Dozier Industries overview and operations

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).

3. The cost of hedging

The international market is extremely dynamic and however the financial tools have developed along, there still are investors and players who do not protect themselves against the exchange rate risks. There are mainly three reasons why investors would not protect themselves against currency risks:

they hope that the risks will materialize in a devaluation or valuation to their benefit; in other words, they speculate in the hope of registering gains the second reason is that many investors are still unaware of the existence, characteristics and benefits of using a future, forward or (call / put) option contract finally, the third reason is that hedging against currency risks involves some additional costs, and for varied reasons, investors prefer not to make the additional expenses and simply hope that currency fluctuations do not manifest in their detriment

Given that managers may at times feel reluctant towards hedging, when analyzing the matter through the lens of monetary costs, the need to clearly assess the involved risks arises. This is done relative to the available alternatives: 'to hedge or not to hedge'.

The costs of hedging refer mainly to the costs of the strategies employed and the financial commission to the banking institutions. The cost of not hedging is the risk. Otherwise put, the cost of not hedging materializes in the possibility that the currency will valuate or devaluate in the detriment of the investor. His losses might as such be larger than the costs it would have required to hedge. Ultimately then, the costs of hedging need to be related to the costs implied if the exchange rate evolves against the interest of the investor (Giddy).

By applying this principle to Dozier Industries, one would conclude that the company's managerial team should assess the costs of hedging and then compare them with the costs of not protecting the company against currency risks. While the numbers for the first category of calculi are fixed, those for the second category are unknown. Ergo, the organization will have to estimate when measuring the costs of not hedging. In doing this, they would use the devaluation tendency of the Great British Pound, the average of the past six months. It is likely that the retrieved results will indicate a cost of not hedging significantly larger than that of hedging.