Question

Dealeo Foods Inc. purchases vitamins from a supplier abroad. The invoices received by Dealeo are denominated in the foreign currency. Dealeo understands that fluctuations in foreign currency exchange rates may adversely affect the company’s earnings. The CFO of Dealeo wants you to investigate derivative instruments and determine whether or not the use of a foreign currency forward contract or foreign currency options is best to hedge the company’s exposure to foreign currency exchange risk.

REQUIRED:

Suppose you chosed any country other than the US...

1. Draft a memo to explain to the CFO the advantages and disadvantages of using a foreign currency forward contract and foreign currency options for hedging. Based on the history of the exchange rates, how might these options impact Dealeo?

2. Make a recommendation on the hedging instrument that you believe the company should use. Justify/support your recommendation.

NOTE: Please cite any sources used, FASB Codification and any other sources.

Answer 1

Question 1

For this question, we assume that the country we work from is Britain.

Let us take a simple example, let us say the Vitamins are purchased from the India in June 2016(pre-brexit referendum) when the exchange rate of GBP to INR was around Rs. 100 for every GBP.

Purchases generally have 1-3 months of credit period and hence lets say the payment was to be made in August 2016 (pre-brexit referendum) when the exchange rate fell to Rs. 85 per GBP.

Assuming an invoice value of Rs. 10,000 at the time of purchase the company would have paid GBP100. However post brexit it's liability would rise to GBP 10,000/85 = 117GBP

The Company would lose an extra 17% of the total purchase value.

The use of derivatives is a good way to hedge against any exchange fluctuations which can sometimes impact companies in very large scale.

Forwards

Forward contracts are contracts that create an obligation to exchange a currency at a fixed price at a future date. For example, the above Company can fix the forward price at Rs. 100 per GBP. However the buyer of the currency would price the forward price based on the expectation on how the forward contract is likely to move.

Options

Options are similar to Forwards, but instead of a obligations it gives the buyer a right to purchase at the fixed price. For example, if the above forward was an option, the Company may or may not purchase at the option price at the exercise date depending upon the actual price of the currency on that date.

Advantages of Forwards:

a. Fixes the price for a future date.

b. No premium or lower premium as compared to a option

Disadvantages of Forwards

a. The price is fixed and the buyer cannot backout. Depreciation in foreign currency can result in a higher cost than it would have originally been

Advantages of Options

a. The price is fixed and hence exchange fluctuations cannot affect the Company

b. THere is only a right and no obligations and hence the Company need not buy in case of depreciation of the foreign currency.

Disadvantages of Options

a. The price of options is generally higher than other derivative investments.

Question 2

Based on the recent history of the GBP it is likely that the GBP is going to depreciate as compared to the INR. The Indian economy is growing faster and the GBP with less support from EU is likely to struggle. As a result it is better for the Company to fix a price for the exchange rates. Since it is reasonably certain that GBP will depreciate, it is better for the Company to use Forwards and reduce the commission paid on purchase of these derivates.