Fenwick Instruments: hedging a $5m receipt
Fenwick Instruments Ltd, a UK company, expects to receive $5,000,000 from a US customer in three months. Spot is $1.3000/£ and the three-month forward is $1.2980/£. Annual interest rates are: UK borrowing 6.0%, UK deposit 4.5%, US borrowing 3.5%, US deposit 2.8%; three-month rates are one quarter of these. A three-month over-the-counter put option on dollars at a strike of $1.3000/£ costs a premium of 2 cents per dollar, payable now. Fenwick has a £1m overdraft facility with $0.6m currently unused and no dollar borrowing facilities. The treasurer expects the dollar to weaken over the next three months, but board policy is to hedge at least 70% of committed foreign currency exposures.
1. Compare a forward market hedge with a money market hedge and recommend one.
Read the worked answer
Forward hedge Sell $5m forward at 1.2980: 5,000,000/1.2980 = £3,852,080 received in three months, certain.
Money market hedge ($ receipt, so borrow dollars now, convert, invest sterling)
- Borrow $5m/1.00875 = $4,956,640
- Convert at spot 1.3000 = £3,812,800
- Invest for three months at 1.125% = £3,855,700
The money market hedge is better by about £3,620, or 0.09%.
Judgement The gain is negligible and does not survive transaction costs - bid-offer spreads on the dollar loan, the spot deal and the sterling deposit would easily exceed £3,620. Two further factors favour the forward:
- Fenwick has no dollar borrowing facilities. Arranging one takes time, requires credit approval and creates a $4.96m liability on the balance sheet, which may affect covenants. The forward is an off-balance-sheet contract requiring no funding.
- The money market hedge locks up the transaction in four separate deals, each of which must be executed and monitored; the forward is a single contract.
Recommendation Hedge $5m forward at 1.2980, fixing £3.85m. The money market route is theoretically marginally superior but operationally unavailable and practically equivalent after costs. Note that the forward rate is close to interest rate parity (1.3000 x 1.0075/1.01125 = 1.2952), which confirms there is no arbitrage gain to chase.
2. Evaluate the put option. At what exchange rate does it beat the forward, and would you buy it?
Read the worked answer
Premium 2 cents per dollar x $5m = $100,000, paid now = £76,923 (about 2.0% of the sterling receipt). This is a certain cost and it uses part of the £0.6m unused overdraft.
Outcomes at maturity
- At $1.3000 or weaker sterling: exercise, receive 5,000,000/1.3000 = £3,846,154, less premium = £3,769,231
- At $1.2500 (dollar weaker): let the option lapse and sell at spot, 5,000,000/1.2500 = £4,000,000, less premium = £3,923,077
- At $1.3500 (dollar stronger): exercise, receiving £3,769,231
Break-even against the forward Option outcome = 5,000,000/S - 76,923. Set this equal to the forward's £3,852,080: 5,000,000/S = 3,929,003, so S = $1.2726/£. The option only beats the forward if the dollar strengthens beyond $1.2726/£, a move of about 2.0% from spot, and the option's protection is capped at £3.77m - worse than the forward if the dollar strengthens.
Judgement The option is an expensive way to buy upside. Fenwick pays 2% of the receipt for a payoff that requires a 2% favourable move merely to break even against a free forward contract. The treasurer's expectation of dollar weakness supports the unhedged position, not the option. Buy the option only if the board genuinely believes sterling will strengthen sharply and wants protection against being wrong, and then only on part of the exposure. The forward remains the better default.
3. Recommend how the 70% hedging policy should be implemented, given the treasurer's expectation.
Read the worked answer
Applying the policy Hedge at least 70% of $5m = $3.5m forward at 1.2980, giving £2,696,456 certain. The remaining $1.5m is left open.
Outcome range on the open portion
- Spot $1.25: £1,200,000; total receipt £3,896,456
- Spot $1.30: £1,153,846; total £3,850,302
- Spot $1.35: £1,111,111; total £3,807,567 A 5% move in the rate swings the total by roughly £45,000 - real, but modest relative to the hedged core.
Judgement
- The 70% figure is a minimum, not a target. Hedging exactly 70% satisfies the policy and preserves some upside if the treasurer is right about the dollar.
- Do not increase the open position beyond 30% on the strength of a rate forecast. Forecasts of this kind have a poor record, and the policy exists precisely because the board does not want the company's results to depend on being right.
- If the treasurer wants protection on the open $1.5m without giving up the upside, a put option over $1.5m costs only $30,000 (£23,077) - a more proportionate use of options than covering the whole $5m.
- Check the customer's credit standing before hedging: a forward is a binding obligation, and if the US customer fails to pay, Fenwick must still settle the contract and would be left with an open currency position. Also confirm the receipt is a committed exposure within the policy's wording.
Recommendation Hedge $3.5m forward, leave $1.5m unhedged, and review the rate monthly.