Question

Discos plc is negotiating an export contract with a customer in a developing country, Xeridia. Discos have not exported to the country before, and is concerned both about the risk of late or non-payment for the exports, and about the foreign exchange risks associated with the Xeridian peso. The contract specifies that Discos should receive 55 million Xeridian pesos in three months’ time. Discos will require short-term finance for the full value of the exports.

Exchange rates (peso/£)

Spot 32·34 – 32·89

3 months forward 33·82 – 34·55

6 months forward 35·17 – 35·90

Current short-term UK interest rates available to Discos plc:

Borrowing 6·5%

Investing 5·3%

Discos is considering to protecting against the foreign trade risk through forward market hedge. An insurance policy is available at a cost of 1·25% of the spot Sterling equivalent of the export value. The policy gives the following protection: 95% cover against non-payment as a result of political actions by a foreign government; 90% cover against other nonpayment. Any payment by the insurer would be after six months.

Discos have been advised that there is at least a 5% chance of late payment after six months or default by the client. The Xeridian government is not expected to take any action that is detrimental to foreign trade during the next six months.

Required:

Discuss the one advantage and a disadvantage of the alternative. State clearly any assumptions that you make.

Compute the expected returns if Discos defaulted

Answer 1

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Answer:

Advantage and a Disadvantage of the assumption:

Advantage would be Protection against Default.

Insurance Cost would be an extra cost which Disco need to bear.

Since, the Disco is exporting; payment will be made according to Bid price.

Expected Return calculation:

Chances of late payment after 6 months is 5%

Return after 6 months = (Forward - Spot) / spot

                                        = [(35.17 - 32.34) / 32.34]*55 million

                                         = 4.81 million Xeridian pesos

1£ = 32.34 - 32.89 pesos

4.81 million Pesos = 1/32.34 *4.81 million = £0.149 million

Return after 3 months = (Forward - Spot) / spot

                                        = [(33.82 - 32.34) / 32.34]*55 million

                                         = 2.51 million Xeridian pesos

1£ = 32.34 - 32.89 pesos

2.51 million Pesos = 1/32.34 *2.51 million = £0.077million

Expected Return = 5%*£0.149 million + 95% * £0.077million

                               = £0.0806 million