Question

Wrangler Company is a U.S. firm conducting a financial plan for the next year. It has no foreign subsidiaries, but more than half of its sales are from exports. Its foreign cash inflows to be received from exporting and cash outflows to be paid for imported supplies over the next year are shown in the following table:

Currency	Total Inflow	Total Outflow
Canadian dollars (C$)	C$ 72,000,000	C$ 32,000,000
New Zealand dollars (NZ$)	NZ$ 25,000,000	NZ$ 14,000,000
Mexican pesos (MXP)	MXP 111,000,000	MXP 10,000,000
Singapore dollars (S$)	S$ 39,000,000	S$ 68,000,000

The spot rates as of today are:

Currency	Spot Rate
C$	1.25 Canadian Dollars per US Dollar
NZ$	$ .50 US Dollars per New Zealand Dollar
MXP	8.33 Mexican Pesos per US Dollar
S$	1.82 Singapore Dollars per US Dollar

(a) Based on the information provided, determine the net transaction exposure of each foreign currency in dollars.

(b) Assume that the Canadian dollar net inflows may range from C$20,000,000 to C$60,000,000 over the next year. Explain the risk of hedging C$50,000,000 in net inflows. How can Wrangler Company avoid such a risk? Is there any tradeoff resulting from your strategy to avoid that risk?

Answer 1

Part a)

The net transaction exposure of each foreign curreny in dollars is calculated as below:

Currency	Total Inflow	Total Outflow	Net Inflow/Outflow	Spot Exchange Rate [Converted to Dollars]	Net Transaction Exposure in Dollars
Canadian dollars (C$)	C$ 72,000,000	C$ 32,000,000	C$ 40,000,000 Inflow (72,000,000 - 32,000,000)	0.8000 (1/1.25)	$32,000,000 Inflow (40,000,000*.80000)
New Zealand dollars (NZ$)	NZ$ 25,000,000	NZ$ 14,000,000	NZ$ 11,000,000 Inflow (25,000,000 - 14,000,000)	0.5000	$5,500,000 Inflow (11,000,000*.50000)
Mexican pesos (MXP)	MXP 111,000,000	MXP 10,000,000	MXP 101,000,000 Inflow (111,000,000 - 10,000,000)	0.1200 (1/8.33)	$12,124,850 Inflow (101,000,000*.1200)
Singapore dollars (S$)	S$ 39,000,000	S$ 68,000,000	S$ 29,000,000 Outflow (68,000,000 - 39,000,000)	0.5495 (1/1.82)	$15,934,066 Outflow (29,000,000*.5495)

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Notes:

1) Actual spot rates (after conversion to dollars) have been taken while the transaction exposure for each currency. The converted spot rates have been shown upto 4 decimal places for representation purposes only.  

2) There can be a difference in final answers on account of rounding off values.

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Part b)

The risk of hedging C$50,000,000 in net inflows arises from the fact that the company may receive total inflows inflow that are lesser than the amount covered by the forward contract forcing it to buy the remaining amount of Canadian dollar at the prevailing spot rate which may exceed the rate higher than the one provided in the forward contract. For instance, if the forward contract provides for sale of C$50,000,000 by the year end and the actual Canadian dollar net inflows turn out to be C$40,000,000 only, the company will be required to purchase C$10,000,000 at the spot rate (which may be higher because of increase in the value of Canadian dollar over the year) in order to honor its forward contract. This may cause the company to incur some loss because of higher purchase price paid for C$10,000,000.

Any company would generally cover the amount that it expects to receive during the year. Therefore, if the company expects to receive C$40,000,000 during the year, it will cover only that amount. There will always be some amount that would be subject to risk as the value of actual cash inflows cannot be predicted with complete accuracy at the time of entering into the forward contract. Therefore, the company can hedge the risk only to the extent it is certain about the cash inflows. The tradeoff resulting from such a strategy would be the value of the inflows (in case they do occur) that will remain exposed even after hedging and would be subject to exchange rate fluctuations because of the uncertainity with respect to occurrence of cash inflows.