AB plc is a UK based importer and exporter of generator for heavy industries. It trades extensively

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Question:

AB plc is a UK based importer and exporter of generator for heavy industries. It trades extensively with the USA. Assume that you are the treasury manager, and it is part of your duties to measure and get on currency risks. You are concerned about the current variations in the exchange rate between USD and GBP and are considering numerous ways of hedging the exchange risk involved. Suppose it is now the end of March. The sales receipts ($450,000) and purchase payable ($250,000) are expected on 30 June. Suppose that the spot rate of exchange USD to GBP is 1.6540 -1.6590. The USD to GBP three-month forward rate of exchange is 1.6458 -1.6513. USA and UK's annual interest rates for three months' borrowing are 6% and 9% respectively, while the USA and UK's annual interest rates for three months' lending are 4% and 6.5% respectively.

(a) Compute the net receipts in home currency that AB plc anticipate from its transactions if the company hedges the exchange risk using:

• the forward foreign exchange market, and

• the money market

Explain the approaches together with your calculations and recommend the most financially advantageous alternative for AB plc. In addition, given that the transaction costs would be 0.2% of the USD transaction value method (i) and (ii), being paid at the beginning of the transaction (now).

(b) Describe and justify the factors AB plc should take into account before deciding to hedge the risk using the foreign currency markets and identify some alternative arrangements available to reduce risk.

(c) Examine the relative advantages and disadvantages of using foreign currency options compared with forward contracts. Suppose that the actual spot rate in three months' time is 1.6458 - 1.6513, and evaluate whether options contract or forward contract would be better for AB plc in hedging its foreign currency risk exposure.