Exchange-Rate Exposure of an Electronics Exporter
A Maltese electronics firm sells 120,000 units a year to a US distributor at a fixed dollar price of $85 per unit. Variable cost per unit is €48, of which €20 is dollar-denominated imported components. Annual fixed costs are €1.8 million. The current exchange rate is $1.10 per euro. The firm's board expects the euro to appreciate to $1.20 over the next year. The US distributor has offered a two-year contract at $82 per unit, or a euro-denominated contract at €70 per unit. The firm has no hedging programme and a €500,000 overdraft. The bank offers a forward contract at $1.15 per euro for 12 months. The board must choose a pricing and hedging strategy at its next meeting.
1. Calculate the firm's current annual profit in euros at $1.10/€ and at the expected $1.20/€, assuming the $85 price and 120,000 units. What does this imply for the board's concern?
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At $1.10/€: revenue = $85 × 120,000 = $10.2 million, or $10.2m/1.10 = €9.273m. Variable cost = €48 × 120,000 = €5.76m; fixed cost = €1.8m; profit = €9.273m − €5.76m − €1.8m = €1.713m.
At $1.20/€: revenue = $10.2m/1.20 = €8.5m. The dollar component cost falls in euro terms: €20 × (1.10/1.20) = €18.33, so variable cost becomes €48 − €20 + €18.33 = €46.33 per unit, or €5.56m. Profit = €8.5m − €5.56m − €1.8m = €1.14m. Profit falls by about €0.573m, or 33%. The imported components provide a partial natural hedge, but the firm's net dollar exposure is still large because all revenue is in dollars while only part of costs is. The board's concern is justified.
2. Evaluate the two contract offers and the forward hedge. Recommend a strategy, showing calculations where useful.
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At the expected $1.20/€, the $82 contract gives revenue of $9.84m/1.20 = €8.2m and profit of €8.2m − €5.56m − €1.8m = €0.84m. The €70 contract gives €8.4m revenue and profit of €8.4m − €5.56m − €1.8m = €1.04m. Continuing at $85 unhedged gives €1.14m, but with exchange-rate risk. A 12-month forward at $1.15/€ on $85 sales gives revenue of $10.2m/1.15 = €8.87m; the dollar import cost becomes €20 × (1.10/1.15) = €19.13, so variable cost is €47.13 × 120,000 = €5.66m; profit is €8.87m − €5.66m − €1.8m = €1.41m. This is the best first-year outcome shown, but it covers only 12 months.
Recommendation: do not accept the two-year $82 contract unhedged; at $1.20 it yields only €0.84m. The €70 euro contract removes revenue risk and yields €1.04m at the expected rate, but it is below the unhedged $85 outcome. Use the forward to hedge most first-year dollar receivables, and negotiate either a higher euro price, around €72–€73, or a price-adjustment clause for the second year. If accepting a two-year dollar contract, hedge year one and use an option or collar for year two. Given the overdraft, leaving the position fully unhedged is not prudent.