Orient Medical: Hedging a USD 5 Million Payable
Karachi-based importer Orient Medical (OM) must pay USD 5.0 million in six months for diagnostic equipment. The current spot rate is PKR 278/USD. The six-month forward is PKR 285/USD. PKR six-month money-market yield is 20% p.a.; USD yield is 5% p.a. A six-month PKR call option (USD put) at a strike of PKR 280/USD costs a premium of 2.5% of notional, payable upfront. OM's board risk policy requires hedging 70–100% of committed foreign-currency exposure. The bank requires a 10% cash margin for forwards but no margin for options. OM's treasury forecasts a 60% probability that the PKR will depreciate to 292/USD, a 30% probability of 284/USD, and a 10% probability of 275/USD. OM has a PKR 40 million overdraft limit and expects operating cash flow of PKR 60 million over the period. The CFO wants to leave the exposure unhedged to benefit from a possible PKR recovery.
1. Compare the forward and option hedges, including the PKR cost at each forecast rate and the expected cost.
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Forward cost = 5.0m × 285 = PKR 1.425bn. Option premium = 2.5% × 5.0m = USD 125,000, or 125,000 × 278 = PKR 34.75m at spot. If exercised, strike cost = 5.0m × 280 = PKR 1.400bn; total exercised cost = PKR 1.43475bn.
At 292: exercise, cost 1.43475bn. At 284: exercise because 284 > 280, cost 1.43475bn. At 275: do not exercise; buy at spot = 1.375bn + 0.03475bn = PKR 1.40975bn.
Expected option cost = 0.6 × 1.43475 + 0.3 × 1.43475 + 0.1 × 1.40975 = 0.9 × 1.43475 + 0.140975 = PKR 1.43225bn. Unhedged expected cost = 0.6 × 1.46 + 0.3 × 1.42 + 0.1 × 1.375 = PKR 1.4395bn. Forward expected cost is PKR 1.425bn, the lowest of the three, and it also caps the cost at 1.425bn. The option caps cost at 1.43475bn and benefits if the PKR strengthens below about 278.05, where the option becomes cheaper than the forward after the premium.
2. Recommend a hedge ratio and instrument given the board policy and OM's cash constraints.
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The policy requires 70–100% cover, but cash limits the choice. A full forward requires 10% margin = 10% × 1.425bn = PKR 142.5m, far above the PKR 40m overdraft. Even a 70% forward needs about PKR 99.75m margin, so forwards are not feasible without negotiating collateral arrangements.
A full option premium is PKR 34.75m, which fits the overdraft but leaves only PKR 5.25m of buffer. A 70% option cover costs about 0.7 × 34.75 = PKR 24.3m, leaves PKR 15.7m of buffer, and satisfies the minimum policy. Recommend hedging at least 70% with the option, or negotiating a margin-free forward/collar for part of the exposure. Leave at most 30% unhedged, monitor the rate, and set a stop-loss trigger. The recommendation should be documented as risk reduction, not as a forecast that the PKR will weaken.
3. Evaluate the CFO's proposal to remain unhedged.
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Remaining unhedged violates the board's 70–100% hedging policy and turns a committed payable into a speculative position. The expected cost is PKR 1.4395bn, only about PKR 14.5m above the forward, but the 60% scenario costs PKR 1.46bn - PKR 35m above the forward - and the outcome is uncertain. The exposure is large relative to OM's PKR 40m overdraft and PKR 60m expected cash flow, so a sharp move could strain liquidity and covenants.
Hedging is not about beating the forecast; it is about reducing cash-flow uncertainty. The CFO should hedge at least 70%, preferably with the option because of the margin constraint, and present the sensitivity analysis to the board. If OM wants to retain some upside, it can leave 30% uncovered within policy rather than going fully unhedged.