Question

Target-Australia is an importer/exporter of textiles and textile machinery which trades extensively with countries throughout Europe. It has a small subsidiary based in Switzerland. The company is about to invoice a customer in Switzerland 750,000 Swiss francs, payable in three months' time. Target-Australia’s treasurer is considering two methods of hedging the exchange risk.

These are:

Method 1: Borrow Fr 750,000 for three months, convert the loan into dollars and repay the loan out of eventual receipts.

Method 2: Enter into a 3-month forward exchange contract with the company's bank to sell Fr 750,000. The spot rate of exchange is Fr 2.3834 to $1. The 3-month forward rate of exchange is Fr 2.3688 to $1. Annual interest rates for 3 months' borrowing are: Switzerland 3%, AUS 6%.

Required

(a) Advise the treasurer on:

(i) Which of the two option is the most financially advantageous for Target-Australia, and

(ii) The factors to consider before deciding whether to hedge the risk using the foreign currency markets

Include relevant calculations in your advice.

(b) Discuss briefly four options a company might use to hedge against the foreign exchange risk involved in foreign trade.

Answer 1

(A)(i) That method will be accepted which provides maximum amount in $ to the company

Method1: Loan taken today

Spot exchange rate = 1$ = Fr2.3834

Receipt in Fr = 750,000

Amount required to be borrowed = 750,000/(1+0.03*3/12) = Fr 744,417

Receipt in $ = Fr744,417/2.3834 = $312,334

Interest earned in Australia for 3 months, amount finally received after 3 months = $312,334*(1+0.06*3/12)

=$317,019

Loan amount with interest will reach Fr 750,000 in 3 months which will be paid from the receipt due

Method 3: Receipt after 3 months

Forward Exchange Rate = 1$ = Fr2.3688

Amount received in $ after 3 months = 750,000/2.3688

=$316,616

First method is most advantageous for Target Australia

(ii) Factors to be considered are:

1. Foreign exchange fluctuation risk

2. Expectation from the market

3. Forward Rates

4. Interest Charges

b) Options that can be used are:

1. Forward Contract: Deal is fixed at a forward rate and executed on the maturity date at the same rate

2. Future Contract: Similar to forward contract, takes place through stock exchange and the difference is settled

3. Options Market: An option is purchased to buy/sell currency at the predetermined price.

4. Money market Hedge: Loan is taken/Investment is done for the amount to be received/paid in future and converted using Spot Rate