Question

Vixor Co. 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
Candian Dollar (C$	C$40,000,000	C$10,000,000
New Zealand Dollar (NZ$)	NZ$5,000,000	NZ$1,000,000
Mexican Peso (MXP)	MXP11,000,000	MXP5,000,000
Singapore Dollar (S$)	S$4,000,000	S$8,000,000

The spot rates and one-year forward rates as of today are shown below:

Currency	Spot Rate	One-Year Forward Rate
C$	$.70	$.73
NZ$	$ .60	$.59
MXP	$.04	$.03
S$	$.69	$.68

1. Given the forecast of the Canadian dollar along with the forward rate of the Canadian dollar, what is the expected increase or decrease in dollar cash flows that would result from hedging the net cash flows in Canadian dollars? Would you hedge the Canadian dollar position?

2. Assume that the Canadian dollar net inflows may range from C$20,000,000 to C$40,000,000 over the next year. Explain the risk of hedging C$30,000,000 in net flows. How can Vixor Co. avoid such a risk? Is there any tradeoff resulting from your strategy to avoid that risk?

Answer 1

Given the forecast of the Canadian dollar along with the forward rate of the Canadian dollar, what is the expected increase or decrease in dollar cash flows that would result from hedging the net cash flows in Canadian dollars? Would you hedge the Canadian dollar position?

We can see from the forward rates that the Canadian dollar is appreciating as compared the US dollar as we have to pay .$0.73 for C$1 one year forward instead of paying $0.70 today.

Now net inflow for us is CAD$ 30,000,000 (CAD$40,000,000-CAD$10,000,000), and if we hedge this position we will end up getting CAD$30,000,000 * 0.73 = USD$ 21,900,000

If we not hedge the position, and since the spot rate after one year is not given for caluculation, I will assume that the prevailing spot rate of $0.70 continues after 1 year, we will receive CAD$ 30,000,000 * 0.70 = USD$ 21,000,000

So the benefit from hedging is USD$ 900,000 and hence it is advisable to hedge the position. Please note that in the absence of the actual spot rate after one year we have assumed it to be same as current spot rate for comparison purpose, if the spot rate afetr one year is given we will take that rate and compare

Assume that the Canadian dollar net inflows may range from C$20,000,000 to C$40,000,000 over the next year. Explain the risk of hedging C$30,000,000 in net flows. How can Vixor Co. avoid such a risk? Is there any tradeoff resulting from your strategy to avoid that risk?

A forward contract involves delivering a fixed quantity of underlying at a fixed rate at some date in the future

If the we enter into a contract for delivering CAD$ 30,000,000 at $0.73 after one year, and if the cash flows fluctuate between CAD$ 20,000,000 to CAD$ 40,000,000, this is how it will look like

Net inflows in CAD	20000000	30000000	40000000
Contractual obligation	30000000	30000000	30000000
Additional purchase/sell	-10000000	0	10000000
Rate for purchase	0.7	NA	NA
Additional outflow in USD	7000000	0	0

When the net inflow is 20000000 then as we have already eneterd in contract to deliver 30000000 CAD we must honor the same bu buying additional 10000000 CAD at the prevailing spot rate. This is the only option when we will make loss of USD 7000000

To avoid this we can buy a currency Put option for CAD which will protect us from the downfall in CAD and also limit our losses to the extent of premium paid.