On January 2d, 2014, BMW expects to ship 27,000 Mini-Cooper cars from its affili

Question

On January 2d, 2014, BMW expects to ship 27,000 Mini-Cooper cars from its affiliated plant in the UK to the US, which it will sell through US dealers on 300-day terms at $31,000 each. So BMW will receive payment from its dealers on October 28th, 2014. Assuming that BMW needs to cover its expenses in the UK and thus wants to hedge its pound exposure using a forward contract with a UK bank in the US, what is the minimum amount of pounds they should receive on October 28th, 2014 given the ten month forward rate for one US dollar in terms of pounds that you calculated above? What are two other ways BMW might hedge their pound/dollar exposure?

Explanation / Answer

It is a problem on minimizing exchange rate risk. It is observed in case of export / import transactions. BMW here has decided to ship some cars on January 2nd 2014 from UK to US. Since the company is situated in UK its domestic currency is pound. But company will sell them in USA through a dealer. The terms is 300 days credit. So amount will be received after 10 months. The rate is $31,000 each. This 31,000 dollar price must have been fixed in such a manner that it includes all expenses and profit.

Here BMW will sale 27,000 mini car in this process. Thus total amount he will receive is 27,000 x $31,000= $837,000,000.

In this problem BMW will suffer loss if the dollsr value depreciates in terms of pound. Suppose current exchange rate is 1.5 dollar per pound. It will mean at current selling price company will receive $837,000,000 / $1.5 = $558,000,000. Definitely this amount will cover its all expenses and required profit. Otherwise the rate $31,000 should have been different.

Now suppose after 10 month dollar depreciates and new exchange rate is 2 dollar per pound. If company is not hedging its risk, then after 10 month the received dollar amount will be converted into pound to get $837,000,000/$2.0 = $418,500,000. So company will suffer a loss of $558,000,000 - $418,500,000 = $139,500,000. This loss will be covered by hedging risk.

Risk is required to be hedged here through forward contract. It is a derivative contract. It is a contract on underlying asset. The terms and conditions of the contract is decided today. But it is implemented at a future date. Here underlying asset is exchange rate between dollar and pound. BMW will receive dollar value after 10 month. So its agreement with UK bank in USA will be to convert dollar into pound so that it can recover its all expenses and profit. Let BMW requires to get at least X pound to cover all its expenses and profit. Then exchange rate required will be $837,000,000 / x per pound. If bank agrees to buy dollar at this rate then BMW will take steps in entering into a forward contract with the bank. If the forward rate offered by bank is more than this exchage rate, then forward contract will not cover its entire currency risk.

Therefore, minimum required forward contract rate is (837,000,000 / x) dollar per pound. The offered rate can be lower than this rate, but it should not be higher.

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There are many other techniques of hedging currency exposure. Two such alternative ways are described below:

1. Option contract: It is also a derivative contract. In forward contract BMW has to fulfill its obligations specified in derivativative contract after 10 months. The company may suffere loss at that time. It can happen if dollar value appreciates after 10 months. But company has to abide by the contract terms.

Option contract is something different. Here company will buy a right but not obligation. If right is profitable on the execution date then only right will be exercised. Otherwise it will be thrown off. Here BMW wants to buy pound by selling dollar. So underlying asset is foreign currency pound in USA. Purchase of buying right is known as call option. Therefore BMW will decide to buy required number of pounds by paying dollar after 10 month. It can hedge the risk by purchasing call option. If dollar depreciates, then right is profitable. It will be exercised to cover up currency loss. If dollar appreciates, then riight will be thrown off and received dollars will be converted to pound by the prevailing exchange rate in the spot market after 10 months.

2. Money market operation: another popular hedging strategy is money market operation. It is a market where money can be invested for short period of time. Here short period will mean a period of less than a year.

in the sale agreement BMW is receiving dollar after 10 month. So it has to operate in money market in such a manner that it has to pay equivalent dollar after 10 month. It is possible by adopting understated steps:

step1: The company will borrow $837,000,000 now.

Step 2: this dollar will be immediately converted into pound by using current spot rate.

Step 3: Converted pound will be invested immediately at pound market for 10 month.

Step 4: After 10 month BMW will receive pound amount invested along with interest.

Step 5: This pound amount should be converted to dollar by using spot rate after 10 month.

Step 6: Finally converted dollar amount will be used to repay the dollar loan along with interest.

If the dollar depreciates then this money market investment strategy will yield positive return. This positive return will cover up loss from normal selling operation.

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