You are a U.S. based exporter that has just secured a 3-year contract that will

Question

You are a U.S. based exporter that has just secured a 3-year contract that will provide 1 million British pounds for each of the next three years, receivable at the end of each year. In order to fulfill this contract, you need to purchase supplies from Thailand that cost 500,000 Baht each year. As well, you’ve booked an order that will secure you 2 million Euros for each of the next seven years, but this particular order is only renewable each year (in other words, you don’t necessarily know that you’ll continue receiving these cash flows for each of the next 4 years). Lastly, you’ve booked a sale that brings 300,000 Baht for each of the next 2 years (the contract, like the one in British Pounds, can be relied upon for each of those years). Discuss, calculate, and analyze different ways to hedge these cash flows. In particular, how these results from a few different options of a combination of: 1. A money market hedge 2. A futures market hedge 3. A forward rate hedge 4. No hedge at all

Explanation / Answer

Cash Flows for the firm

Options available to the firm

Year 1

Receive or pay the amounts in foreign currency as and when due at an exchange rate available on the date of conversion. That is

Receive USD equivalent of 1 Million GBP

Net the receivable and paybale of Bhats = Payable 500,000 – Receivable 300,000

                                                                         = Net Payable 200,000 Bhats

Pay to bank USD equivalent of 200,000 Bhats and remit the funds to the supplier

Receive and convert into USD the amount of EUR 2 Million

Year 2 - The same will repeat. However if the 2 Million Euro contract is not renewed then that receivable will not be available

Year 3 - Net payable will be USD equivalent of 500,000 Bhats at the exchange rate as available on the date of conversion.

With regard to the Euro receivable it will become part of the received amount if contact is renewed and will not be available if the contact is not renewed

Year 1

GBP – Borrow discounted value of 1 Million GBP and convert funds to USD and bring into US. At maturity, the receivable amount of 1 Million GBP will be utilized to close the borrowing.

Similarly a discounted borrowing for year 2 and year 3 can to be made for receivables at the end of year 2 and 3 now itself and convert the borrowed amount into USD.

Bhat - Net the payables and receivables. Convert USD equivalent and make a deposit whose maturity value would be equivalent to Bhat 200,000. The maturity date of the deposit should be co-terminus with the payment of Bhat 200,000. On the date of maturity, close the Bhat deposit and remit 200,000 to supplier.

For Year 2 also remit USD equivalent of discounted value of 200,000 Bhat at current exchange rate. Deposit the amount for 2 years to get a maturity value of Bhat 200,000 and remit the amount to supplier at the end of year 2.

For year 3 – Remit USD equivalent of discounted value of 500,000 Bhat at current exchange rate, deposit the amount for 3 years to get a maturity value of 500,000 Bhat and remit the amount to supplier at the end of year 3.

Euro - Borrow discounted value of Euro 2 Mllion and convert funds to USD and bring into US. At matuirty the borrowing will be extinguished with the receivable amount of Euro 2 Million.

For Years 2, 3, 4 the above process for Euros can be done each year if the contract is renewed.

GBP – Book a forward contract for sale of GBP 1 Mllion (receivable after 1 year) into USD.

Since the forward and futures market is very thin for maturities beyond 1 year the same needs to be repeated for years 2 and 3 at the beginning of the year.

Bhat – For the first two years net out the payables and book a forward contact for purchase of Bhat 200,000 against USD at the beginning of the year

For the year 3, book a forward purchase contract for Bhat 500,000 against USD at the beginning of the year

Euro – Book a forward sale contract at the beginning of the year for sale of Euro 2 Mllion against USD.

The same needs to be repeated at the beginning of years 2-7 based on renewal of the contract

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