An american firm, XE inc, intends to export defence software to a firm in Taiwan. The...

An american firm, XE inc, intends to export defence software to a firm in Taiwan. The export value is in Taiwan's currency (NT$). The agreement is subject to the U.S authority's approval.

Explain option strategies, based on the Taiwan currency, that the firm at risk can use to hedge its risk exposure.

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Answer :-

American firm, XE Inc. can hedge it's foreign exchange risk by the following ways :

(i) Hedging through Forward Contract : The American firm can take full forward cover against foreign exchange exposure and entirely hedge its risk. It can contract with bank to sell Taiwan's currency(NT$) at agreed exchange rate. The receivable is fixed and XE Inc. can concentrate on operation.

(ii) Foreign Currency Option : Foreign currency option is the right to buy or sell a currency at an agreed exchange rate (exercise price ) on or before an agreed maturity period. The right to buy is called a call option and right to sell is put option.

In case of receivables, firm can go for buying a put option and pay premium for purchasing put option. Suppose if at the end of credit period, exchange rate in market is greater than the exercise price, allow the option to lapse and sell the receivable exposure in the market. If exchange rate is less than Exercise price, put option will be exercised.

(iii) Money Market Operations : XE Inc. can borrow in Taiwan currency an amount and get it converted in US$ at spot rate. This amount can invested in US for the agreed credit period and interest will accrue on this deposit. The loan in Taiwan currency can be repaid back after the credit period along with interest, with the receivable exposure. If interest rate parity holds, the difference in the forward rate and spot rate is the reflection of the difference in the interest rates in two countries.

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