- 15 Marks
FM – L2 – Q95 – Currency Risk Management
UK company hedges €2,110,000 net euro payment using forward contract, money market hedge, and currency futures; compare costs.
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.
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