Hedging Decision at Brightwater Chemicals
Brightwater Chemicals expects to receive €40m in 6 months from a German customer. The current spot is €1.14/£ (i.e. £0.8772/€). The 6-month forward is €1.12/£. A 6-month € put option (right to sell € at €1.15/£) costs a premium of 1.5% of the euro amount. UK interest rates are 4.5% pa; euro rates are 3.0% pa. Brightwater's treasury policy requires hedging at least 70% of exposures above €10m. The finance director is worried the euro will weaken to €1.20/£ and wants full protection; the treasurer argues forward cover is cheaper and equally certain.
1. Calculate the sterling receipt under (i) forward, (ii) money market hedge, and (iii) the option, and compare.
Read the worked answer
Forward. €40m / 1.12 = £35.71m (certain).
Money market hedge. Borrow euros today equal to PV of receivable: €40m / (1 + 0.03×0.5) = 40/1.015 = €39.41m. Convert at spot €1.14/£ → £34.57m. Invest sterling at 4.5% for 6 months: £34.57m × 1.0225 = £35.35m (certain).
Option (put on €, strike €1.15/£). Premium = 1.5% × €40m = €0.6m, paid now, converted at spot: £0.526m (or financed).
- If spot at expiry is €1.20/£ (euro weakens), exercise: €40m / 1.15 = £34.78m. Less premium £0.526m = £34.25m.
- If spot is €1.10/£ (euro strengthens), let option lapse: €40m / 1.10 = £36.36m. Less premium £0.526m = £35.84m.
Comparison. Forward £35.71m > money market £35.35m > option worst-case £34.25m, but option best-case £35.84m. The forward gives the highest certain receipt; the option caps downside at £34.25m while retaining upside. Money market hedge is slightly worse than forward here because the interest differential (1.5% vs 1.8% implied by forward) works against it.
2. Advise on the hedging strategy given the policy and the FD/treasurer disagreement.
Read the worked answer
Policy compliance. Exposure €40m exceeds €10m, so at least 70% (€28m) must be hedged. All three instruments can satisfy this.
FD's fear (euro to €1.20/£). If unhedged, receipt = €40m/1.20 = £33.33m - a loss of £2.38m vs forward. The FD is right that full protection against this scenario matters: the forward locks £35.71m.
Treasurer's point. The forward is certain and, on these numbers, the highest certain outcome. But it forgoes upside if the euro strengthens.
Recommended strategy - a layered approach:
- Hedge 70–80% via forward (€28–32m) to satisfy policy and lock in ~£25–28.6m, removing the downside the FD fears.
- Leave 20–30% (€8–12m) unhedged or option-protected to retain upside if the euro strengthens - matching the treasurer's cost concern while respecting the FD's risk appetite.
- Avoid a full option book: the €0.6m premium (£0.53m) is a real cost and the worst-case option outcome (£34.25m) is below the forward.
Conclusion. A forward-heavy layered hedge (e.g. €30m forward + €10m unhedged) satisfies policy, gives near-certainty on the bulk, and keeps some upside - a defensible compromise between the FD and treasurer. Pure option cover is not justified at this premium level.