Question

Hedging transaction exposure

You are the CFO of a medium-sized Norwegian fish-farming company, which has just delivered 100,000 kilos of fresh salmon to Delli Fisheries of London, U.K. Guaranteed payment of £1,000,000 is due in 90 days. You are considering three alternative hedges, these market data apply this morning:

Spot rate NOK 10.2505/£ Forward NOK 10.2627/£

NOK rate 2.15% p.a. GBP rate 1.67% p.a.

Put option at exercise NOK 10.2627/£ Put option premium NOK 0.0500/£

(a) Demonstrate numerically the extent to which your cash receipts in 90 days depending on the hedging technique chosen: Forward market, money market, and options hedge

(b) The currency strategiest with your primary bank tells you that the GBP pound will almost surely appreciate in the coming months. What do you tell him?

Answer 1

(a) Forward hedge:

The fish farming company is supposed to receive a foreign currency payment worth £ 1000000. Once, received the company will convert this £ amount into NOK at the existing exchange rate 90 days from now. However, the value of the receivable will go down in NOK terms if the same appreciate against the £. The hedging will be undertaken to guard against this potential appreciation in NOK value (or depreciation in £ value)

As the foreign currency is receivable, the fish company will sell a forward contract at rate 10.2627 NOK / £ with a tenure of 90 days. Under this contract, the company will sell the £ receivable at the forward contract rate after 90 days irrespective of the actual NOK/£ exchange rate prevailing then.

Forward Rate = NOK 10.2627 / £ and £ Receivable = £ 1000000

Therefore, NOK Value of Receivable = 1000000 x 10.2627 = NOK 10262700

Money Market Hedge:

Current Spot Rate = NOK 10.2505 / £, Norwegian Interest Rate = 2.15 % per annum and UK Interest Rate = 1.67 %

- Borrow the PV of the foreign currency receivable. Borrowing = 1000000 / [1+(0.0167 x 90/360)] = £ 995842.3582

- Convert this borrowing into NOK at the current exchange rate of NOK 10.2025 / £ to yield = 995842.3582 x 10.2505 = NOK 10207882.09

- Invest this converted amount in Norway at the Norwegian Interest Rate of 2.15 % per annum to receive = 10207882.09 x [1+(0.0215 x 90/360)] = NOK 10262749.46

- At the end of 90 days, repay the £ borrowing + interest worth £ 1000000 using the £ receivable.

Put Option:

The company will spend NOK 0.05 / £ to buy a put option, that provided the company with the right to sell the £ 1000000 receivable at the option's exercise price of NOK 10.2627 / £

Net Receivable in 90 days = 10.2627 x 1000000 - 0.05 x 1000000 = NOK 102127000

(b) If the £ appreciates against the NOK, the need for a hedge does not arise as an appreciating £ would only increase the NOK value of the receivable, thereby being beneficial to the fish farming company.