- 15 Marks
FM – L2 – Q95 – Currency Risk Management
Question
It is now the end of July. A UK company, Zenith Enterprises, expects the following receipts and payments in euros at the end of the month in three months’ time (at the end of October):
| Receipts | €540,000 |
| Payments | €2,650,000 |
The company is concerned about the exposure to a risk of a movement in the sterling/euro exchange rate, and it has decided to hedge the exposure.
It is considering three methods of hedging the exposure:
(a) with a forward exchange contract
(b) using a money market hedge
(c) using currency futures.
Relevant data is as follows:
| FX rates, €/£1 | ||
|---|---|---|
| Spot | 1.4537 | 1.4542 |
| 3 months forward | 1.4443 | 1.4448 |
| 3-month interest rates | Borrow | Invest |
|---|---|---|
| Sterling (UK) | 6.2% | 5.6% |
| Euro | 3.8% | 3.4% |
Currency futures: €/£1
Contract size is €100,000 per contract
December futures price: 0.6929
Required:
Demonstrate with relevant calculations how Zenith Enterprises can hedge its exposure to foreign exchange risk using:
(a) a forward exchange contract (3 marks)
(b) a money market hedge (4 marks)
(c) currency futures (3 marks)
Recommend which method of hedging would be preferable in this situation.
Answer
CURRENCY HEDGE
(a) Hedging with a forward exchange contract
Only the net exposure should be hedged. This is a net payment of €(2,650,000 – 540,000) = €2,110,000.
The entity will need to buy euros in three months’ time. The three-month forward rate for the contract would be 1.4443 (the rate more favourable to the bank).
Cost in sterling = €2,110,000 / 1.4443 = £1,460,915.
(b) Money market hedge
The company must pay €2,110,000 in three months’ time. To create a money market hedge, it must therefore buy euros spot and invest them for three months at 3.4% per year. The amount of euros invested, plus accumulated interest, must be worth €2,110,000 after three months.
It is assumed that the three-month investment rate for euros is 3.4% × 3/12 = 0.85%.
The amount of euros to invest now is therefore €2,110,000 / 1.0085 = €2,092,216.
These must be purchased spot at 1.4537, and the cost in sterling will be: €2,092,216 / 1.4537 = £1,439,235.
With a forward FX contract, the payment of £1,460,915 will be made in three months’ time. With a money market hedge, the payment of £1,439,235 would happen immediately. It can therefore be argued that an additional cost of a money market hedge is the loss of interest (opportunity cost) from investing £1,439,235 for three months at 5.6% per year. The lost interest would be £1,439,235 × 5.6% × 3/12 = £20,149.
The overall cost of a money market hedge would therefore be £1,439,235 + £20,149 = £1,459,384.
(c) Currency futures hedge
The company must pay euros. It needs to buy euros to make the payments. The futures are denominated in euros; therefore the company will buy futures.
The number of contracts required = €2,110,000 / €100,000 per contract = 21.1 contracts. The company should probably buy 21 contracts.
The payments are due in October. The company should therefore buy futures with the next settlement date following. It should buy December contracts at 0.6929.
The remaining €10,000 that is not hedged by futures can be purchased forward at 1.4443, at a cost of £6,924.
If the basis is 0 when the futures position is closed in October, the effective exchange rate for the €2,100,000 will be £0.6929 = €1, or £1 = €1.4432.
The net cost in sterling will be:
| £ | |
|---|---|
| 1,455,100 | |
| 6,924 | |
| 1,462,024 |
The money market hedge is the cheapest method of hedging.
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