Hot Wheels) to a major distributor in
Antwerp. The receivable, €30 million, is due in 90 days, standard terms for the toy industry in Europe. Mattel’s treasury team has
collected the following currency and market quotes. The company’s foreign exchange advisors believe the euro will be at about
$1.4200/€ in 90 days. Mattel’s management does not use currency options in currency risk management activities. Advise Mattel on
which hedging alternative is probably preferable.
Assumptions Values
90-day A/R (€) € 30,000,000.00
Current spot rate ($/€) $1.4158
Credit Suisse 90-day forward rate ($/€) $1.4172
Barclays 90-day forward rate ($/€) $1.4195
Expected spot rate in 90 days ($/€) $1.4200
90-day eurodollar interest rate 4.000%
90-day euro interest rate 3.885%
Implied 90-day forward rate (calculated, $/€) $1.4162
90-day eurodollar borrowing rate 5.000%
90-day euro borrowing rate 5.000%
Mattel Toys weighted average cost of capital ($) 9.600%
Risk
Hedging Alternatives Values Assessment
If spot rate in 90 days is same as Credit Suisse forward rate $42,516,000.00 Risky
Evaluation of Alternatives
The money market hedge guarantees Mattel the greatest dollar value for the A/R when using the cost of capital as the reinvestment
rate (carry-forward rate).
111
Bobcat Company, U.S.-based manufacturer of industrial equipment, just purchased a Korean company that produces plastic nuts and
bolts for heavy equipment. The purchase price was Won7,500 million. Won1,000 million has already been paid, and the remaining
Won6,500 million is due in six months. The current spot rate is Won1,110/$, and the 6-month forward rate is Won1,175/$. The six-
month Korean won interest rate is 16% per annum, the six-month US dollar rate is 4% per annum. Bobcat can invest at these interest
rates, or borrow at 2% per annum above those rates. A six-month call option on won with a 1200/$ strike rate has a 3.0% premium, while
the six-month put option at the same strike rate has a 2.4% premium.
Bobcat can invest at the rates given above, or borrow at 2% per annum above those rates. Bobcat's weighted average cost of capital is
10%. Compare alternate ways that Bobcat might deal with its foreign exchange exposure. What do you recommend and why?
Assumptions Values
Purchase price of Korean manufacturer, in Korean won 7,500,000,000
Less initial payment, in Korean won (1,000,000,000)
Net settlement needed, in Korean won, in six months 6,500,000,000
Current spot rate (Won/$) 1,110
Six month forward rate (Won/$) 1,175
Bobcat's cost of capital (WACC) 10.00%
3. Money market hedge. Exchange dollars for won now, invest for six months.
The forward contract provides the lowest CERTAIN cost hedging method for payment settlement. If, however, the firm believes the
ending spot rate will be a weaker Won, Won1,200/$ or higher, then the call option would be a lower cost alternative. This would require,
however, that the firm accept foreign exchange risk and be willing to suffer the higher cost of the call option in the event that the Won
did not fall to the needed level.
Problem 10.8 Aquatech
Aquatech is a U.S.-based company which manufactures, sells, and installs water purification equipment. On April 11th the company sold a
system to the City of Nagasaki, Japan, for installation in Nagasaki’s famous Glover Gardens (where Puccini’s Madame Butterfly waited for the
return of Lt. Pinkerton.) The sale was priced in yen at ¥20,000,000, with payment due in three months.
Note: The interest rate differentials vary slightly from the forward discounts on the yen because of time differences for the quotes. The spot
¥118.255/$, for example, is a mid-point range. On April 11, the spot yen traded in London from ¥118.30/$ to ¥117.550/$.
Additional information: Aquatech’s Japanese competitors are currently borrowing yen from Japanese banks at a spread of 2 percentage points
above the Japanese money rate. Aquatech's weighted average cost of capital is 16%, and the company wishes to protect the dollar value of this
receivable.
a) What are the costs and benefits of alternative hedges? Which would you recommend, and why?
b) What is the break-even reinvestment rate when comparing forward and money market alternatives?
Assumptions Values
Amount of receivable, Japanese yen (¥) 20,000,000
Spot exchange rate at time of sale (¥/$) 118.255
Booked value of sale (amount/spot rate) $169,126.04
Days receivable due 90
Aquatech's WACC 16.0%
Competitor borrowing premium, yen (¥) 2.0%
1. Remain uncovered.
Account receivable (yen) 20,000,000
Possible spot rate in 90 days (yen/$) 118.255
Cash settlement in 90 days (US$) $169,126.04 Uncertain.
The put option does not GUARANTEE the company of settling for the booked amount.
