Note$-$ Kindly note that the currency quotation USD$/$EUR $0\mathrm{.}96$ represents that $0\mathrm{.}96$ units of euros can be exchanged for one US Dollar. Please use the same convention throughout the same question paper.

Mini Case$-$

Currency Hedging at ABC Industries

Richard Rothschild the chief financial officer of ABC Industries returned to his office after his meeting with two officers

of southeastern National Bank. He had requested the in order to discuss financial issue related to ABC First major international sales contract, which had confirmed the previous day feb $2,1994$ initially Rothschild had contacted Roberts Leigh a vice Preseident at the bank who had contacted Primary Responsibilities for ABC Business With Southeastern National.Leigh had inturn suggested that jane gunn of the banks international division be included in the meating since leigh felt that he$,$ himself lacked the international expertise to answer all the questions Rothschild might raise the meeting had focused on the exchange risk related to the new sales contract ABC bid of $59400$ euro currency for the installation of an internal security system for a large manufacturing firm in the united kingdom had been accepted. In accordance with the contract the British firms had transferred by cable $59400$ euro.$($ i$.$e $10$ percent of the contract amount as depreciation on the contract with the balance due at the time system was completed $.$abc production vice president mike miles had assured Rothschild that their would be no difficulty in the completing the project within the $90$ day period stipulated in the bid as a result Rothschild was planning on receiving $534600$ euro on may $21994$

Foreign Exchange Risk and hedging.

On feb $2$ the day the bid was accepted the value of the pound was $1\mathrm{.}41$ dollar $.$ however the pound had been deprecating slightly for the past six months see exhibit $-1$ rothschild was concerned that the value of pound might depreciate even further during the next $90$ days and it was this worry that prompted his discussion at the bank he wanted to find out what techniques were available ABC reduce exchange risk created by outstanding pound receivable.

Jane gunn the international specialist had explained the Rothschild had several options first of course he could do nothing $.$ this would leave ABC vulnerable to pound fluctuations which would entail losses if the pound depreciated or gains $.$if it is appreciated versus the dollar on the other hand Rothschild could choose to hedge involved take a position opposite to the one that was creating the foreign exchange exposure. this could be accompolished either by engaging in derivative contract such as forward and options or via money market hedge that ABC would receive a set dollar values for its pound receivable regardless of the spot rate that existed in the future.

ABC considered $17\%$ to its weighted average cost of capital. Its cost of borrowing for the working capital needs was currently $13\%$ the business risk in u$.$k contract was currently$13\%$ the business risk on the Uk contract was fairly typical of other projects in which ABC was involved in us would be able to assist abc in implementing whatever decision rothschid made. Abc had a $1\mathrm{.}5$ milion dollar line of credit with the south eastenern national.

Jane gun indicated that there would be no difficulty for southeastern to arrange the pound bank in London. She felt that such a loan would be at $2$ percent above the u$.$k prime rate in order to assist Rothchild in making his decision $.$gunn provided him with information on recent interest rates spot and forward exchange rates and options contracts $($see exbit$2$ or $3)$ rothscild was aware that in preparing the bid, ABC had allowed for a markup of only $6$ percent in order to increase the likehood of winning the bid hence developing an important foreign contract the bid was submitted on december $16,1993.$ In arriving at the bid the company has estimated the cost of the project added an amount as profit but kept in mind the highest bid that could conceivably win the contract. The calculations were made in dollars and then converted and then converted in pounds at the spot rate existing on December $16.$ since the uk customer had stipulated payment in pound see exhibit $4.$

In figuring the cost on this particular contract abc had assumed that virtually all components and technical expertise would need to be sourced in the united states however, ABC Hoped that if a a foot hold were gained in the united kingdom $,$ some of the direct costs on future contracts would be source there,as ABC become acquainted with local suppliers.

Rothschiled realized that the amount involved in the pound exchange rate could put ABC IN A loss position for $1994$ if the transactions were left unhedged on the other hand. He also become aware of the fact that hedging had its own cost still a decision had to be made $.$ he know that no action implied that unhedged position was the best alternative of the company.

An