Shrewsbury Herbal Products, LTD. Shrewsbury Herbal Products, located in central

Question

Shrewsbury Herbal Products, LTD.

Shrewsbury Herbal Products, located in central England close to the Welsh border, is an old-line producer of herbal teas, seasoning, and medicines. its products are marketed all over the United Kingdom and in many parts of continental Europe as well.  Shrewsbury generally invoices in British pound sterling when it sells to foreign customers in order to guard against adverse exchange rate changes. Nevertheless it has just received an order from a large wholesaler in central France for 320,000 pound of its products, conditional upon delivery being made in three months' time and the order invoiced in euros. Shrewsbury's controller, Elton Peters, is concerned with whether the pound will appreciate versus the euro over the next three month, thus eliminating all or most of the profit when the euro receivable is paid. He thinks this an unlikely possibility, but he decides to contact the firms banker for suggestions about hedging the exchange rate exposure. Mr. Peters learns from the banker that the current spot exchange rate in euros/pound is 1.4537 pound thus the invoice amount should be 465,184 euros. Mr. Peters also learns that the three-month foward rates for the pound and the euros versus the US dollar are $1.8990/1.00 pound. and 1.3154/1.00 euros respectively. The banker offers to set up a foward hedge for selling the euro receivable for pound sterling based on the euro/pound foward cross-exchange rate implicit in the foward rates against the dollar. What would you do if you were Mr. Peters?

Explanation / Answer

Answer:

Suppose Shrewsbury sells at a twenty percent markup. Thus the cost to the firm of the £320,000 order is £256,000. Thus, the pound could appreciate to €465,184/£256,000 = €1.8171/1.00 before all profit was eliminated. This seems rather unlikely. Nevertheless, a ten percent appreciation of the pound (€1.4537 x 1.10) to €1.5991/£1.00 would only yield a profit of £34,904 (= €465,184/1.5991 - £256,000). Shrewsbury can hedge the exposure by selling the euros forward for British pounds at F3(€/£) = F3($/£) ÷ F3($/€) = 1.8990 ÷ 1.3154 = 1.4437. At this forward exchange rate, Shrewsbury can “lock-in” a price of £322,217 (= €465,184/1.4437) for the sale. The forward exchange rate indicates that the euro is trading at a premium to the British pound in the forward market. Thus, the forward hedge allows Shrewsbury to lock-in a greater amount (£2,217) than if the euro receivable was converted into pounds at the current spot.

If the euro was trading at a forward discount, Shrewsbury would end up locking-in an amount less than £320,000. Whether that would lead to a loss for the company would depend upon the extent of the discount and the amount of profit built into the price of £320,000. Only if the forward exchange rate is even with the spot rate will Shrewsbury receive exactly £320,000.

Obviously, Shrewsbury could ensure that it receives exactly £320,000 at the end of three-month accounts receivable period if it could invoice in £. That, however, is not acceptable to the French wholesaler. When invoicing in euros, Shrewsbury could establish the euro invoice amount by use of the forward exchange rate instead of the current spot rate. The invoice amount in that case would be €461,984 = £320,000 x 1.4437. Shrewsbury can now lock-in a receipt of £320,000 if it simultaneously hedges its euro exposure by selling €461,984 at the forward rate of 1.4437. That is, £320,000 = €461,984/1.4437.

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