The money market and forward hedges do; the money market yielding the higher proceeds.
b) Breakeven rate between the money market and the forward hedge is determined by the reinvestment rate:
Money market, US$ up-front $168,245.38
Forward contract, US$, end of 90 days $171,188.91
(1 + x) 101.750% $168,245.38 (1+x) = $171,188.91
x 1.74954% For 90 days
Breakeven rate, % per annum $0.06998
Problem 10.9 Compass Rose
Compass Rose, Ltd., a Canadian manufacturer of raincoats, does not selectively hedge its transaction exposure. Instead, if the date
of the transaction is known with certainty, all foreign currency-denominated cash flows must utilize the following mandatory
forward contract cover formula:
Compass Rose's Manadatory Forward Cover 0-90 days 91-180 days > 180 days
Paying the points forward 75% 60% 50%
Receiving the points forward 100% 90% 50%
Compass Rose expects to receive multiple payments in Danish kroner over the next year. DKr 3,000,000 is due in 90 days; DKr
2,000,000 is due in 180 days; and DKr 1,000,000 is due in one year. Using the following spot and forward exchange rates, what
would be the amount of forward cover required by company policy by period?
Forward
Assumptions Values Discount
Spot rate, DKr/C$ 4.70
3-month forward rate, DKr/C$ 4.71 -0.85%
6-month forward rate, DKr/C$ 4.72 -0.85%
12-month forward rate, DKr/C$ 4.74 -0.84%
South Face's Exposures 0-90 days 91-180 days > 180 days
A/R due in 3 months, DKr 3,000,000
A/R due in 6 months, DKr 2,000,000
A/R due in 12-months, DKr 1,000,000
Required Forward Cover for Compass Rose: 0-90 days 91-180 days > 180 days
A/R due in 3 months, DKr 75%
A/R due in 6 months, DKr 60%
A/R due in 12-months, DKr 50%
Pupule Travel, a Honolulu, Hawaii – based 100% privately owned travel company has signed an agreement to acquire a 50%
ownership share of Taichung Travel, a Taiwan – based privately owned travel agency specializing in servicing inbound
customers from the United States and Canada. The acquisition price is 7 million Taiwan dollars (T$ 7,000,000) payable in cash
in 3 months.
Thomas Carson, Pupule Travel’s owner, believes the Taiwan dollar will either remain stable or decline a little over the next 3
months. At the present spot rate of T$35/$, the amount of cash required is only $200,000 but even this relatively modest
amount will need to be borrowed personally by Thomas Carson. Taiwanese interest-bearing deposits by non-residents are
regulated by the government, and are currently set at 1.5% per year. He has a credit line with Bank of Hawaii for $200,000
with a current borrowing interest rate of 8% per year. He does not believe that he can calculate a credible weighted average
cost of capital since he has no stock outstanding and his competitors are all also privately-owned without disclosure of their
financial results. Since the acquisition would use up all his available credit, he wonders if he should hedge this transaction
exposure. He has quotes from Bank of Hawaii shown in the table below.
Analyze the costs and risks of each alternative, and then make a recommendation as to which alternative Thomas Carson
should choose.
Assumptions Values
Acquisition price & 3-month A/P, NewTaiwan dollars (T$) 7,000,000
Spot rate (T$/$) 33.40
3-month forward rate (T$/$) 32.40
3-month Taiwan dollar deposit rate 1.500%
3-month dollar borrowing rate 6.500%
3-month call option on T$ not available
Thomas Carson's credit line with Bank of Hawaii $ 200,000
3. Money Market Hedge: Exchanging US$ for T$ now, depositing for 3-months until payment
The currency risk is eliminated, but since Thomas Carson would have to exchange the money up front, it would require him to
borrow the money, increasing his debt outstanding for the entire 3 months.
Discussion.
This is a difficult decision. The forward contract appears to be the preferable choice, protecting him against an appreciating
T$, and creating a certain cash purchase payment. The problem, however, will be whether the Bank of Hawaii will allow him
to purchase a forward for the full $216,049.38, which is slightly above his credit line currently in place. If his relationship is
good with the bank, they most likely would increase his line sufficiently to allow the forward contract.
Problem 10.11 Chronos Time Pieces
Chronos Time Pieces of Boston exports wrist watches to many countries, selling in local currencies to watch stores and distributors.
Chronos prides itself on being financially conservative. At least 70% of each individual transaction exposure is hedged, mostly in the
forward market, but occasionally with options. Chronos's foreign exchange policy is such that the 70% hedge may be increased up to a
120% hedge if devaluation or depreciation appears imminent. Chronos has just shipped to its major North American distributor. It has
issued a 90-day invoice to its buyer for €1,560,000. The current spot rate is $1.2224/€, the 90-day forward rate is $1.2270/€.
Chronos’s treasurer, Manny Hernandez, has a very good track record in predicting exchange rate movements. He currently believes the
euro will weaken against the dollar in the coming 90 to 120 days, possibly to around $1.16/€.
