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Financial Management | March 2012

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Paper T4 (part b) The seven deadly sins of a case study p45

Paper P3 Foreign currency hedging
Many P3 students understand the principles behind foreign currency hedging techniques but struggle to demonstrate the calculations in an exam. Let’s get some practice on how to figure out those numbers By Christine Bligh, content specialist, Kaplan edging involves reducing or eliminating financial risk by passing that risk on to someone else. It can provide certainty of cash flows, which helps with budgeting, encourages management to undertake investment, reduces the possibility of financial collapse and makes for a more attractive company to risk-averse staff. Foreign currency hedging specifically tries to reduce the risk that arises from future movements in an exchange rate. This is a two-way risk since exchange rates can move adversely or favourably. Management generally hedges for adverse movements only, for example higher costs and reduced income. Foreign currency hedging is a topic that frequently worries CIMA P3 students. Many seem to understand the basic principles of the available hedging techniques. However, demonstrating the calculations in an exam, under pressure, can cause problems. In this article, each foreign currency hedging technique is demonstrated numerically to give students further practice. Then the conditions for the use of each technique are discussed. Throughout this article the following scenario will be used:

Imagine USB Inc, an American software house, is due to pay a UK supplier £1m in three months’ time. It is now 1 May. Relevant data from the foreign currency and money market is given below. Exchange rates quoted today are: \$/£ Spot rate 0.5120 – 0.5152 One-month forward rate 0.5141 – 0.5171 Three-month forward rate 0.5171 – 0.5202 Interest rates (p.a.) are: UK US % 5 – 5.5 2 – 2.4

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Futures market (£100,000 contracts, margins are \$1,000 per contract) £1 June \$1.9305 September \$1.9170 December \$1.9005 Note: The contract size of £100,000 has been chosen to avoid under- or over-hedging. The usual contract size is £62,500. Options market (£250,000 contracts, premiums are quoted in cents per £1) Call option Put option Exercise price June September June September 1.9000 2.88 3.55 0.15 0.28 1.9200 1.59 2.32 1.00 1.85 1.9400 0.96 1.15 2.05 2.95 Note: The contract size of £250,000 has been chosen to avoid under- or over-hedging. Let us calculate the dollar payment using each type of hedging technique suggested by the information above.

Hedging using a forward contract

The transaction is to pay £1m in three months’ time. USB is an American company that would usually trade in dollars. It will have to buy some pounds

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Paper P3 Foreign currency hedging
sterling (by selling some dollars) so that it can make this payment to its UK supplier. The three-month forward rates are given: 0.5171 – 0.5202. But which one is it? And what do you do with it? To answer “which one is it?” you need to remember that whenever you buy something you invariably pay more than you want to. (And when you sell something you will usually get less than you wanted. Believe me, I have just sold my old car and bought a new one – it was painful.) Alternatively you can think of yourself as a loser. The bank will always win and you will always lose when exchanging money. (If you are ever in doubt as to which rate to use, calculate both and choose the one where you lose.) In this example we use the rate of 0.5171. To answer “what do you do with it?” you need to look at the brackets at the top of the table – \$ / £. This means that the numbers in the table are the pounds you would swap for \$1. (The sign on the left-hand side is the 1, in this case the \$.) This means that we will swap £0.5171 for \$1. So if we want to swap £1m for dollars we need to divide the £1m by £0.5171, giving \$1,933,862. This is the fixed amount of dollars it...