Question

You are a financial analyst for a relatively small global car designer that was founded in Australia. Only recently, they have decided to vertically integrate and manufacture cars using their self propulsion technology. The firm has chosen Mexico as its first manufacturing destination, although they will be sourcing material from all over the world. Given the need for the firm to exchange multiple currencies they have asked you to provide and justify the three best strategies for them to reduce their exchange rate risk.

Answer 1

Although, there are a lot of techniques and strategies which are used to reduce the exchange risk but in the current case, it is much complex as they are sourcing material from various countries, production in a country other than their home country.

As the company is going to trade in multiple currencies, They have to reduce the exchange rate risk. Some of the useful techniques for the company are mentioned below:

1.Using Forward Contract

In Forward Contracts, Two parties agree to sell and buy the specific asset on a future date at a predecided price.

So the company can enter into these types of contracts, they are easily available at stock exchanges. It will hedge them from exchange rate risk.

In this strategy, they do not have to pay any amount while entering the contract but they have obligation to fulfill the contract on its expiry.

2. Matching Strategy

In this strategy, Companies match their receipt and payment in a single currency. For example, Suppose If a company is purchasing a product from U.S.A. which costs $10,000 in a year, They try to sell their product of $10,000 in that country. In the long term, it increases the sale of the company and reduces exchange risk.

Similarly In the current case, as the company is sourcing various components from different countries, they try to sell their product (car) in that country to reduce the difference between receipt and payments.

3.Using Options

Option contracts give the right to buy/sell the asset at a predecided price to the buyer of the option contract. These types of contracts are also easily available on the stock market.

The benefit of this strategy is that In this case company has to pay a small amount of option premium while entering the contract. After that, there is no obligation for the company to fulfill this commitment. They can exercise the option only if it is beneficial to them.

This strategy is also beneficial for the company to reduce their change rate risk.