Shrewsbury Herbal Products, lo
Shrewsbury Herbal Products, located in central England close tothe Welsh border, is an old-line producer of herbal teas,seasonings, and medicines. Its products are marketed all over theUnited Kingdom and in many parts of continental Europe as well.Shrewsbury Herbal generally invoices in British pound sterling whenit sells to foreign customers in order to guard against adverseexchange rate changes. Nevertheless, it has just received an orderfrom a large wholesaler in central France for £320,000 of itsproducts, conditional upon delivery being made in three months’time and the order invoiced in euros. Shrewsbury’s controller,Elton Peters, is concerned with whether the pound will appreciateversus the euro over the next three months, thus eliminating all ormost of the profit when the euro receivable is paid. He thinks thisan unlikely possibility, but he decides to contact the firm’sbanker for suggestions about hedging the exchange rate exposure.Mr. Peters learns from the banker that the current spot exchangerate in €/£ is €1.4537; thus the invoice amount should be €465,184.Mr. Peters also learns that the three-month forward rates for thepound and the euro versus the U.S. dollar are $1.8990/£1.00 and$1.3154/ €1.00, respectively.
1) What is the inherent issue or problem in this case? Describethe issue or problem with no more than two sentences.
2) If you were Mr. Peters, what would you do? Answer thefollowing 6 questions.
a. Action or no action?
b. If the decision is no action, describe the problem. What isthe term in Finance for this kind of decision?
c. If there is an action, you will engage in a three-monthforward contract. What is the term in Finance for this kind ofdecision.
d. What position would you take if you decide to engage in theforward contract in c).
e. Plot the profit (or loss) profile for your position in the3-month forward contract. You have to show graphically therelationship between unanticipated changes in the spot exchangerate in 3 months and gains (or losses) of your position on the3-month forward contract.
f. Draw the outcomes of b) and c) on a graph with the horizontalaxis (possible future spot exchange rates in 3 months) and verticalaxis (£ value of € receivables).
Answer:
.1 Whatis the inherent issue or problem in this case?
Realissue is variation in exchange rate and risk of loss due toappreciation of British Pound in three months. Since the invoicewill be in Euros, there will be loss if British Poundappreciates.
2. If youwere Mr. Peters, what would you do
Answer:Action to protect the amount of recept
Theaction is called HEDGING. It can be hedged by a forward contract tobuy British Pound after three months at a specified exchangerate.
Theposition to be taken:
i)Sellreceivable(465184 Euro) and buy US dollar at forward rate $1.3154/€1.00
ii) Sell(1.3154*465184)US dollars and Buy British Pounds at rate$1.8990/£1.00
Theamount to be received after 3 months=(1.3154*465184)/1.8990=322,224Pounds
Profit/Loss:
|
A |
B=465184/1.4537 |
C |
D=C-B |
|
Spot Exchange Rate(€/£) |
Amount to be received withouthedging (Pounds) |
Amount to be received with Hedging(Pounds) |
Profit/(Loss) in Pounds |
|
1.3000 |
357834 |
322,224 |
(35,610) |
|
1.3500 |
344581 |
322,224 |
(22,357) |
|
1.4000 |
332274 |
322,224 |
(10,050) |
|
1.4537 |
320000 |
322,224 |
2,224 |
|
1.5000 |
310123 |
322,224 |
12,101 |
|
1.5500 |
300119 |
322,224 |
22,105 |
|
1.6000 |
290740 |
322,224 |
31,484 |
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