Here, the treasury manager should reject the proposal of importing woolen sweaters from Kreploc amid the significant foreign exchange risk involved in the business transaction. As disclosed in the case study, Kreploc is based in Slobodia, and the Slobodian Blivit has a tendency to fluctuates as much as 30% during the 90 day period. Moreover, since the company will be supposed to make payment in 90 days to the supplier in his domicile currency, the company may suffer a big foreign exchange translation loss.
For instance, let us assume that at present, the exchange rate between Blivit and Canadian Dollar is 250B/USD, and we assume that Warm Wear Inc placed order worth C$1 million with Kreploc, with an agreement to make the payment in 90 days from now. This means that at present rate, the company need to buy 1 million*250= 250000000 Blivit to pay the supplier. However, as we expect that eventually at the time of 90 day period, Blivit appreciates against C$ and the price falls to 175B/C$. Thus, in order to pay them 250 million Blivit, Warm Wear Inc. will now have to purchase, 250000000/175= C$1.43 million. As you noticed, the entity will lose C$0.43 million in the transaction.
However, the company can hedge the transaction using the following options:
i)Advance payment to supplier: If the supplier agree, the companye can make advance payment at the spot rate. This will avoid any sort of exchange rate risk.
ii)Forward contracts: Warm Wear Inc. can also consider entering into forward contracts for 90-day contract period with a counterparty under which the rate of Blivit will be fixed at the expiration of the contract, and eventually they will be mitigating our risk. (Forward Contract, 2015)
Here, the manager of Overseas Sprocket Company will need to assist Harry over his understanding of the foreign exchange losses which the company may bear if his advice is followed up. Below are the drawbacks of heeding to Mr. Harry’s advice:
i)It will be both unsafe and costly for us to hold a million dollar foreign exchange in the company’s premises.
ii) The company cannot make cash payments to our suppliers based in offshore countries. In addition, sending cash payments through mail is also a legal offence.
Thus, to mitigate the risk effectively, Overseas Sprocket Company will have to enter into the following derivate instruments:
i)Forward contract: The company can purchase forward contracts for the stipulated time period according to our prescribed payment period. In this way, they will be locking in the exchange rate, and will be free from any exchange rate fluctuation at the time of honoring payments. However, it should be noted that there is always a risk of counterparty default in the forward contracts.
ii) Future Contracts: These are another form of derivate instruments that are traded on organized exchanges, and are free from counterparty default risk. Hence, just like forwards, company can purchase future currency contracts for the appropriate time period to lock-in the exchange rate.
Forward Contract. (2015, April 18). Retrieved from Investopedia: http://www.investopedia.com/terms/f/forwardcontract.asp
Forward Contracts. (n.d.). Retrieved April 17, 2015
Lander, S. (n.d.). How Do Companies Mitigate the Risk of Foreign Currency? Retrieved April 17, 2015
Phung, A. (2015, April 18). What is the difference between forward and futures contracts? Retrieved from Investopedia: http://www.investopedia.com/ask/answers/06/forwardsandfutures.asp
Walker, R. S. (n.d.). The illegal movement of cash and bearer negotiable instruments: Typologies and regulatory responses. Retrieved April 17, 2015