- 15 Marks
Question
Alpha Plc. is a Nigerian manufacturer of plastic containers, selling across West African and other African countries. In three months, Alpha Plc. is due to receive 70 million Kudi from a Central African country. At today’s board meeting, the directors will discuss the need to hedge the foreign exchange exposure associated with this transaction and potential methods.
Three alternatives will be considered:
(i) Not to hedge this transaction;
(ii) Use a forward contract, with current exchange rates quoted by Alpha Plc.’s bank as follows:
- Spot: 1.1548 – 1.1608 Kudi/N
- 3 months forward: 1.1438 – 1.1508 Kudi/N
(iii) Use an over-the-counter currency option on Kudi, available through Alpha Plc.’s bank. Current premiums at an exercise price of 1.1650 Kudi/N are N1.10 per 100 Kudi for a call option and N1.25 per 100 Kudi for a put option.
Required:
a. State four reasons why a firm might reasonably choose not to hedge its exposure to exchange rate risk. (4 Marks)
b. Show the effect of each of the three alternatives being considered, assuming that the spot exchange rate in three months’ time is:
i. 1.1850 – 1.1880 Kudi/N
ii. 1.1295 – 1.1320 Kudi/N (7 Marks)
c. State four methods available to firms to reduce their exposure to foreign exchange risks that do not involve the use of financial contracts. (4 Marks)
Answer
a. Reasons why a firm might reasonably choose not to hedge its exposure to exchange rate risk include:
- Costs (direct and implicit);
- Materiality of the exposure;
- Attitude to risk – the firm may prefer to leave the upside potential open;
- Portfolio effect; and
- If shareholdings are fully diversified, shareholders’ exposure to systematic risk remains unaffected, providing no hedging benefit.
Alternative 1 – Do not hedge
If the company does not hedge, the receivables will be converted at the spot rates in three months.
Alternative 2 – Forward Contract
Under this option, the receivables are converted at the agreed forward rate of 1.1508, regardless of future spot rates.
- Amount due:
70,000,000 Kudi/1.1508 Kudi/N=N60,827,251
Alternative 3 – Currency Option
As Alpha Plc. is hedging a foreign asset, a put option (the right to sell) is needed. The premium cost is N1.25 per 100 Kudi:
- Premium payable:
(70,000,000 Kudi / 100) ×N1.25=N875,000
c. Methods to reduce foreign exchange risk without using financial contracts:
- Choice of invoice currency;
- Matching payments and receipts in the same currency;
- Matching assets and liabilities (e.g., using overdraft borrowing in the same currency as receivables);
- Leading and lagging payments; and
- Maintaining currency accounts
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