As the CFO of Melbourne Manufacturing, Shiela Forbes needs to draw a conclusion on whether to hedge while realizing the sale of a turbine generator. The deal between the US-based Melbourne Manufacturing and the UK-based Crown involves £5,000,000. The sale is organized in February, and the payment will be completed in six months (in August). As a result, it is necessary to analyze the available options for hedging and propose the solution to the currency exposure problem with reference to the fact that the purpose of hedging is to minimize possible risks.
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The first alternative for Forbes is not to hedge and wait for receiving the payment in August. While accepting the transaction risk, it is possible to expect the payment equal to £5,000,000 that will be uncertain in six months. If the rate is $1.36 per pound, as it is expected by financial advisors, Forbes will receive $6,800,000. However, if the rate is $1.3549 per pound, as it is prospected, the company will receive only $6,774,500.
Hedging in the Forward Market
The second alternative refers to the forward hedge (Eun & Resnick, 2015). The six-month forward rate is $1.3549 per pound. While referring to this option, the company will receive $6,774,500 (5,000,000 x 1.3549). The positive aspect is that Forbes will get this sum for certain, and it is higher than the minimum acceptable margin of $6,500,000. However, if the rate will be $1.36 per pound in six months, the company will lose $25,500.
Hedging in the Money Market
The third alternative is to refer to the money market hedge (Titman, Keown, & Martin, 2017). To cover £5,000,000 in six months, Forbes can borrow pounds at 8% per year (4% per six months), which is the UK borrowing rate per year. She will receive £4,807,692 (£5,000,000 / 1.04). After converting this sum into US dollars, Forbes will receive $6,557,692 (4,807,692 x 1.3640).
The second step is to use the US savings account for six months at the US investment interest rate per year in 3% (1.5% for six months). The company will receive $6,656,057 ($6,557,692 x 1.015) (Variant 1). Another variant is to borrow in the United States with the annual borrowing interest rate in 4% (2% for six months). Melbourne Manufacturing will have $6,688,846 ($6,557,692 x 1.02) (Variant 2). Furthermore, Forbes can decide to invest into the company and refer to the cost of capital in 12% per year. While using 6% for six months, she will receive $6,951,154 ($6,557,692 x 1.06) (Variant 3).
Hedging in the Options Market
At-the-money-option is available for Melbourne Manufacturing. In order to calculate the option premium, it is necessary to multiply the size of an option, the spot exchange rate, and the premium cost (Eun & Resnick, 2015). Thus, the option premium will be $27,280 ((1,000,000 x 1.3640) x 0.02). The option premium employed at the cost of capital for six months will be $28,917 ($27,280 x 1.06). Net proceeds for the company will be $6,721,083 (6,750,000 – $28,917).
In order to draw a conclusion, Forbes needs to assess all possible risks and compare potential profits of hedging using different alternatives. Remaining un-hedged is risky for the company because of potential losses if the future rate changes significantly. Hedging in the options market is not attractive to the company. Variant 3 that is associated with hedging in the money market and investing in the company is very attractive, but it is also highly risky if the situation changes in the future. Hedging in the forward market is appropriate because this sum will be received for certain. Therefore, Forbes should choose between hedging in the forward market and applying Variant 3 of hedging in the money market.
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Eun, C. S., & Resnick, B. G. (2015). International financial management (8th ed.). New York, NY: McGraw-Hill Higher Education.
Titman, S., Keown, A. J., & Martin, J. D. (2017). Financial management: Principles and applications. New York, NY: Pearson.