Average order size is 20 solar panels. The manufacture and sales processes work

Question

Average order size is 20 solar panels. The manufacture and sales processes work as follows:
Step 1: a UK or New Zealand retailer enters into a sales contract with SSP's local subsidiary (ie.
SSP's New Zealand or UK subsidiary). The sales contract stipulates that delivery will occur in
three months. The price in local currency (ie. GBP or NZD) is also stipulated in the contract.
Step 2: After the sales contract is executed, SSP immediately orders raw materials from
Indonesia. This order stipulates a six week delivery of raw materials and the price of the raw
materials which is denominated in IDR.
Step 3: After receiving the raw materials and settling the account with the Indonesian supplier
in IDR, the company manufactures the product as per the sales contract and ships the product
off to the UK or New Zealand.
Step 4: After receiving the finished product, the UK or New Zealand customer pays for the
goods. SSP is about to engage in a new investment project which it will fund through a debt
facility of AUD$100 million and wants protection against increases in interest rates over the next
five years. SSP also has purchased 10 fixed income securities using retained earnings each with
a face value of AUD$1 million with five years to maturity and a coupon rate of 10% paid once
per annum. The issuer has a call provision which enables them to prepay the debt at any time.
Currently the Company has no definitive strategies on managing financial risk.

For risks associated with the ordering and sales process described above:

1. Identify and explain the financial risk that SSP is potentially exposed to. Use examples
of possible scenarios that may occur for SSP to illustrate the nature of these risks.
2. Using examples, explain how the risk can be managed using futures.
3. Aside from a futures based risk management strategy, you should identify and explain
three additional risk management strategies using three alternative Over-The-Counter
(OTC) derivatives.

Explanation / Answer

1) Financial risks involved are Exchange rate risk and interest rate risk in medium term. The price difference is due to the exchange rates between the countries which is determined by the strength of the currency. Say if GBP or NZD currency appreciated then SSP will face huge losses if it is not hedged.

2) This risk can be hedged by purchasing futures of the same value of potential risk faced. From buyer (say XYZ corp) point of view, who needs to pay money for goods purchased from ABC Inc should hedge by buying futures of similar values. And for seller (ABC Inc) who is naturally holds a long position should short futures of the similar value of risk it faces.

3) Aside from a futures based risk management strategy, the company can hedge from Exotic options, Swaps, forwards/FRAs.  

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