Question

We have 10 million South African rand that is payable in one year ( we have to pay it to a South African company.) Assume the spot exchange rate is 10.02 rand equal one US dollar. Also, assume that the forward exchange rate is 10 rand equal one dollar. Furthermore either calls or puts cost .01(1%). Expound on how to hedge the aforementioned exposure. Moreover, the market expectation is that the rand will depreciate against the dollar. Ascertain that we use a forward contract, or an options approach, or risk sharing, or leading and lagging for transactions exposure.

Answer 1

Let South African rand be SAR

10 Million SAR payable in one year

Spot rate = SAR10.02 per USD

Forward rate = SAR10 per USD

Call or Put = 1%

Payable amount in USD as per Spot rate = 10 million/10.02 = 998K

Payable amount in USD as per forward rate = 10 Million/10 = USD 1 million

If the SAR depreciated rate is within the forward rate say below 10, hedging forward rate is beneficial.

Option pricing is beneficial as it is only an option and not obligation to execute the option contract. This depends upon the excercise price and future market rate.

Leading and lagging As the market expectation the SAR will weaken against USD, they will hold off payment (lag) in the hope that it becomes cheaper in U.S. dollar terms.

Risk sharing - Normally Currency risk involves a legal agreement binding price-adjustment clause ibetween parties, where the base price of the transaction is adjusted if the exchange rate of SAR fluctuates beyond a specified neutral band or zone. If the SAR at the time of transaction settlement is beyond the neutral band agreed, in which case the two parties split the profit or loss, the risk sharing will occur.