Lanka Auto Components' USD Payable
Lanka Auto Components must pay USD 4.2m to a Japanese steel supplier in 90 days. The spot rate is LKR 305/USD. The 90-day forward is LKR 312/USD. LKR 90-day interest is 13% a year and USD 90-day interest is 5.5% a year. A 90-day USD call option at a strike of LKR 310/USD costs a premium of LKR 4.50 per USD. The company has a LKR overdraft at 14% and expects the LKR to depreciate to around LKR 320/USD if import restrictions tighten, but it could also strengthen to LKR 298/USD if tourism receipts improve. Treasury policy requires hedging at least 70% of committed exposures but allows options for the remainder. The CFO wants to know the all-in LKR cost of each alternative and whether a collar or a partial hedge is better than a full forward.
1. Calculate the all-in LKR cost of a forward hedge, a money-market hedge and a call-option hedge.
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Forward: 4.2m × 312 = LKR 1,310.4m.
Money-market hedge: discount the USD payable at USD interest: 4.2 / (1 + 0.055 × 90/360) = 4.2 / 1.01375 = USD 4.143m. Buy USD spot at 305: 4.143 × 305 = LKR 1,263.6m. Borrow LKR at 13% for 90 days: 1,263.6 × (1 + 0.13 × 90/360) = 1,263.6 × 1.0325 = LKR 1,304.7m.
Option: premium = 4.2m × 4.50 = LKR 18.9m, paid now. Future value at the 14% overdraft rate over 90 days = 18.9 × 1.035 = LKR 19.56m. If the option is exercised at 310: 4.2 × 310 = 1,302.0m, plus premium FV = LKR 1,321.6m. If the option is not exercised, the cost is 4.2 × spot + 19.56m.
The money-market hedge is the cheapest certain cost at LKR 1,304.7m, slightly below the forward at LKR 1,310.4m. The option has a maximum cost of LKR 1,321.6m but benefits if the LKR strengthens. The option beats the forward if the spot at maturity is below (1,310.4 − 19.56) / 4.2 = LKR 307.3/USD.
2. Recommend a hedge ratio and instrument mix under the treasury policy. Include a comparison with a collar.
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Treasury policy requires at least 70% hedged. A full forward locks in LKR 1,310.4m but gives up all upside if the LKR strengthens to 298. A 70/30 split is more balanced: forward 70% costs 0.70 × 1,310.4 = LKR 917.3m; option 30% costs a premium FV of 0.30 × 19.56 = LKR 5.87m plus, if exercised, 0.30 × 1,302 = LKR 390.6m, total LKR 396.5m. Maximum total cost ≈ LKR 1,313.8m, only LKR 3.4m above the full forward. If spot falls to 298, the option leg costs 0.30 × 4.2 × 298 = LKR 375.5m plus premium 5.87m = LKR 381.4m, and total cost is LKR 1,298.7m, better than the full forward.
A collar - buy the 310 call and sell a put, say at 300 - would reduce or eliminate the premium, but it caps the benefit if the LKR strengthens below 300. It suits a company that wants protection but is willing to give up extreme upside.
Recommendation: hedge 70% with the money-market or forward instrument (use the forward if the overdraft limit is tight, because the money-market hedge consumes LKR borrowing) and 30% with the call option. Review the ratio if the bank renews the overdraft or if the forward premium widens. Monitor counterparty credit risk and mark-to-market collateral terms.