Download Hedging Instruments available to Mrs. Jane

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Case Study Report
On
International Trade Finance
By
Date
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Table of Contents:
Introduction: .................................................................................................................................... 3
Risks Faced by Parties involved: .................................................................................................... 4
Exchange Rate Risks: ................................................................................................................. 4
Transaction Risk: ........................................................................................................................ 4
Parties Involved: ......................................................................................................................... 5
Mrs. Jane (Buyer/Importer): ................................................................................................... 5
Farmer’s Cooperative (Seller/Exporter): ................................................................................ 5
Bank ........................................................................................................................................ 6
Hedging Instruments available to Mrs. Jane: .................................................................................. 6
Letter of Credit:............................................................................................................................... 8
Types of LC: ................................................................................................................................... 9
Transferable Letter of Credit: ..................................................................................................... 9
Irrevocable Letter of Credit: ..................................................................................................... 10
Revocable Letter of Credit: ....................................................................................................... 10
Payment at Sight Letter of Credit: ............................................................................................ 10
Deferred Payment Letter of Credit: .......................................................................................... 10
Hedging strategies for Jane: .......................................................................................................... 10
Calculation of forward exchange rates ..................................................................................... 11
INCO terms used in the case:........................................................................................................ 12
CPT: .......................................................................................................................................... 12
CIT: ........................................................................................................................................... 12
Work Cited:................................................................................................................................... 13
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Introduction:
The given case study gives the highlights of the business of Mrs. Jane Ross, who imports
quality fresh spices and vegetables from Thailand. These are then supplied to various restaurants
in the England. She also uses these supplies for her restaurant as well. With the passage of time,
the business of importing and selling spices, vegetables to the local restaurants has increased, and
Mrs. Jane is now getting large orders from various chains of the England. For this purpose, she
has made some large investments by buying a large warehouse, and extra staff.
For last ten years, Jane has been using a single bank for her financing and transaction
handling. The bank account she is holding right now has an overdraft facility of up to GBP40K.
Currently, this overdraft has been consumed considerably, and the bank has thus asked Jane for a
reviewing of their relationship. During this reviewing meeting, Jane has requested the bank to
provide a quotation of Letter of credit exchange rates for GBP to USD for a new supplier in
Thailand. Previously, Jane has been trading in CPT (Carrier paid to) terms by which the seller of
her imports has the liability to look after all the costs exempting any insurance costs until the
delivery of the consignment. Now she is hoping to deal with the new vendor on CIP (Carrier and
insurance paid to) terms which also includes the insurance costs of the consignment liable to the
seller.
The consignment of USD 50,000 is to reach through airfreight to Manchester under CIP
terms within two months. The credit is to be paid within 60 days of the receiving of the
consignment. The bank has provided Jane with exchange rate quotation as well as an alternative
of Over the Counter currency option. Other than this, a colleague of Jane's Husband has shown
interest in her business and offered her to provide with finance in return for a lump sum
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payments in future date with a stake in her business. This is also one of the options for increasing
her financing and not depending completely on the bank.
The various options, which are available to Jane for the hedging of exchange rate risk
with its pros and cons, are discussed in detail as follows:
Risks Faced by Parties involved:
Exchange Rate Risks:
Exchange rate risk is the risk, which arises with the effect of the unexpected and
unpredictable changes in the exchange rates on the value of the firm. The loss arising from these
changes is reported and considered as direct loss by some companies and indirect loss of cash
flow by the others. Any company, which is operating in or is taking part in foreign operations or
foreign transactions have to deal with this risk. A firm can be exposed to various types of
exchange rate risks. However, as per the case of Mrs. Jane business, she is involved in
transactions with foreign exporters having mostly the transaction risk on her cash flows. This
risk is explained in detail as follows:
Transaction Risk:
This type of exchange rate risk is the one that is faced by Mrs. Jane. Transactional Risk is
the risk, which is because of the transactional exposure of the company to the fluctuations in the
exchange rate. This is cash flow risk. This risk is related to the transactions like payables,
receivables or the repatriation of the dividends. Any change in the exchange rate of the currency
in the transaction is denominated; the firm gets under direct exposure to the transaction risk. The
payment, which Ms. Jane has to make to the Farmer’s cooperative in Thailand, has to be hedged
through various strategies so that any change in the exchange rate of the GBP or USD would
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cause an adverse effect for the Firm. As Mrs. Jane has to make the payment in USD, it is
depicted from the exchange rate or the spot rate quoted by the Bank of her that GBD is stronger
than USD (Kallianiotis, 2013).
