Question

Question 1 Coombes is a U.S.-based IT company. In September Coombes delivers a large shipment of computer equipment to a major distributor in Seville. The receivable, €10 million, is due in 90 days, standard terms for the IT industry in Europe. Note that the sale is large relative to Coombes’s other business and that they currently have no other foreign customers. Required: Evaluate the arguments for and against hedging. Consider this from both the company’s and the shareholder’s viewpoint. Recommend whether Coombes should take hedging in this example.

Answer 1

The receivables are huge from the company's point of view and any huge currency risk exposure is a point of concern for the company and its shareholders. Currency exposure and risk is something that a trading firm can better understand, analyze and take bets on. But for a IT firm with no competency in understanding market risk from currency fluctuations, this will be an unwanted risk as currency is quite volatile in today's market. Thus sufficient hedging at appropriate cost will be the best option to avoid currency risk both for company and shareholders.

Pros of hedging

1. Avoid currency risk

2. Certainty in cash flows

Cons of hedging

1. Cost associated with hedging depending on the instrument used (futures or options or something else)

2. Loss if currency moves in a direction which could have led to profit if hedge was not in place

3. Currency hedging is not simple and requires sufficient expertise and analysis