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.

The MEMO should contain these parts:

Subject: An appropriate subject for the memo. It is brief, but informative

Issue
In this section clearly define the issue that will be addressed. This may be stated in the form of a question or two. This should be succinctly stated (in your own words).

Conclusion
This is typically written last. In a few sentences, explain the solution to the issue.
Example: The company should select XXX, which is consistent with XXXX. This may result in or yield XXX.

Analysis
In this section discuss the alternatives and the related pros and cons of each. This section only discusses facts; it does not explain which is best. This section should include authoritative support that helps explain the similarities/differences among the alternatives and the potential impact of the alternatives.

Discussion
Which alternative is best and why?
Based on the analysis, this section explains which alternative is selected. This section supports the Conclusion.

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

Answer 1

Answer 1 and 2)

MEMO

Subject: To protect Dealeo Foods Inc. from foreign exchange risk exposure:

Issue: Dealeo Foods Inc. purchases vitamins from a supplier abroad and the invoices are denominated in the foreign currency, lets's suppose Indian currency, the fluctuations in foreign currency exchange rates may adversely affect the company’s earnings. Now the question arises is that which derivative instrument should be used by the company to hedge itself against the foreign currency exposure?

Analysis: Currency options and forward contracts can be used to hedge against the change in exchange rates that can adversely affect the profitability of the firm. let's discuss the advantages and disadvantages of these one by one in detail.

Currency options: A currency option is a contract that gives the buyer the right, but not the obligation, to buy or sell a certain currency at a specified exchange rate on or before a specified date.

Advantages:

• Options are relatively cheaper hedging instrument.
• Thses are traded in the stock market and hence are liquid.
• These are regulated by the central banks.

Disadvantage:

• Holder is at a disadvantage due to expiry period of the option.
• Writer of the option are exposed to unlimited risk.
• The holder has to pay a premium or margin amount to enter into a option contract which is forfeited if the option is not excercised.

Forward Contract: Forward contracts are the contracts to buy or sell at a specified price at a specified future date. Here are the following advantages and disadvantages of forward contracts:

Advantages:

• Forward contacts are customised as per the customes's need
• They are traded over the counter.
• No extra premium or margin is required to be paid.

Disadvantages:

• They are not regulated, are not traded on national stock exchange and hence have low liquidity.
• They are costly as are not traded widely and have less demand.
• Their might be a possibility of default as it is a private agreement between two parties.

Discussion:

Based on the analysis done above, it can be safely said that as per the present scenario forward contract would work best for the dealer due to the following reasons:

• Forward contracts offers customisation which is why the importer can customise the contract as per his transaction exposure.
• Forward contract not only reduces the risk but it also eliminates the risk thus not at all affecting the profitability of the company and zero risk involved.
• Options are only feasible when the importer thinks that there would be extreme risk involved. that is the currency prices will move extremely up or down which is generally not the case.

Conclusion Or Recommendation as asked by question 2:

Due to the reasons mentioned above, I believe the importer should go with forward contract in order to best protect his interests. this would not affect the profitability of the company and the profits would always be net of foreign currency rate rise or fall.

Inshort it can be said that foreign currency options are best for speculation and hedging can be done through forward contracts.