FNCE 4103 Week 8 Currency Hedging Comparison Example

Four Ways to Handle Lakeland's €2 Million Pump Payable: A Forward Contract, a Money Market Hedge, a Euro Call Option and Leaving It Open, Compared at Four Settlement Rates, With a Natural Offset From the Hamburg Subsidiary

Student Name

Walden University

FNCE 4103: International Finance

Instructor Name

Month Day, Year

Four Ways to Handle Lakeland's €2 Million Pump Payable: A Forward Contract, a Money Market Hedge, a Euro Call Option and Leaving It Open, Compared at Four Settlement Rates, With a Natural Offset From the Hamburg Subsidiary

The Exposure

Lakeland Process Equipment, the composite Minneapolis manufacturer used throughout this course, owes Rhein-Pumpen €2,000,000 in 90 days. Spot is $1.0850 per euro, the bank's 90-day forward rate is $1.0890, the 90-day dollar interest rate is 5.0 percent a year and the euro rate 3.6 percent. All rates are illustrative. Each alternative below is described by what it commits Lakeland to, what it costs up front or in spread and what the dollar cost would be at settlement.

Forward Contract

Lakeland agrees today to buy €2,000,000 in 90 days at $1.0890. The commitment is binding in both directions: Lakeland pays $2,178,000 whatever the spot rate turns out to be, giving up any gain if the euro falls. There is no up-front payment; the cost is the bank's spread, built into the forward rate, and the obligation to perform. Shapiro and Hanouna (2019) note that forwards are the instrument most firms reach for first with known payables, because they are simple, need no cash today and match the amount and date exactly.

Money Market Hedge

Lakeland borrows dollars today, converts them to euros at spot and invests the euros for 90 days so that they grow to exactly €2,000,000. It needs €2,000,000 / (1 + 0.036 x 0.25) = €1,982,161 today, which costs €1,982,161 x $1.0850 = $2,150,644. Repaying the dollar loan with interest at 5 percent for 90 days costs $2,150,644 x 1.0125 = $2,177,527. The result is almost identical to the forward, as covered interest parity predicts (Madura, 2021). The money market hedge uses Lakeland's borrowing capacity, which matters because its credit line is partly drawn.

Euro Call Option

Lakeland buys a 90-day call option on €2,000,000 with a strike of $1.0900, for an illustrative premium of $0.0150 per euro, $30,000 paid today. If the euro ends above $1.09, Lakeland exercises and pays $1.09 plus the premium; if it ends below, Lakeland buys at the lower spot rate and lets the option lapse. The worst case is $2,210,000; the best case falls with the euro. The $30,000 premium is about 1.4 percent of the payable's value, a meaningful cost for a three-month hedge, and it is paid whether or not the option is ever used. A higher strike would cut the premium but also lower the protection.

The Outcomes Side by Side

The unhedged position wins if the euro falls and loses most if it rises. The forward and money market hedge lock in about $2,178,000 in every case. The option costs more than the forward if the euro stays flat or rises, by up to $32,000, but saves money if the euro falls, by $48,000 at $1.05. It is insurance with a premium.

Table 1

What Each Alternative Costs in Dollars at Four Possible Settlement Rates

Composite company; option premium and rates illustrative. Option costs include the $30,000 premium without interest on it.

The Natural Offset

Lakeland already earns euros. Its Hamburg subsidiary collects about €55 million a year from European customers. If the subsidiary's euro receipts in the next 90 days exceed its own euro costs by at least €2,000,000, Lakeland could pay the supplier from those receipts and avoid converting dollars at all. Natural offsets are free of premiums and spreads, but they depend on timing: the subsidiary's surplus must arrive before the payable is due, and moving cash between the subsidiary and the parent may have tax consequences. Allayannis et al. (2001) found that operational hedges such as matching currency inflows and outflows work best alongside financial hedges rather than instead of them.

Recommendation

Use a forward contract for 75 percent of the payable, as the Week 5 memo recommended, because Lakeland's priority is a known dollar cost and the forward provides it without using credit capacity. Cover the remaining 25 percent from the Hamburg subsidiary's euro surplus if its cash forecast confirms enough is available in time; if not, buy a call option on that portion so that a euro fall can still help. The money market hedge is a close substitute for the forward and should be used only if the bank's forward rate moves out of line with parity.

References

Allayannis, G., Ihrig, J., & Weston, J. P. (2001). Exchange-rate hedging: Financial versus operational strategies. American Economic Review, 91(2), 391-395. https://doi.org/10.1257/aer.91.2.391

Madura, J. (2021). International financial management (14th ed.). Cengage Learning.

Shapiro, A. C., & Hanouna, P. (2019). Multinational financial management (11th ed.). Wiley.