Question

Moyes has taken delivery of 50,000 electronic devices from a firm in Malaysia. The seller is in a strong bargaining position and has priced the devices in Malaysian dollars at M$ 12 each.

It has granted Moyes 3 months’ credit. Malaysian interest rates are 3% per quarter. Moyes has all its money tied up in its operations but could borrow in sterling, its home currency at 4% per quarter if necessary.

Exchange rate :Malaysian dollar per £

Spot : 5.4165

Three-month forward= 5.425

A three-month sterling put, Malaysian dollar call currency option with a strike price of M$ 5.425/£ for M$ 600,000 is available for a premium of M$ 15,000.

Required:

a) Discuss, with the help of calculations three hedging strategies available to Moyes.

b) Weigh up the advantages and disadvantages of each strategy

Answer 1

a) following hedging strategies available to Moyes.

1.forward contact:

Mr.Moyes can enter into a forward contact today to buy Malaysian dollars 600,000 after 3 months at today forward rate which is 1 £ = 5.425M$

And pounds required after 3 months will be

= 600,000/5.425

= 110,599 £

2.money market hedging:

In money market hedging ,to hedge currency risk we invest in the currency in which we need to pay so that amount invested and amount payable after 3 months wil be in same currency.

The amount to be invested or deposited can be found out by discounting the amount to be payable using the interest rate with which we invest or deposit .

Amount to be deposited will be

= 600,000 M$ × PVF( 3%,1)

= 600,000 M$ × 0.97087

= 582,522M$

So above amount will be deposited in Malaysia at interest rate of 3% for 3 months and it will become 600,000M$ after 3 months which will be paid to supplier.

Now to get 582,522M$ today we will borrow equalint amount of pounds today.

Amount to be borrowed in pounds will be found out using today spot rate which is 1£ = 5.4165M$

= 582,522M$ /5.4165

= 107,545.83 £

So we have to borrow today 107,545.83£ at interest rate of 4% for 3 months ..

After 3 months amount payable will be

= 107,545.83× (1.04)

= 111,847.67 £

3.using options :

In this strategy we purchase put option available which has strike price 1£= 5.425 for 600,000M$ which is available for 15,000M$

The logic behind this is that the if the pound value decreases we have to pay more more pounds to buy 600,000M$.so we dont want pound value to be reduced and we want minimum value which we can get by buying put option.

The put option gives is the right to sell pound at exercise price which is 1 £=5.425.So if incase pound value decreases and we have to use more pounds to buy M$ ,we get profit in our put option as we has right to sell at 5.425 in contrast to then prevailing reduced pound value.And seller of put option will pay the amount..

The net effect will be that we lock the payment for exchange rate 5.425 incase pound value decreases.

Amount will be = 600,000M$ /5.425

= 110,599£

Suppose in case pound value increases beyond 5.425 we don't exercise the put option and we can get 600,000M$ for relatively less pounds than above in market.

So today we buy put option using 15,000M$

Which will be 2,769.32£ on today using spot rate 1£ = 5.4165M$

So total outflow under this strategy will be = 110,599+2,769.32

= 113,368.32£

So we can see from the above 3 strategies that using forward contact gives least cash outflow.But using forward contact comes with its own disadvantage as if currency moves in our favor we can't cancel the contract ( we can cancel contact with some cost).

Where as using options you no need to exercise option in case currency moves in our favor and it also comes with cost in terms of premium to be paid .

b)

Forward contract:

Advantages:

1.Very simple to setup

2.Buy now and pay later

Disadvantages

1. If the currency moves in your favour you have missed the gains

2)Money market hedging:

Advantages:

1.Money market hedging is feasible in case of areas where forward contract is not available

2.Flexibility with regarding to amount to be covered

Disadvantages:

1.More complicated to organise than a forward contact

2.Fixes the future rates and no opportunity to benefit incase currency moves for our benefit

3)Hedging using options:

Advantages

1.Reduces the risk

2.Greater flexibility in cancelling commitment

Disadvantages

1.Complex to understand

2.Option can only be bought or sold in lots

3.Premium cost