Voyages Soleil (VS) is one of the leading tour operators in Quebec. The organization has managed to establish strong relationships both with its customers and suppliers. The company’s owner Jacques Dupuis needs to decide how to manage VS’s foreign exchange obligations. Vendors accept payment only in US dollars, yet the customers pay in Canadian dollars. Considering the great uncertainty of market conditions and the volatility of the Canadian Stock Market Index, VS faces foreign exchange risk on its packages. In particular, the firm’s profitability will suffer if the Canadian dollar continues to fall. Jacques Dupuis has to choose between the three alternatives to cope with the risks.
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To estimate the expected exchange rate of the US dollar against the Canadian dollar and evaluate the profitability of each alternative, the International Fisher Effect theory was applied. It has been found that waiting until October 2002 is a rather risky decision that may have unpredictable consequences. The employment of a forward contract for all of the payable is a better choice than the first alternative, yet it needs a line of credit. Borrowing the Canadian dollars to buy the US dollars is the least predictable alternative from the accounting perspective, and it is assumed to be more costly than the purchase of forwarding contracts. Thus, Jacques Dupuis is recommended to employ forward contracts to avoid exchange rate risk and save money.
When considering hedging, there is a need to analyze several important factors that have an impact on currency fluctuations. These factors are the inflation rate, which indicates the value of the nation’s currency, and the interest rate, an increase in which can make a currency more attractive for buyers. Both of these measures can be used to estimate the exchange rate, which will be the key criterion in the decision-making process.
The calculation of the projected exchange rate can be based on the International Fisher Effect theory. It assumes that countries that have higher nominal rates have higher rates of inflation (Gitman et al. 34). Thus, the change in the exchange rates is related to the change in both the interest rate and the expected inflation rate. The formula that will be used to calculate the projected exchange rate is as follows:
is the expected change in the exchange rate,
ih s the nominal rate in the US, and it is the nominal rate in Canada. In contrast to the real interest rate, the nominal rate takes into account the expected inflation. In the given case, the nominal rate will be calculated as:
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The First Alternative: Doing Nothing
According to the instructions, interest rates in both Canada and the US will continue to decrease. One may assume that the US real interest rate is equal to 3.7%, and the Canadian real interest rate is equal to 2.5 % (based on Exhibit 4). The Canadian expected inflation rate is equal to 117 (or 1.17%), and the US expected inflation rate is equal to 175 (or 1.75%) (based on Exhibit 6). Thus, the US nominal rate is equal to:
The Canadian nominal rate is equal to:
The projected exchange rate is equal to:
The spot exchange rate was 0.6298 US/CAD in late March 2002. Under the IFE theory, the Canadian dollar is expected to depreciate. Therefore, if Jacques Dupuis waits and exchanges the Canadian dollars in October, the US $60 million payable will cost:
The Second Alternative: Forward Contracts
If the owner of VS decides to employ forward contracts for all of the payable, the six-month forward rate will be equal to 0.6271 US/CAD. The amount of CAD required for the second alternative is equal to:
The company will pay CAD $95,678,520 to its vendors regardless of an increase or decrease in the exchange rates in the future.
The Third Alternative
If Jacques Dupuis decides to borrow Canadian dollars to buy US dollars and then to invest the US dollars for six months, the amount of deposit in the US dollars that is required is equal to:
The number of periods is equal to 0.5 because the interest rate for depositing is annualized. In late March 2002, this amount of US dollars will be equal to the following amount of Canadian dollars (the principal payment):
The cost of borrowing CAD $94,491,969.5 is equal to the cost of principal plus interest:
Table 1 compares three decisions based on the expected payment and the extent of associated risk. It can be seen that the first alternative is too costly, and it carries a high risk since the exchange rate cannot be accurately estimated and some unpredictable changes in the interest and inflation rates may occur in the future. Thus, this option may be regarded as the least feasible one. The second option requires the lowest amount of payment, and it is relatively safe. The main advantage of this choice is that it will hedge VS against the potential exchange rate risk. The third alternative holds the middle position in terms of the expected payment. Its main drawback is the difficulty to estimate the payment of interest for accounting.
Table 1. Summary of the Three Alternatives.
|Decision||Required payment, CAD||Risk|
|Wait and exchange CAD in October||96, 754, 221||High|
|Employ forward contracts||95, 678, 520||None|
|Borrow CAD to buy USD to invest them for six months||95, 759, 114. 4||Low|
Conclusions and Suggestions
Based on the analysis of the three possible options, Jacques Dupuis may be recommended to employ forward contracts for all of the payable. The estimated payment for this alternative is equal to CAD $95,678,520. Waiting and exchanging CAD in October will cost CAD $1,075,701 more, and borrowing CAD to invest in USD for six months will cost CAD $80,594.4 more. However, the second alternative is considered the most optimal not only due to the lower amount of the required payment but also because of the minimal risk. The amount of money required for forwarding contracts for the US $60 million payable does not depend on any future currency fluctuations and market uncertainties, which is why the company’s owner will be able to manage VS’s upcoming foreign exchange obligations successfully without worrying about foreign exchange risk. Since Jacques Dupuis is concerned with the exposure of the transaction to the volatility of the exchange rate, a forward contract is the most reasonable option for him. However, it is important to find a reliable counterparty that will deliver the needed amount of the asset.
Gitman, Lawrence, et al. Principles of Managerial Finance. 6th ed., Pearson Education Limited, 2015.