CQS plc is a UK company that sells goods solely within UK. CQS plc has recently tried a foreign supplier in Netherland for the first time and need to pay €250,000 to the supplier in six months’ time. You as financial manager are concerned that the cost of these supplies may rise in Pound Sterling terms and has decided to hedge the currency risk of this account payable. The following information has been provided by the company’s bank:

Assuming CQS plc has no surplus cash at the present time you are required to evaluate whether a money market hedge, a forward market hedge or a lead payment should be used to hedge the foreign account payable.

Solution

Money market hedge (Invest – Buy – Borrow)

CQS plc should place sufficient Euros on deposit now so that, with accumulated interest, the six-month liability of €250,000 can be met. Since the company has no surplus cash at the present time, the cost of these Euros must be met by a short-term Pound Sterling loan.

Step 1 : Invest

Six-month Euro deposit rate = 3·5/2                                 = 1·75%

Euros deposited now = 250,000/1·0175                             =€ 2,45,700

Step 2 : Sell

Current spot selling rate =€ 1·998– 0·002                         =€1·996 per£

Cost of these Euros at spot = 245,700/1·996                    = £ 1,23,096

Step 3 : Borrow

Six-month Pound Sterling borrowing rate = 6·1/2                                           = 3·05%

Pound Sterling value of loan in six months’ time

= 123,096 x 1·0305                                                        = £ 1,26,850

Forward market hedge (Buy FC Forward)

Six months forward selling rate =€ 1·979–€ 0·004          =€ 1·975 per £

Pound Sterling cost using forward market hedge

= € 2,50,000/1·975                                                               = £ 1,26,582

Lead payment

Since the Euro is appreciating against the Pound Sterling, a lead payment may be worthwhile.

Pound Sterling cost now =€ 2,50,000/1·996                      = £ 1,25,251

This cost must be met by a short-term loan at a six-month interest rate of 3·05%

Pound Sterling value of loan in six months’ time

= £ 1,25,251 x 1·0305                                                            = £1,29,071

Evaluation of hedges The relative costs of the three hedges can be compared since they have been referenced to the same point in time, i.e. six months in the future. The most expensive hedge is the lead payment, while the cheapest is the forward market hedge. Using the forward market to hedge the account payable currency risk can therefore be recommended

Also study these questions

1. If the interest rate for the next 6 months for the US$ is 1.5% (annual compounding).
2. M/s Omega Electronics Ltd. Exports air conditioners to germany by importing all the components from Singapore.
3. On 30th June 2009 when a forward contract matured for execution
4. Wenden Co is a Dutch-based company which has the following expected transactions.
5. CQS plc is a UK company that sells goods solely within UK.