Nimbus Co: hedging a foreign currency payment

Tick each point that your answer made clearly and only once. Points here are this site's own. A real examiner may accept other valid points.

• Forward contract: FC 2,400,000 / 3.01 = $797,342.
• Money market hedge: the amount to deposit now is FC 2,400,000 / 1.025 = FC 2,341,463.
• Dollars needed now to buy this at the spot rate = 2,341,463 / 3.00 = $780,488.
• Nimbus Co borrows these dollars, and repays $780,488 x 1.02 = $796,098 in six months.
• The money market hedge costs $796,098 and the forward contract costs $797,342, so the money market hedge is cheaper by $1,245.
• For comparison, the forward rate implied by interest rate parity is 3.00 x 1.025 / 1.02 = 3.0147, which is close to the 3.01 on offer.
• Both methods fix the cost in dollars today and remove the exchange rate risk and the chance of any gain.
• The difference is small, so other factors may decide the choice.

Marks counted: 0 of 8

Tick each point that your answer made clearly and only once. Points here are this site's own. A real examiner may accept other valid points.

• Futures are standardised contracts traded on an exchange, with set sizes and dates, so the hedge may not match the exposure exactly, which leaves basis risk, and the contracts need margin payments.
• Futures can be closed out before the due date, which gives flexibility if the payment date changes.
• An OTC option gives the right but not the obligation to buy the currency at a set rate. If the rate moves against Nimbus Co it can exercise, and if it moves in its favour it can let the option lapse and buy at the spot rate.
• The option costs a premium, which is paid at the start, and this makes it more costly than a forward contract.
• The forward contract is tailored to the amount and the date and has no premium, but it is binding, so Nimbus Co cannot benefit from a favourable move.
• The choice depends on how certain the payment is, the cost, the directors' attitude to risk and the skills available.
• If the payment is certain and the directors want certainty, the forward contract or money market hedge are suitable, and an option is better if the payment is uncertain.
• The recommendation is clear and links to the facts of the scenario.

Marks counted: 0 of 8

Tick each point that your answer made clearly and only once. Points here are this site's own. A real examiner may accept other valid points.

• Transaction risk is the risk that the rate changes between agreeing the purchase and paying, which is the exposure here.
• Translation risk arises when foreign subsidiaries' accounts are consolidated, so it is not relevant to this single payment.
• Economic risk is the longer-term effect of exchange rates on competitiveness, which could affect Nimbus Co if its supplier's currency strengthens permanently.
• Netting or matching is not possible unless Nimbus Co has receipts in the same currency.

Marks counted: 0 of 4