- 15 Marks
FM – Nov 2018 – L3 – Q6 – Foreign Exchange Risk Management
Evaluate foreign exchange hedging options for Alpha Plc’s expected receipt of Kudi and discuss non-financial risk reduction methods.
Question
Alpha Plc. is a Nigerian manufacturer of plastic containers, selling across West African and other African countries. In three months, Alpha Plc. is due to receive 70 million Kudi from a Central African country. At today’s board meeting, the directors will discuss the need to hedge the foreign exchange exposure associated with this transaction and potential methods.
Three alternatives will be considered:
(i) Not to hedge this transaction;
(ii) Use a forward contract, with current exchange rates quoted by Alpha Plc.’s bank as follows:
- Spot: 1.1548 – 1.1608 Kudi/N
- 3 months forward: 1.1438 – 1.1508 Kudi/N
(iii) Use an over-the-counter currency option on Kudi, available through Alpha Plc.’s bank. Current premiums at an exercise price of 1.1650 Kudi/N are N1.10 per 100 Kudi for a call option and N1.25 per 100 Kudi for a put option.
Required:
a. State four reasons why a firm might reasonably choose not to hedge its exposure to exchange rate risk. (4 Marks)
b. Show the effect of each of the three alternatives being considered, assuming that the spot exchange rate in three months’ time is:
i. 1.1850 – 1.1880 Kudi/N
ii. 1.1295 – 1.1320 Kudi/N (7 Marks)
c. State four methods available to firms to reduce their exposure to foreign exchange risks that do not involve the use of financial contracts. (4 Marks)
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