Madesco faces a contingent exposure. The company is not naturally hedged since the recent trend is that Mark appreciates against the Dollar. Despite the personal opinion of the Director of Finance that the Mark may have reached its peak and that it will fall in the next few months, the risk associated with exchange rate is very high. In any case, director’s opinion is not really supported by the recent economic reports that show further growth of the German GDP and even lower inflation rates. If both predictions happened to be realized, we know from the parity conditions that Mark will appreciate further.
The company on March 1 is not assured if Germans are finally going to buy the outdated microchips. As a result, Madesco needs a kind of insurance that will protect company from currency exchange risk in case the deal goes through. On the other hand, Madesco should not be entered into a commitment that it may creates losses for locking a cash flow payment that it may never happened in case the Germans decide to not buy the microchips. That is why we recommend Madesco to buy a put option of DMs. Madesco, in case the deal go through, will have the right (but not the obligation) to exercise its options and protect its cash flows in terms of Dollar in case DM appreciates. In case the deal never goes through, the company knows from the begging that it have sacrificed only the premium cost for buying the options. Also, that strategy fits better to Madesco because the time horizon of the hedge is less than 18th months. Finally, since the company is a midsize one with cash shortages a potential exposure on forward losses could be catastrophic for the existence of the company.
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