This means that she has to pay a lower number of pounds to equal a one USD. This is in
her favor. However, if the USD becomes stronger in the coming days, or on the dates of the
payment, and the GBP became weaker against it. Then it would be evident that the company of
Mrs. Jane would have to bear the loss if she has not applied any hedging strategies. Therefore,
there are many ways to mitigate the transactional risk, which would be discussed in the later part
of the report.
Parties Involved:
Mrs. Jane (Buyer/Importer):
One of the main parties, which are involved in the transaction, is the buyer or importer of the
Spices and vegetables from one of the suppliers in Thailand. This is Mrs. Jane. Mrs. Jane is the
one who has to make the payment of the commodities she is importing. Therefore, the risk of the
cash flow is most regarding her firm. The cash, which has to be sent from one currency into
another, is coming from Mrs. Jane business and therefore any changes in the exchange rate will
directly affect the cash flow of Mrs. Jane business. Therefore, Mrs. Jane can be said to have
transactional risk exposure.
Farmer’s Cooperative (Seller/Exporter):
The Farmer’s Cooperative is the seller or the exporter for the supplies of the spices and
vegetables for Mrs. Jane business. The farmer cooperatives are the one, which needs to have the
money or the receivables to be sent to them in USD in exchange of their products of spices and
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vegetables. Any loss to the buyer of their product may cause the buyer to transfer the loss to the
sellers by deducting their payments. Moreover, the farmer cooperatives also face risk because of
the inability of the buyer that is Mrs. Jane to make payment to them in the case of any default.
Therefore, the Letter of credit is a better option to safeguard the cash flow of the Farmer's
Cooperative. This is done because of the reason that the bank is made the guarantee provider of
the buyer and in if any case the buyer is not able to make the payment then the bank has to bear
the cost of payment to the seller. Through this, the bank issuing the letter of credit makes the
payment on behalf of the buyer and the buyer makes the payment to the bank.
Bank
The Bank here is the one, which is providing finance in the form of overdraft up to
GBP40K. There is a risk which the bank exposes itself to while making this overdraft to Mrs.
Jane as in any case Mrs. Jane business gets bankrupt and is not able to make this payment due to
the bank now then the bank would be the one bearing the loss. Other than this, if the company of
Mrs. Jane opts for Letter of Credit at one of the quoted rates by the Bank and the GBP become
weaker against the USD then the bank would have to bear the loss, buy the USD at higher price,
and sell it to the Mrs. Jane at lower rate decided at first.
Hedging Instruments available to Mrs. Jane:
For the eradication or at least reducing the transactional risk, Mrs. Jane can use many
financial techniques. There are many methods for mitigating the risk for transactional exposure
to the exchange rate fluctuations. The transactional risks are normally hedged and managed
tactically. This is done to maintain and preserve earnings and cash flows depending on the
perception of the firm of the future, current rate changes. This is usually chosen by the firms for
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their short-term transactions like making payments, recovering receivables. On the other hand,
the strategically hedging is chosen by the firms who have to make long period transactions.
Moreover, there are some firms, which use a passive hedging policy, which means that the firm
does not, takes into account the perception of the currency rate changes and implies a fixed
hedging policy irrespective of the exchange rate fluctuations (Dohring, 2008).
The instruments for exchange rate hedging have increased dramatically over the period.
