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Adopting Strategies to Minimize Foreign Exchange Risk

You are the chief financial officer (CFO) of a company that has recently entered the global marketplace. You have been meeting with the marketing and sales managers of the firm, and you are trying to adopt strategies that will minimize foreign exchange risk.

The sales and marketing managers are weighing the pros and cons of selling to customers in Mexico versus selling to customers in England. Because the sales and marketing managers are about to enter negotiations with large customers in both countries, you want to prepare them with important background information.

Part I

Complete the following requirements, and answer the following questions. Be sure to show all calculations:

1. Go to http://www.xe.com/ to determine the current exchange rate of U.S. dollars to Mexican pesos, and U.S. dollars to British pounds. Make sure to cite the source of data and the date on which you found it because exchange rates are always shifting.
2. Without hedging currency, answer the following questions:
2.1. What would happen to profits if you sold 1,000 widgets to each country (at today's exchange rate) at a price of either 1 pound each (if sold to England) or 25 pesos (if sold in Mexico)?
2.2. If the dollar weakened by 10% relative to each country's currency, what would be the new exchange rate used for this calculation?
3. What would happen to profits if you did hedging by buying forward contracts in foreign currency (at today's exchange rate) at a cost of $50, and after the purchase, the U.S. dollar depreciated by 10%?

Part II

From the exchange rate data determined, complete the following requirements:

1. Explain the pros and cons of hedging strategies
2. Explain what would have happened to profits or potential profits if the dollar had strengthened, rather than weakened (in Part I) and if the same forward contracts had been purchased for $50.
3. From the information obtained, give specific factors that you feel must be considered before buying futures contracts for currency.

Part III

Address the following questions and requirements:

1. How would you describe the political risks of doing business with a firm in England?
2. Would the political risks be different if you did business with a firm in Mexico? Explain your reasoning.
3. For each country, give at least 3 factors (good or bad) that must be considered before entering any business transactions with a firm from each respective country.

Solution Preview

Please see the attached files for the complete tutorial.

PARTS I and II
1 USD = 12.6595 MXN (XE, 2012)
1 USD = 0.633589 GBP (XE, 2012)

Without hedging the transaction, if the company sold 1,000 widgets to Mexico and Great Britain, the table below shows the company's profits (sales revenues) in each country.
GBP MXN
Sales, units 1,000 1,000
Price per unit 1 25
Current exchange rate 0.633589 12.6595
Sales revenue $ 1,578.31 $ 1,974.80

Now, if the dollar weakened by 10% relative to each country's currency, then the new exchange rate used for the profit calculation now would be:
1 USD = 13.9255 MXN
1 USD = 0.696948 GBP

These new rates or the 10% weakening of these currencies mean that the US dollar can now buy 10% more of them. This also means that without hedging the company would have lost $143.48 in its sales to Great Britain and $179.53 in its Mexico sales.

GBP MXN
Sales, units 1,000 1,000
Price per unit 1 25
Exchange rate 0.696948 13.92545
Sales revenue $ 1,434.83 $ 1,795.27
Loss $ 143.48 $ 179.53

Now, if the company instead hedged its transactions, then the profits would have been
GBP MXN
Sales, units 1,000 1,000
Price per unit 1 25
Current exchange rate 0.633589 12.6595
Sales revenue $ 1,578.31 $ 1,974.80
Less: Hedge cost 50.00 50.00
Net sales revenue $ 1,528.31 $ 1,924.80

Hedging strategies allow the company to ...

Solution Summary

The expert examines how to adopt strategies to minimize foreign exchange risks.

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