Question

P & G India. Proctor and Gambles's affiliate in India, P & G India, procures much of its toiletries product line from a Japanese company. Because of the shortage of working capital in India, payment terms by India, payment terms by Indian importers are typically 180 days or longer. P & G India wishes to hedge an 8.5 million Japanese yen payable. Although options are not available against the yen. Additionally, a common practice in India is for companies like P&G India to work with a currency agent who will, in this case, lock in the current spot exchange rate in exchange for a 4.85% fee. Using the following exchange rate and interest rate data, recommend a hedging strategy.

Answer 1

180-day account payable, Japanese yen (¥) 8,500,000

Spot rate (¥/$) 120.60

Spot rate, rupees/dollar (Rs/$) 47.75

Implied (calculated) spot rate (¥/Rs) 2.5257 (120.60 / 47.75)

180-day forward rate (¥/Rs) 2.4000

Expected spot rate in 180 days (¥/Rs) 2.6000

180-day Indian rupee investing rate 8.000%

180-day Japanese yen investing rate 1.500%

Currency agent's exchange rate fee 4.850%

P & G India's cost of capital 12.00%

Hedging alternatives                       values                       spot rate                           risk assessment

1. Remain Uncovered, settling A/P in 180 days at spot rate

If spot rate in 180 days is

Same as current spot rate, value is 3365464.34           2.5257                                risky                       

If spot rate in 180 days is

Same as spot rate, value is              3541666.67            2.4000                                risky

If spot rate in 180 days is

Expected spot rate, value is           3269230.77             2.6000                                risky

2. Buy Japanese yen forward 180 days:

Settlement amount at                    3541666.67             2.4000                               certain                                      

Forward rate

3. Money market hedge:

Principal A/P (¥)                             8,500,000

Discount factor for yen                       0.9926

For 180 days                             

Principal needed to meet           8,436,724.57

A/P in 180 days

Current spot                                         2.5257

Indian rupee current amt         3,340,411.26

P&G WACC carry forward                   1.0600

Rate for 180 days

Future value of money market 3,540,835.94                                                    certain

Hedge

4. Indian currency agent hedge:

Principal A/P                                  8,500,000

Current spot rate                              2.5257

Current A/P                                3,365,464.34

Plug agent’s fee (4.85%)               163,225.02

P&G’ WACC carry forward

For 180 days on the fee                      1.0600

Total future value of

Agent’s fee                                    173,018.52

Total A/P future value

A/P +fee                                3,538,482.87                                                                  certain

Evaluation of alternatives:

The currency agent is lowest total cost in certain future rupee value of all alternatives.