These are available on both OTC Over the counter currency instruments as well as in exchange
traded products. The most common types of the Over the Counter currency instruments are the
currency swaps and the currency forwards. The bank of Mrs. Jane has already made a proposal
for the Over the Counter option at a strike Price of 1.58 and a premium of £750. The currency
forwards are often of two types. One is that in which the currency is delivered physically that is
the outright forward, whereas the other one is the one in which the transaction is settled on net
cash basis known as the deliverable forwards. With the use of the forwards, the firms are fully
hedged. The only risk is the moving of the exchange rate in the opposite direction that is the
strengthening of the GBP against the USD causing the USD to become cheaper while the
company would have bought it at a higher price (Papaioannou, 2006).
Other than this, another alternative is the Options. Options are the foreign currency
options which contracts are having an upfront cost, which is paid to the bank or financial
institution. This contract gives the right to the owner of the option but not make it liable to buy
the domestic currency that is the GBP against the foreign currency, which is the USD, in a
specified period at a specified price. The main difference or the advantage that the options
provide as compared to the forward contracts or other hedging instruments is that options have
nonlinear payoff profile. This offers the company to remove the downside risk but do not remove
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it at the cost of gaining any benefit from the upside risk. This means that if the USD gets stronger
against the Great Britain Ponds, then the company can opt for exercising the option, as it would
provide the advantage of buying the USD at a lower rate than the market. Whereas if the USD
gets weaker against the GBP which means that it would take lower GBP to buy a dollar then the
company can opt for not exercising the option and buy the USD at market rate which is lower
giving the benefit of the upside risk (Chorafas, 2008).
Options are also of different kinds. These kinds are dependent on the various factors like
the exercise time of the option, the payoff fee, the possibility of the payoff, etc. One of these
option kinds is the look back or average rate option. This option is also known as the Asian
option. In this option, the price or the payoff of the option is not the spot price of the option but
the average of the spots price for the life of the contract that it is made. Thus, this is very suitable
for a company that has a constant flow of inflows and outflows within the company from and to
the foreign locations in foreign currencies. One quite large option rate that is an average of all the
spot rates will act as a hedge for a very large number of transactions in this case. Furthermore, as
the average rate is less volatile and changes less as compare to the rate at the period ending,
therefore, it can be said that this option is cheaper as compared to the other options available in
the market. Moreover, as this option also facilitates in hedging of a long period of transactions,
the transaction cost of this type of option also decreases as compared to the other options
available in the market.
Letter of Credit:
The Farmer’s Cooperative has asked for a guarantee from the bank for the contract of
exporting its spices and vegetables to Mrs. Jane business in England for the first time. This is for
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the first time that the Farmer is cooperative is exporting in England; therefore, they want to be
secure from their end and hence want the buyer to make the payment through Letter of Credit.
Letter of Credit is in actual a letter from the bank of the buyer who guarantees that the buyer's
payment will be made to the seller on time and of the decided amount. In any event, that the
buyer is not able to make the payment, the bank is the one who is liable to make all or the
remaining part of the payment. Because of the nature of security, it provides to the seller; this
instrument has become very popular among the exporters, and the importers and buyers thus
have to facilitate them with it for gaining the trust of the exporters and for the cause of healthy
long-term relationship (Sumangil, 2014).
In fact, the bank is the one who makes the payment to the seller on behalf of the buyer in
this instrument, and the buyer then transfers the payment amount to the bank. Therefore, the risk
is bear by the bank in this type of instrument. Moreover, the seller in both cases, even if the
buyer can make the payment or not, gets the payment of the right amount at the right time.
Types of LC:
Transferable Letter of Credit:
The Transferable Letter of Credit is that type of the Letter of Credit in which the seller or
the beneficiary has the advantage to transfer some or part of the LC to any other party. It
facilitates the seller not to engage in the transferring of the part of the payment by itself. This is
beneficial in those cases when the seller is not the only party who is involved in the
manufacturing of the product, and another party is required to have its part of the payment
(Internationaltrade.co.uk, 2016).
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Irrevocable Letter of Credit:
This type of the Letter of Credit cannot be modified or canceled without the consent of
the seller. In this type of Letter of Credit, the bank is completely liable to the seller.
Revocable Letter of Credit:
As compared to the irrevocable Letter of Credit, this is the one, which can be canceled or
modified without the consent of the seller on the request of the buyer that is the customer of the
issuing, bank. The bank in this type of LC is not liable to the seller after the revoking of the
Letter of Credit.