Assumptions Values
Account recievable in 90 days (€) € 1,560,000
Initial spot exchange rate ($/€) $1.2224
Forward rate, 90 days ($/€) $1.2270
Expected spot rate in 90 to 120 days ($/€): Case #1 $1.1600
Expected spot rate in 90 to 120 days ($/€): Case #2 $1.2600
Hedged Hedged
If Chronos Time Pieces …… the Minimum the Maximum
This is not a conservative hedging policy. Any time a firm may choose to leave any proportion uncovered, or purchase cover for more
than the exposure (therefore creating a net short position) the firm could experience nearly unlimited losses or gains.
Problem 10.12 Lucky 13
Lucky 13 Jeans of San Antonio, Texas, is completing a new assembly plant near Guatemala City. A final construction payment
of Q8,400,000 is due in six months. (―Q‖ is the symbol for Guatemalan quetzals.) Lucky 13 uses 20% per annum as its
weighted average cost of capital. Today’s foreign exchange and interest rate quotations are as follows:
Lucky 13's treasury manager, concerned about the Guatemalan economy, wonders if Lucky 13 should be hedging its foreign
exchange risk. The manager’s own forecast is as follows:
What realistic alternatives are available to Lucky 13 for making payments? Which method would you select and why?
The second choice, the forward contract, results in the lowest cost alternative among certain alternatives.
Problem 10.13 Burton Manufacturing
Jason Stedman is the director of finance for Burton Manufacturing, a U.S.-based manufacturer of hand-held computer systems for inventory
management. Burton’s system combines a low-cost active bar-code used on inventory (the bar-code tags emit an extremely low-grade radio
frequency) with custom-designed hardware and software which tracks the low-grade emissions for inventory control. Burton has completed the
sale of a bar-code system to a British firm, Pegg Metropolitan (UK), for a total payment of £1,000,000. The following exchange rates were
available to Burton on the following dates corresponding to the events of this specific export sale. Assume each month is 30 days.
Analysis
a. The sale is booked at the exchange rate existing on June 1, when the product is shipped to Pegg Metropolitan, and the shipment
is categorized as an account receivable. This sale is then compared to that value in effect on the date of cash settlement,
the difference being the foreign exchange gain (loss).
b. The value of the foreign exchange gain (loss) will depend upon when Jason actually purchases the forward contract. Because
many firms do not define an "exposure" as arising until the date that the product is shipped (loss of physical control over
the goods) and the sale is booked on the income statement, that is a common date for the purchase of the forward contract.
A more aggressive alternative is for Jason to purchase the forward contract on the date that the contract was signed, March 1, locking-
in Burton's U.S. dollar settlement amount a full 90 days earlier in the transaction exposure's life span.
Note that in this case if Jason had covered forward on March 1st rather than June 1st, the amount of the foreign exchange loss would
have been even greater, although "fully hedged." The difference is of course the result of the forward rate changing with spot rates
and interest differentials.
Problem 10.14 Micca Metals, Inc.
Micca Metals, Inc. is a specialty materials and metals company located in Detroit, Michigan. The company specializes in specific
precious metals and materials which are used in a variety of pigment applications in many other industries including cosmetics,
appliances, and a variety of high tinsel metal fabricating equipment. Micca just purchased a shipment of phosphates from
Morocco for 6,000,000, dirhams, payable in six months. Micca’s cost of capital is 8.600%.
Six-month call options on 6,000,000 dirhams at an exercise price of 10.00 dirhams per dollar are available from Bank Al-
Maghrub at a premium of 2%. Six-month put options on 6,000,000 dirhams at an exercise price of 10.00 dirhams per dollar are
available at a premium of 3%. Compare and contrast alternative ways that Micca might hedge its foreign exchange transaction
exposure. What is your recommendation?
Assumptions Values
Shipment of phosphates from Morocco, Moroccan dirhams 6,000,000
Micca's cost of capital (WACC) 14.000%
Spot exchange rate, dirhams/$ 10.00
Six-month forward rate, dirhams/$ 10.40
3. Money market hedge. Exchange dollars for dirhams now, invest for six months.
Account payable (dirhams) 6,000,000.00
Discount factor at the dirham investing rate for 6 months 1.035
Dirhams needed now for investing (payable/discount factor) 5,797,101.45
Current spot rate (dirhams/$) 10.00
US dollars needed now $ 579,710.14
Carry forward rate for six months (WACC) 1.070
US dollar cost, in six months, of settlement $ 620,289.86 Certain.
The lowest cost certain alternative is the forward. If Micca were to expect the dirham to depreciate significantly over the next six
months, it may choose the call option.
