- 20 Marks
Question
Your customer, Adonteng Traders Limited has finished all the registration formalities to take advantage under the new continental trading booming in Africa. Specializing in export of food throughout the continent, Adonteng Traders have negotiated with South African buyers for supply of assorted foodstuff. The arrangement allows them to draw bill of exchange on buyers immediately after shipment for full payment after 90 days. Because of restricted profit margins over the past few months due to the Russian-Ukraine problem, and a shortage of working capital, the customers called to see you on 30 March to seek your advice on how best they can finance this transaction worth USD250, 000 falling due on 30 June. The credibility of the South African buyers is highly undoubted. Adonteng Traders are seeking funding from your bank for three months in either Ghana Cedi equivalent or USD250, 000 and would pay off when final proceeds are due from the buyers. Additional information available on 30 March is as follows:
(i) USD/GHS
Spot 7.7120 7.7160
1 month forward 0.035 0.043 Cedis disc
2 months forward 0.051 0.063 Cedis disc
3 months forward 0.060 0.065 Cedis disc
(ii) Base rate is 19.0%
(iii) US 3 month LIBOR rate is 5.25%
(iv) Adonteng Traders is borrowing dollars from your US correspondent bank at 1.5% over US LIBOR rate.
(v) For interest on USD borrowing, kindly use mid-rate to convert.
(vi) Your customers do not purchase goods for which they have to pay in foreign currency.
REQUIRED:
(a) By what methods can your customers be protected from foreign exchange risks whilst preserving their profit margins? [2 marks]
(b) Outline any contractual obligations in respect of foreign exchange that your customers would have to undertake. [2 marks]
(c) Show by calculation the proceeds of each method proposed in the answer to
(a) above, and the cedis proceeds which each method would produce, stating which of the two options is better for Adonteng Traders. [10 marks]
(d) Set out a formula which your customers would use to compare cedis and foreign
currency borrowing costs, taking into account, where appropriate, the advantages or disadvantages of forward cover. [6 marks]
Notes: (2) Base your calculations on a 30 day month and a 360 day year.
[Total Marks 20]
Answer
(a) The two methods to protect Adonteng Traders from foreign exchange risks while preserving their profit margins are:
- Entering into a forward exchange contract to sell the USD250,000 for GHS in three months at a fixed rate.
- Borrowing the required funds in USD for three months, matching the currency of the borrowing with the currency of the expected proceeds.
These methods fix the exchange rate or eliminate FX exposure, ensuring the profit margins are not eroded by adverse currency movements.
(b) For the forward exchange contract, the customer would have to undertake the obligation to deliver the USD250,000 on the maturity date (30 June) at the agreed forward rate, or close out the contract at the prevailing spot rate if the proceeds are not received, with any gain or loss settled accordingly.
For the USD borrowing, the customer would have to undertake the obligation to repay the USD principal of USD250,000 plus interest at 6.75% on the maturity date (30 June), regardless of whether the export proceeds are received.
(c) Calculations are based on a 30-day month and 360-day year, with three months = 90/360 = 0.25 year.
Forward rates:
Bank’s buy rate: 7.7120 + 0.060 = 7.7720 GHS per USD
Bank’s sell rate: 7.7160 + 0.065 = 7.7810 GHS per USD
Mid spot rate: (7.7120 + 7.7160)/2 = 7.7140 GHS per USD
For the forward contract method (GHS borrowing with forward cover):
Future GHS from forward sale (using bank’s buy rate): USD250,000 × 7.7720 = GHS1,943,000
Interest on GHS borrowing at 19%: GHS1,943,000 × 0.19 × 0.25 = GHS92,292.50
Net cedis proceeds (future GHS minus interest): GHS1,943,000 – GHS92,292.50 = GHS1,850,707.50
For the USD borrowing method:
GHS from spot sale of borrowed USD (using bank’s buy rate): USD250,000 × 7.7120 = GHS1,928,000
Interest on USD borrowing at 6.75%: USD250,000 × 0.0675 × 0.25 = USD4,218.75
Interest converted to GHS using mid-rate: USD4,218.75 × 7.7140 = GHS32,543.44
Net cedis proceeds (GHS from spot sale minus interest in GHS): GHS1,928,000 – GHS32,543.44 = GHS1,895,456.56
The USD borrowing method is better for Adonteng Traders as it produces higher net cedis proceeds (GHS1,895,456.56 > GHS1,850,707.50).
(d) The formula to compare cedis and foreign currency borrowing costs, taking into account forward cover where appropriate, is the effective annual cost for foreign currency borrowing:
Effective cost (%) = Foreign currency borrowing rate + \left[ \frac{(Forward\ rate – Spot\ rate)}{Spot\ rate} \right] \times \left( \frac{360}{Days} \right) \times 100
Where:
- Foreign currency borrowing rate is the rate on USD borrowing (e.g., LIBOR + margin = 6.75%).
- Forward rate and spot rate are the bank’s buy rates for the customer selling the foreign currency (e.g., forward 7.7720, spot 7.7120).
- Days is the period (e.g., 90 days).
This effective cost is compared to the cedis borrowing rate (19%). If the effective cost of foreign currency borrowing is lower, it is advantageous; the formula accounts for the forward discount advantage in the cedis option via the premium term.
- Uploader: Samuel Duah