Question

1. A US firm has an account receivable for 1,000,000 pounds due in 180 days. Nontechnically describe hedging transactions (or a sequence of transactions) that the firm may want to undertake for each of the following hedging alternatives:

• Forward hedge
• Money market hedge
• Option hedge

Answer 1

1. Forward hedge - The US firm will enter into a forward contract to sell the 1000000 pounds in 180 days. The forward contract is a negotiated contract to sell foreign currency in the future.

Once the firm enters into the contract, as the spot rate and interest differential between the two countries changes, the value of the contract may or may not move in favour of the firm. Mark to market captures the difference between forward price as determined by interest rate parity using spot and interest rates versus the forward price set at the beginning of the contract. If the rates are not favourable the forward contract may be cancelled at prevailing rates.

2. Money market hedge

The US firm can borrow an amount equivalent to the present value of 1000000 pounds. This present value in dollars should include the equivalent of foreign currency and an interest amount. The next step is to convert the foreign currency into domestic currency at spot exchange rate. The domestic currency can be deposited in a bank at the prevailing interest rate. When the foreign currency receivable comes in, the firm can repay the loan and interest.

3. Option hedge

A option hedge gives the firm a right but not an obligation to sell the currency at an exercise price in the future date.

If there is a favourable movement in the spot rates, the firm will allow the option to lapse. If there is an adverse movement in the spot rates, the firm will exercise the option.

a. The firm needs to buy put option to be able to sell the pound in future at a predetermined strike price. Also the firm should do an analysis about how many contracts it needs to buy as well as the expiry which will commensurate with the actual receivable date.

b. Once the option is bought on the exchange by paying some upfront premium, the firm needs to wait till the settlement date.

c. On the settlement date, the firm will compare the settlement option price and prevailing spot rate.

d. The firm should compare the net cash flows and exercise the option accordingly.