FM – April 2022 – L2 – Q3b – Foreign exchange risk and currency risk management

Evaluate the outcome of hedging strategies for Healthy Beverages Ltd using forward contracts and money market transactions.

Question

b) Healthy Beverages Ltd is a food processing company based in Accra, Ghana. It has imported raw soybeans from farmers in the United States for processing into soy milk. The shipment is invoiced at USD800,000, and the company is expected to make payment in three months’ time. The exchange rate between the Ghanaian cedi and the U.S. dollar is currently quoted at GH¢5.8555 / USD1 bid and GH¢5.8585 / USD1 ask/offer. Considering that the Ghanaian cedi has been depreciating against the U.S. dollar in recent times, the managers of the company are worried that the exchange rate might rise further over the next three months.

The Finance Manager is considering two strategies for hedging the company’s foreign exchange risk exposures: a forward market hedge and a money market hedge. Below are pieces of information from the forward foreign exchange market and the money markets:

Forward market FX rates:
- 3-month forward rate: bid rate = GH¢5.8755 / USD1; ask/offer rate = GH¢5.8785 / USD1
- 6-month forward rate: bid rate = GH¢5.8955 / USD1; ask/offer rate = GH¢5.8985 / USD1
Money market average interest rates:
- Ghana money market: lending/investing rate = 16.5%; borrowing rate = 18.5%
- U.S. money market: lending/investing rate = 6.5%; borrowing rate = 8.5%

Required:
i) Suppose the risk exposure is to be hedged using a forward foreign exchange contract, calculate and comment on the outcome of the forward market hedge. (4 marks)
ii) Suppose the risk exposure is to be hedged using money market transactions, calculate and comment on the outcome of the money market hedge. (6 marks)

Answer

i) Setup and Evaluation of the forward market hedge:

Setup:
The underlying exposure is a USD payable (i.e., short). Thus, the forward hedge will be set up as follows:
- Position: Buy dollars forward (long)
- Maturity: 3 months
- Contract size: USD800,000
Evaluation:
With the forward contract, the entity will buy dollars from the dealer at the 3-month forward ask price of GHS5.8785/USD1

Outcome=Underlying exposure × Forward ask rate = USD800,000 × GHS5.8785/USD = GHS4,702,800

Thus, the outcome of the forward market hedge for the dollar payable will be locked at GHS4,702,800.

(Marks allocation: Setup = 1; Evaluation of the outcome = 3)

ii) Setup and Evaluation of the money market hedge:

Setup:
The underlying exposure is a USD payable (i.e., a liability). Thus, the money market hedge will be set up as follows:
- Position in the domestic money market: Borrow cedis (liability) @ the cedi borrowing rate
- Position in the international money market: Invest dollars (asset) @ the dollar investing rate.
Evaluation:
- Step 1: Determine the cedi loan
  The cedi loan is the cedi equivalent of the present value of the dollar payable:

PV of dollar payable =

As pounds would be bought at the ask rate, convert the PV of the dollar payable at the current spot ask rate to obtain the cedi amount to borrow:

Step 2: Buy dollars with the cedi loan at the current spot ask rate.
Step 3: Invest dollars at a dollar annual investing rate of 6.5%.

At maturity:

Step 4: Collect the proceeds of the dollar investment:
Step 5: Use the proceeds from the dollar investment to settle the dollar payable.
Step 6: Pay the maturity value of the cedi loan as the guaranteed domestic currency cost of the dollar payable:

The maturity value of the dollar investment and the dollar payable cancel out. Thus, the outcome of the money market hedge is the maturity value of the cedi borrowing, GH¢4,825,155.72.

Tags: Currency risk management, Foreign exchange exposure, Forward market hedge, Money market hedge
Level: Level 2

Topic: Foreign exchange risk and currency risk management
Series: APR 2022

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