Hedging exchange rate risk in Dozier Industries' international contract

Dozier Industries

Exchange rate on bid

Dozier Industries set the basis for an international contract which posed both advantages, as well as risks. In terms of benefits, the contract opened the door to international expansion, but it posed the risks of fluctuating exchange rates. The price set for the contract was of 594,000 GBP, and it included a 6% profit margin; it was also based on the costs of the project and the bids made by the competition. The exchange rate at the time was of 1 GBP = 1.41 USD; the Great British Pound had been registering a trend of devaluation throughout the past six months, and the managerial team at Dozier feared the financial consequences of a continued devaluation.

The resolution to this problem comes in the form of hedging operations. One aspect of the activities aimed to protect a company against the risks of conducting international operations refers to the establishment of a fixed exchange rate between the two currencies of the contractual parties. Such an endeavour protects the parties against facing losses due to currency fluctuations, but it also implies that if the exchange rate modifies in their interest, they will not benefit from the financial gains generated by the modifications.

Keeping in mind the specifications from above, as well as the items included in the establishment of the project bid, Dozier Industries should set the contractual exchange rate at 1.41 dollars per pound. This would ensure that they still register the profits estimated at this time and they are also protected against the potential risks (which are alarming given the latest devaluation tendency of the GBP). Another benefit of this exchange rate is that it is justifiable to the American party, which also protects itself in case of USD devaluation.

2. Alternative Hedges

Hedging operations refer to actions the parties could take in order to minimize the risks. Generally, hedging against a risk consists of "taking an offsetting position in a related security, such as a futures contract" (Investopedia, 2009). Hedges occur in a wide variety of situations, but are extremely common is situations of international operations. Relative to Dozier Industries' current project, various alternatives of hedging are available. The following lines will succinctly present them, ranked by their levels of flexibility (least flexible to most flexible):

Forward contracts - they present a mechanism by which the parties involved in international operations set the exchange rate at which a future payment will be made. It is a simple agreement and has the benefit of entirely removing the currency risks for the partners, while transferring it to the bank (ergo, the losses or gains determined by the currency rate fluctuations will be transferred to the banking institution). However, it may at times be difficult to find a partner who desires to sign a forward, and despite their simplicity, they are only limitedly used. The reasons for this may include the fact that there exists no formal institution to handle the operations and no international body to regulate them (Meera, 2002).

Futures contracts - they came into being as a response to the limitations presented by the forward contracts. "A currency futures contract is an agreement between two parties - a buyer and a seller - to buy or sell a particular currency at a future date, at a particular exchange rate that is fixed or agreed upon today" (Meera, 2002). The benefit of the futures contracts is that they are more liquid and more flexible than forwards. In this order of ideas, the futures allow one of the parties to not finalize the transaction at the established future time. Then, the transactions are clearly monitored on the futures market, giving parties an increased sense of safety and stability. Finally, the futures can be traded for other contracts within the futures market, as they are as mobile as the stock options. Another difference between the forwards and futures refers to the action one must make relative to the exchange rate fluctuations. As such, in case of currency devaluation, the individual will engage in the selling of futures contracts, whereas if the currency risks materialize in a valuation, the individual will purchase futures contracts.

Options - this third hedging alternative is the most flexible one and borrows elements from both forwards and futures. "A currency option may be defined as a contract between two parties - a buyer and a seller - whereby the buyer of the option has the right but not the obligation, to buy or sell a specified currency at a specified exchange rate, at or before a specified date, from the seller of the option" (Meera, 2002). However the buyer may change his mind and freely renounce the purchase discussed ("the right, but not the obligation"), the seller does have the obligation to make the object of the contract available for purchase.

Options can be divided into two groups: call options and put options. The first category protects the right of the buyer to purchase a particular currency, at a given time in the future, at an established exchange rate. The put options on the other hand, give the buyer the right to sell a particular currency, at a given time in the future and at an established exchange rate.

The main difference between options, and futures and forwards is the fact that in the case of the first type of contracts, the seller faces an increased risk - that of not being ensured he will sell his contract at the given time in the future. Ergo, his compensation for taking this risk materializes in the form of a premium on the option (Meera, 2002).

4. Conclusions

Dozier Industries has a long standing tradition and a favourable reputation. The company worked mainly with the military, but also came to engage in civilian contracts. Having operated mostly nationwide, the UK-based company is now presented with the opportunity of conducting international activities. This however implies both benefits, as well as limitations.

A relevant limitation is given by the risks implied by the exchange rates, namely by their future and unknown fluctuations. This is the main reason why organizations choose to sign hedging contracts. The most common hedging alternatives are the forward, futures and option contracts. The option contracts are the most flexible ones, but they do present an additional risk for the seller, ergo employing the premium.

Despite the advances in the financial market, there still are investors who do not protect themselves against currency risks. The main reasons for this include speculation, poor information or fear of high hedging costs. Similar to the insurance business, the costs of hedging must be compared against the costs of not hedging. Otherwise put, the costs of protection are to be compared with the costs of having the currency fluctuate in the detriment of Dozier's interests.