Question

Suppouse a firm anticipates an account payable of 1000000£ in 90 days . they have hired you to explain this cash flow to family owners of the firm. given what we have covered in this course regarding risk (and potential risk managment), explain the risks an at least one low-cost method of off-setting that risk?

Answer 1

Since it is a payable, the risk attached to the exposure is that of adverse exchange rate movements.

The risk is that the exchange rate of $/GBP may move u days90 days, that is more number of dollar may have to be paid for each GBP to bought then, when compared with the dollars payable at the current spot rate for GBP.

Though the reliable exchange rate predictions would be available, some unpredictable events can put the actual figure way off after 90 days. These changes may be favorable of unfavorable according as the GBP depreciates or appreciates against the dollar in 90 days. To put it briefly, one is unsure of the future exchange rate and the total liability in dollars.

To make the liability certain there are several options (derivates).

One such simple option is the forward contract.

A forex dealer may contacted to get a rate for buying GBP 1,000,000 after 90 days and then the contract to buy the required GBP may be entered into. If the rate is say 1.2$/GBP, we can be sure of the final liability in $, which will be 1,000,000*1.2 = $1,200,000. This amount is certain irrespective of the spot rate after 90 days, which may be more or less than the current spot rate. The idea here is to make certain the dollar liability today itself based on the forward contract.