Question

Shrewsbury Herbal Products, located in central England close to the Welsh border, is an old-line producer of herbal teas, seasonings, and medicines. Its products are marketed all over the United Kingdom and in many parts of continental Europe as well. Shrewsbury Herbal generally invoices in British pound sterling when it sells to foreign customers in order to guard against adverse exchange rate changes. Nevertheless, it has just received an order from a large wholesaler in central France for £320,000 of its products, conditional upon delivery being made in three months’ time and the order invoiced in euros. Shrewsbury’s controller, Elton Peters, is concerned with whether the pound will appreciate versus the euro over the next three months, thus eliminating all or most of the profit when the euro receivable is paid. He thinks this an unlikely possibility, but he decides to contact the firm’s banker for suggestions about hedging the exchange rate exposure. Mr. Peters learns from the banker that the current spot exchange rate in €/£ is €1.4537; thus the invoice amount should be €465,184. Mr. Peters also learns that the three-month forward rates for the pound and the euro versus the U.S. dollar are $1.8990/£1.00 and $1.3154/ €1.00, respectively.

1) What is the inherent issue or problem in this case? Describe the issue or problem with no more than two sentences.

2) If you were Mr. Peters, what would you do? Answer the following 6 questions.

a. Action or no action?

b. If the decision is no action, describe the problem. What is the term in Finance for this kind of decision?

c. If there is an action, you will engage in a three-month forward contract. What is the term in Finance for this kind of decision.

d. What position would you take if you decide to engage in the forward contract in c).

e. Plot the profit (or loss) profile for your position in the 3-month forward contract. You have to show graphically the relationship between unanticipated changes in the spot exchange rate in 3 months and gains (or losses) of your position on the 3-month forward contract.

f. Draw the outcomes of b) and c) on a graph with the horizontal axis (possible future spot exchange rates in 3 months) and vertical axis (£ value of € receivables).

Answer 1

.1 What is the inherent issue or problem in this case?

Real issue is variation in exchange rate and risk of loss due to appreciation of British Pound in three months. Since the invoice will be in Euros, there will be loss if British Pound appreciates.

2. If you were Mr. Peters, what would you do

Answer: Action to protect the amount of recept

The action is called HEDGING. It can be hedged by a forward contract to buy British Pound after three months at a specified exchange rate.

The position to be taken:

i)Sell receivable(465184 Euro) and buy US dollar at forward rate $1.3154/ €1.00

ii) Sell (1.3154*465184)US dollars and Buy British Pounds at rate $1.8990/£1.00

The amount to be received after 3 months=(1.3154*465184)/1.8990=322,224 Pounds

Profit/Loss:

A	B=465184/1.4537	C	D=C-B
Spot Exchange Rate(€/£)	Amount to be received without hedging (Pounds)	Amount to be received with Hedging (Pounds)	Profit/(Loss) in Pounds
1.3000	357834	322,224	(35,610)
1.3500	344581	322,224	(22,357)
1.4000	332274	322,224	(10,050)
1.4537	320000	322,224	2,224
1.5000	310123	322,224	12,101
1.5500	300119	322,224	22,105
1.6000	290740	322,224	31,484