Payment at Sight Letter of Credit:
In this type of Letter of Credit, the payment is not made to the Seller or exporter, unless
the time the required documents are not submitted to the ban by the seller. The payment is made
on the sight of the documents requested. The bank, in this case, is not liable to make the payment
to the seller until the seller has submitted the required documents to the bank.
Deferred Payment Letter of Credit:
This is the type of Letter of Credit in which the payment is deferred to the time when the
buyer has received the goods from the seller. The payment, in this case, is not made on the
submission of the documents only, but on the receiving of the goods bought by the buyer.
Hedging strategies for Jane:
After the complete analysis of the instruments available for hedging, we can assess the
one, which would be more suitable to Mrs. Jane business in the short term as well as in the longterm period.
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The most suitable alternatives for hedging for Mrs. Jane would be the using of the
“Options” for 2 Months. The “Over the Counter” option is also preferable for Mrs. Jane
proposed by the bank. Options will be preferable because of the reason that it provides the
advantage of not losing the benefit of the upside risk of the exchange rate even with hedging the
risk of the downside risk. The decision of the exercising of the options remains with the
company, with no as such loss (SCHOENBERGER, 2011).
Other than this, the Type of Letter of Credit that would be most suitable for the business
of Mrs. Jane would be the Deferred Payment Letter of Credit. This can assure the risk of having
rotten vegetables or lower quality spices from the seller, as this will assure the making of
payment to be deferred to the time of the receiving of the goods from the seller.
Calculation of forward exchange rates
OTC option
Option Pricing
Premium
Total Pricing of the
Contract
1 Month
=50000/1.585 =
£ 31,545.74
=(50*0.44)/1.585 =
£
13.88
£
750.00
£ 32,309.62
2 Months
=50000/1.585
=£ 31,545.74
=(50*0.56)/1.5
85£
17.67
£
750.00
£ 32,313.41
3 Months
=50000/1.585 =
£
31,545.74
=(50*0.62)/1.585
£
19.56
£
750.00
£
32,315.30
The above calculations show that the most suitable of these options would be the 2
Months pricing as the company is expecting to have the shipment received within two months.
This can be further maintained for the other shipments of the year after the first one is received
and settled. For the coming years, Mrs. Jane, after discussing with her exporter, should know
how many consignments she would be receiving in a year. Therefore, based on that, the options
for longer periods or shorter periods can be decided.
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Selected Option Pricing Rates from the Quoted Rates of the Bank:
2 months
0.56c pm
0.51c pm
INCO terms used in the case:
CPT:
Carriage Paid To (the decided place of destination)
CIT:
Carriage and Insurance Paid To (the decided place of destination)
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Work Cited:
Chorafas, D. (2008) Introduction to Derivative Financial Instruments, Chapter 4 - Hedging,
McGraw-Hill Professional.
Dohring, B. (2008) Hedging & Invoicing Strategies to Reduce Exchange Rate Exposure,
January, [Online], Available:
http://ec.europa.eu/economy_finance/publications/publication11475_en.pdf [30 August
2016].
Internationaltrade.co.uk (2016) How A Letter Of Credit Helps International Trade, [Online],
Available: http://www.internationaltrade.co.uk/articles.php?CID=15&SCID=&AID=435
[30 August 2016].
Kallianiotis, J. (2013) Exchange Rates, and International Financial Economics: History,
Theories, and Practices, Springer.
Papaioannou, M. (2006) Exchange Rate Risk Measurement and Management: Issues and
Approaches for Firms , [Online], Available:
https://www.imf.org/external/pubs/ft/wp/2006/wp06255.pdf [30 August 2016].
SCHOENBERGER, C. (2011) Exposed!As currency volatility rises, companies scramble to
avoid being caught with their hedges down, 2 March, [Online], Available:
http://www.wsj.com/articles/SB10001424052970203731004576045680094212132 [30
August 2016].
Sumangil, C.(.A. (2014) Keys to Understanding Documentary Letters of Credit, LULU.