ECON 5003 Module 5 Currency Exposure and Hedging Analysis Example

Nine Hundred Eighty Thousand Euros Due in Nine Months: Measuring a Concrete Producer's Currency Exposure and Deciding What to Cover

Student Name

American College of Education

ECON5003: Economics Analysis

Module 5 Assignment

Instructor Name

July 31, 2028

The Exposures

Bellwether Ready-Mix, the composite concrete producer in this course, has almost no foreign sales; concrete does not travel far enough to export. It does, however, have two euro exposures. The first is large and one-time. To replace its oldest plant, Bellwether has ordered a central-mix batch plant from a German manufacturer for 1.4 million euros, with 30 percent paid on order and 70 percent, 980,000 euros, due on delivery in nine months. The deposit of 420,000 euros was paid at the current spot rate of about $1.08 per euro, or about $453,600. The second exposure is smaller and recurring: Bellwether buys specialized admixtures from an Italian supplier for about 380,000 euros a year, invoiced monthly.

The balance due on the plant is a transaction exposure, a known foreign currency payment on a known date. At today's spot rate, it would cost about $1.058 million. If the euro rose 10 percent against the dollar, to about $1.19, it would cost about $1.164 million, about $106,000 more. If the euro fell 10 percent, Bellwether would save a similar amount. A company that does nothing about a currency exposure has not avoided a decision; it has decided to speculate.

Should a Small Firm Hedge at All?

A classic argument holds that hedging cannot create value, because shareholders can diversify away currency risk in their own portfolios. For a family-owned firm like Bellwether, whose owners have most of their wealth in the company, the argument is weak to begin with. But there is a stronger reason. Froot et al. (1993) argued that hedging adds value when external financing is costly, because it ensures that a firm has enough internal funds to make its valuable investments when it needs to. A company that must borrow at high cost or forgo investment when a currency move drains its cash is worse off than one that hedged.

That describes Bellwether's position closely. Module 4 forecast a decline in volume of about 10 percent next year and recommended reducing borrowing on the floating-rate credit line. A $106,000 increase in the plant's cost would arrive at the moment the company's cash is weakest, forcing it to borrow at higher rates or cut other spending. Evidence from large firms points the same way: Allayannis and Weston (2001) found that U.S. companies with foreign currency exposure that used currency derivatives were valued higher on average than those that did not, consistent with hedging adding value.

The Instruments

Bellwether's bank offers four ways to handle the plant payment. A forward contract fixes the exchange rate today for delivery in nine months; the bank quotes about $1.092 per euro, so the payment would be fixed at about $1.070 million. The forward rate is higher than spot not because the bank expects the euro to rise, but because dollar interest rates are higher than euro rates in this case, and the forward rate reflects that difference; it is a price, not a forecast. A currency option gives Bellwether the right, but not the obligation, to buy euros at about $1.10 in nine months, protecting against a rise while keeping the benefit of a fall, for a premium of about 2.5 percent of the amount, roughly $26,500 paid now. Paying the balance early at today's spot rate would remove the risk but require $1.058 million of cash now, which Bellwether does not have without drawing on its credit line. Doing nothing leaves the full exposure open.

The forward costs about $11,800 more than paying at today's spot rate, but it removes all uncertainty and requires no cash now. The option costs more up front and leaves Bellwether better off only if the euro falls substantially, a bet the company has no special ability to make.

The Recommended Coverage

For the plant payment, Bellwether should cover the full 980,000 euros with a forward contract. The payment is certain in amount and timing, the company's cash will be tight when it is due and the forward's cost is small relative to the protection. The option's flexibility is worth little when the payment will certainly be made, and its premium would be paid from cash the company is trying to conserve.

For the admixtures, full coverage is unnecessary. The amounts are small, about $34,000 a month, and a currency move would change annual costs by perhaps $40,000. Bellwether should cover the next six months of expected purchases with a series of monthly forwards and, at the next contract renewal, ask the Italian supplier to price in dollars, even at a small premium, or qualify a domestic alternative. Leaving the more distant purchases uncovered is reasonable, because their volumes depend on demand that Module 4 expects to fall. Bartram et al. (2009), in an international study of derivatives use, found that many nonfinancial firms use currency derivatives, but that hedging is typically partial rather than complete, which matches the logic here: cover what is certain and material, leave open what is uncertain or small.

Controls Around the Hedge

A small company entering its first derivative contract needs a few simple rules, because the same instruments that remove risk can create it if used carelessly. Bellwether's owners should adopt a one-page policy before the forward is signed. It should state that currency contracts may be used only to cover identified payments or receipts in foreign currency, never to take a view on exchange rates; that no contract may exceed the amount or run past the date of the payment it covers; that the controller may enter contracts up to 250,000 euros and larger contracts require an owner's approval; and that every contract is recorded with the payment it covers.

The policy should also address two practical points. The bank will require the forward to be covered by Bellwether's credit facility, reducing the amount available for other borrowing by a margin of about 10 percent of the contract value, roughly $107,000, until delivery; the controller should confirm that the remaining availability is enough for the working capital needs forecast in Module 4. And if the plant's delivery date slips, the forward can be extended, but at a cost that depends on interest rates at the time, so the purchase contract should require the manufacturer to give sixty days' notice of any delay. With these controls, the hedge does what it is meant to do and nothing more.

Tariff Exposure

The module also asks about trade exposure. Bellwether's German plant is subject to the tariff schedule in force at import, and a change in trade policy before delivery could add cost that no currency hedge would cover. The purchase contract places delivery at Bellwether's site with duties paid by the buyer, so Bellwether bears this risk. It cannot hedge tariffs in financial markets, but it can reduce the exposure by asking the manufacturer to ship in advance of any announced policy change and by including a clause allowing renegotiation if duties rise by more than a set amount. The company's customs broker will monitor trade announcements affecting industrial machinery until the plant clears customs.

References

Allayannis, G., & Weston, J. P. (2001). The use of foreign currency derivatives and firm market value. The Review of Financial Studies, 14(1), 243-276. https://doi.org/10.1093/rfs/14.1.243

Bartram, S. M., Brown, G. W., & Fehle, F. R. (2009). International evidence on financial derivatives usage. Financial Management, 38(1), 185-206. https://doi.org/10.1111/j.1755-053X.2009.01033.x

Froot, K. A., Scharfstein, D. S., & Stein, J. C. (1993). Risk management: Coordinating corporate investment and financing policies. The Journal of Finance, 48(5), 1629-1658. https://doi.org/10.1111/j.1540-6261.1993.tb05123.x