- 15 Marks
FM – L2 – Q92 – Foreign exchange risk and currency risk management
Question
Riverfront Plc has just delivered a major export order to a customer in Canada at a price of $35 million payable in six months’ time and as the company’s finance director you are concerned about the potential impact of currency volatility on the profitability of this particular order.
You have obtained the following exchange rate and interest rate data at the close of business today:
| Spot rate (ZMW/$) | ZMW 5 – ZMW 6 |
|---|---|
| 6-month forward rate (premium) | 0.08 – 0.12 |
Annual interest rates:
| Deposit | Borrowing | |
|---|---|---|
| Zambia | 10% | 14% |
| Canada | 5% | 6% |
Riverfront Plc’s bank has quoted a premium of ZMW 10,000 (payable up-front) for a $35 million six-month over-the-counter currency put option with an exercise price of ZMW 5.6 = $1.
Riverfront Plc has the ZMW 10,000 available on deposit at the current time and would leave it on deposit for the next six months if it was not used to purchase the currency put option.
Required
(a) Calculate the unhedged ZMW value of the $35 million receivable if, in six months’ time, ZMW has depreciated by 5%. Explain how this compares to the ZMW value of the sale when it was made.
(b) Calculate the hedged ZMW value of the $35 million receivable if Riverfront Plc chooses to use a forward exchange contract.
(c) Calculate the hedged ZMW value of the $35 million receivable if Riverfront Plc chooses to use a money market hedge and calculate the effective forward exchange rate achieved.
(d) Calculate the hedged ZMW value of the $35 million receivable if Riverfront Plc chooses to use an over-the-counter currency put option and the spot exchange rate in six months’ time is:
(1) ZMW 5 = $1
(2) ZMW 6 = $1
Answer
(a) Unhedged ZMW value in 6 months
The company needs to sell dollars for ZMW. The appropriate rate is ZMW 5/$1. (ZMW 6 = $1 is the rate at which the bank would sell dollars to the company).
The current spot rate is ZMW 5 = $1
If the ZMW depreciates against the dollar by 5% this implies that each ZMW will be worth 5% less dollars than the previous year.
Therefore the rate will change to: ZMW 5 = 0.95 × $1.
This rearranges to: ZMW 5 / 0.95 = $1 or ZMW 5.263 = $1.
The ZMW value of the $35m receipt would be:
$35m × ZMW 5.263 = ZMW 184.21m
This would be more than the company expected when it made the sale ($35m × ZMW 5 = ZMW 175m). This is because the company has a dollar asset. If the ZMW weakens then the dollar strengthens so the company’s better off in ZMW terms.
(b) ZMW receipt in 6 months if hedged using a forward contract
A forward premium must be added to a direct quote. Therefore, the forward rate is ZMW 5 + ZMW 0.08 = ZMW 5.08 = $1
The ZMW value of the $35m receipt would be:
$35m × ZMW 5.08 = ZMW 177.8m
(c) ZMW receipt in 6 months if hedged using a money market hedge
Step 1: Borrow the number of dollars today that will grow to the expected dollar receipt in 6 months.
Let Q be the number of dollars
Therefore:
Q × (1 + 6m dollar borrowing rate) = $35m
Q = $35m / (1 + 6m dollar borrowing rate)
Q = $35m / (1 + 6%/2) = $33.981m
Step 2: Translate the borrowed dollars into ZMW
$33.981m × ZMW 5 = ZMW 169.91m
Step 3: Invest the ZMW at the available ZMW rate
ZMW 169.91m × (1 + 10%/2) = ZMW 178.4m
(d) ZMW receipt in 6 months if hedged using an over-the-counter put option
| Spot rate: ZMW 5 = $1 | Spot rate: ZMW 6 = $1 | |
|---|---|---|
| ZMW receipt if the option is allowed to lapse and dollars are sold at the spot rate | $35m × ZMW 5 = ZMW 175m | $35m × ZMW 6 = ZMW 210m |
| ZMW receipt if the option is exercised | $35m × ZMW 5.6 = ZMW 196m | $35m × ZMW 5.6 = ZMW 196m |
| Decision in 6 months | Exercise the option | Allow the option to lapse and sell dollars at spot |
- Tags: Currency Options, Currency Risk, Exchange Rates, Hedging, Put Option
- Level: Level 2
- Uploader: Samuel Duah