Currency exposures are big risks for companies that engage in international trades across their borders. A company is exposed to currency risk when revenue earned abroad is converted into the money of the domestic country, and when payables are converted from the domestic currency to the foreign currency. Hedging enables international traders or businesses to manage their exposure to currency risk. When a firm hedges its currency risk it eliminates the variance in expected cash flows from the trade that may arise as a result of unexpected changes in the exchange rates.
Baker Adhesive just made it first foray into the international market from its sales to Novo, a Brazilian toy manufacturer. The first order has been profitable; however, the second order that is 50% larger than the first order does not seem profitable due the unforeseen exchange rate changes which would affect its profit margin. Baker Adhesive must strategize on how to deal with the currency risk that is affecting the profitability of its sales. In order to do this, Baker Adhesive must choose out of the hedging options which are; No hedge, hedge in the forward market or to hedge in the money market. With the support from the bank Baker has to decide if it wants to venture or accept the new order since Novo refused to change the price per gallon of the current demand. This study is to find the most profitable undertaking for Baker Adhesive in mitigating the risk on current exchange risk.
How profitable is the original sale to Novo once the exchange-rate changes are acknowledged? How might the exchange-rate risk, which affected the value of the order, have been managed? Do not forget to consider possibilities beyond the two hedges introduced in the case.
If Baker agrees to the new Novo sale they should consider hedging the exchange rate risk. The case introduces three possibilities:
(1) No hedge,
(2) Hedging using a forward contract, and
(3) Hedging using the money market. Clearly describe the hedging possibilities in your own words. What exact steps need to be taken by Baker to implement the hedges?
Are the money markets and forward markets in parity?
Determine the present value of the expected future cash inflow for the three possibilities. Explain the discount rates you are using.
(Finding a present value is necessary for the following reason: With no hedge or a with forward contract hedge, the cash flow will occur at the time of payment by Novo. With the money-market hedge, Baker receives a cash flow immediately.)
Compare the three present values and comment on the differences. Why is the cost of the two hedging possibilities different? Which one would you prefer? Why?
Is the exchange rate risk completely eliminated by the hedges?
How profitable will the follow-on order be? Would you make this new sale? Would you hedge it and – if yes – how?