Discos plc is negotiating an export contract with a customer in a developing country, Xeridia. Discos have not exported to the country before, and is concerned both about the risk of late or non-payment for the exports, and about the foreign exchange risks associated with the Xeridian peso. The contract specifies that Discos should receive 55 million Xeridian pesos in three months time. Discos will require short-term finance for the full value of the exports.

Exchange rates (peso/)

Spot 3234 3289

3 months forward 3382 3455

6 months forward 3517 3590

Current short-term UK interest rates available to Discos plc:

Borrowing 65%

Investing 53%

Discos is considering to protecting against the foreign trade risk through forward market hedge. An insurance policy is available at a cost of 125% of the spot Sterling equivalent of the export value. The policy gives the following protection: 95% cover against non-payment as a result of political actions by a foreign government; 90% cover against other nonpayment. Any payment by the insurer would be after six months.

Discos have been advised that there is at least a 5% chance of late payment after six months or default by the client. The Xeridian government is not expected to take any action that is detrimental to foreign trade during the next six months.

Required:

Discuss the one advantage and a disadvantage of the alternative. State clearly any assumptions that you make. (5 marks)

Compute the expected returns if Discos defaulted