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Currency Risk
When SALAM, an American company, makes its first foreign sale, a primary issue of concern is the currency exchange rate. Since SALAM is working on a very tight budget, losses can happen if the currency exchange rate changes during the three-month period between purchase and payment. Additionally, with concerns about the pound falling in the next three months, SALAM must make a decision quickly to ensure their profit margin is protected. SALAM has four possible options to avoid loss of profit. SALAM can either hedge in the forward market, hedge in the money market, hedge in the options market or choose to not hedge.
Remaining unhedged would mean that SALAM selected no further protection and simply waits for the three months to pass, accepting the exchange rate at the time of sale in three months. This option is always possible; however the company has intelligence suggesting that the pound will fail in the...
This would cause SALAM's sale to be at a loss for the company. Given that SALAM's cost of capital is only 16%, a loss on a 1 million dollar sale would be highly detrimental to the company. So, remaining unhedged is not a wise option for the company.
The second option is that the company hedges in the forward market. Hedging in the forward market means that the two companies agree on a specific exchange rate for the time of the sale regardless of what happens in the market. Hedging in the forward market is strictly a private deal and does not have any limitations on the type of currency or the way in which the currency is exchanged. Scout Finch is willing to hedge in the forward market at an amount of $1.5549 per pound. The spot exchange rate at the time of the contract was $1.5640. This hedge would result is a loss of roughly $9,100. While the loss could be potentially smaller than remaining unhedged, SALAM…
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