Problem 10.15 Maria Gonzalez and Trident
Trident — the same U.S.-based company discussed in this chapter, has concluded a second larger sale of telecommunications
equipment to Regency (U.K.). Total payment of £3,000,000 is due in 90 days. Maria Gonzalez has also learned that Trident will only
be able to borrow in the United Kingdom at 14% per annum (due to credit concerns of the British banks). Given the following
exchange rates and interest rates, what transaction exposure hedge is now in Trident’s best interest?
Assumptions Value
90-day A/R in pounds £3,000,000.00
Spot rate, US$ per pound ($/£) $1.7620
90-day forward rate, US$ per pound ($/£) $1.7550
3-month U.S. dollar investment rate 6.000%
3-month U.S. dollar borrowing rate 8.000%
3-month UK investment interest rate 8.000%
3-month UK borrowing interest rate 14.000%
Put options on the British pound: Strike rates, US$/pound ($/£)
Strike rate ($/£) $1.75
Put option premium 1.500%
Strike rate ($/£) $1.71
Put option premium 1.000%
Trident's WACC 12.000%
Maria Gonzalez's expected spot rate in 90 days, US$ per pound ($/£) $1.7850
Analysis: Maria Gonzalez would receive the most certain US$ from the forward contract, $5,265,000; the money market hedge is
less attractive as a result of the higher borrowing costs in the U.K. now. The two put options would yield unattractive amounts if
they had to be exercised. As shown, the $1.75 strike price put option would be superior to the forward if the ending spot rate were
$1.7825 or higher; the $1.71 strike price would be superior to the forward if the ending spot rate were $1.7732 or higher.
Problem 10.16 Larkin Hydraulics
On May 1st, Larkin Hydraulics, a wholly owned subsidiary of Caterpillar (U.S.), sold a 12 megawatt compression turbine to Rebecke-
Terwilleger Company of the Netherlands for €4,000,000, payable €2,000,000 on August 1st and €2,000,000 on November 1st. Larkin derived
its price quote of €4,000,000 on April 1st by dividing its normal U.S. dollar sales price of $4.320,000 by the then current spot rate of $1.0800/€.
By the time the order was received and booked on May 1st, the euro had strengthened to $1.1000/€, so the sale was in fact worth €4,000,000
x $1.1000/€ = $4,400,000. Larkin had already gained an extra $80,000 from favorable exchange rate movements. Nevertheless Larkin's
director of finance now wondered if the firm should hedge against a reversal of the recent trend of the euro. Four approaches were possible:
1. Hedge in the forward market. The 3-month forward exchange quote was $1.1060/€ and the 6-month forward quote was $1.1130/€.
2. Hedge in the money market. Larkin could borrow euros from the Frankfurt branch of its U.S. bank at 8.00% per annum.
3. Hedge with foreign currency options. August put options were available at a strike price of $1.1000/€ for a premium of 2.0% per contract,
and November put options were available at $1.1000/€ for a premium of 1.2%. August call options at $1.1000/€ could be purchased for a
premium of 3.0%, and November call options at $1.1000/€ were available at a 2.6% premium.
4. Do nothing. Larkin could wait until the sales proceeds were received in August and November, hope the recent strengthening of the euro
would continue, and sell the euros received for dollars in the spot market.
Larkin estimates the cost of equity capital to be 12% per annum. As a small firm, Larkin Hydraulics is unable to raise funds with long-term
debt. U.S. T-bills yield 3.6% per annum. What should Larkin do?
The money market hedge provides the highest certain outcome. If Larkin Hydraulics believes the euro will strengthen versus the dollar over the
coming months, and it is willing to take the currency risk, the put option hedges could be considered.
Mini-Case: Banbury Impex (India)
Lapura's Turkish sale is for TL 369,825 ($250,000 at the current spot rate of TL1.4793/$). The receivable is for settlement 60
days from now (end of January, it is currently the end of November).
Since Lapura has no real insight -- or view -- on the direction of exchange rate movements, there is no motivation to use
currency options. Options require a directional view by the user if they are to be considered preferable to forward contracts.
Choosing the currency of invoice is a question of which hedge, if any, Lapura uses. If the 60-day forward rates are applied to
the three different currency of invoice choices, the greatest INR proceeds result from using a dollar currency of invoice and
covering the exposure with a 60-day forward rate to sell dollars for rupees.
Although Lapura could leave the receivable uncovered, given the volatility of exchange rate markets, and how "cheap"
forwards are at this time (meaning they differ little from the current spot rate as a result of such low interest rates in the
dollar, euro, and yen markets), it would mean taking on unneeded risk.
A money market hedge would be extremely difficult to accomplish in the immediate time frame. The need for a bank
relationship, the establishment of a line of credit in order to secure a loan, and the unattractive interest rates (the Turkish lira
borrowing rate would cut severely into the value of the receivable), all make the money market hedge impractical for this
sale.