Palmetto Bug Extermination Corporation (PBEC), a U.S. company, regularly purchas
ID: 2586127 • Letter: P
Question
Palmetto Bug Extermination Corporation (PBEC), a U.S. company, regularly purchases chemicals from a supplier in Switzerland with the invoice price denominated in Swiss francs. PBEC has experienced several foreign exchange losses in the past year due to increases in the U.S. dollar price of the Swiss currency. As a result, Dewey Nukem, PBEC’s CEO, has asked you to investigate the possibility of using derivative financial instruments, specifically foreign currency forward contracts and foreign currency options, to hedge the company’s exposure to foreign exchange risk.
Required
Draft a memo to CEO Nukem comparing the advantages and disadvantages of using forward contracts and options to hedge foreign exchange risk. Recommend the type of hedging instrument you believe the company should employ and justify this recommendation.
Explanation / Answer
MEMO
To,
Dewey Nukem, PBEC's CEO,
Sub : Hedging Company's exposure to foreign exchange risk.
Recommendation to use forwad contracts and options :
Advantages :
1. The future rate of exchange is fixed and thus is not connected to the actual rate that would be prevailing at the time of expiry of the contract.
2.It gives an option to be flexible depending upon the amount to be covered. i.e. tenure can be varied .
3. Plan the budget effectively
Disadvantages :
1. Contractual obligation : Need to be transacted on the due date/expiry irrespective of the spot rate at the time of expiry.
2. If the rate at the time of expiry is favourable, the benefit would not be passed upon .
Recommendation :
Since PBEC regularly purchases chemicals in Swiss Francs, it would be beneficial for PBEC to enter into a forward contract and options ,as it is almost certain that there would be an increase in the value of the swiss currency in future. By entering into a forward contract now, the exchange loss can be mitigated i.e. any unexecpected rate fluctualtions are already factored in and company can plan their budget accordingly.
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