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Currency Risk Management Guide

Mr. Peters, the controller of Shrewsbury Herbal Products, is concerned about exchange rate risk on a large order from France that is to be invoiced in euros. He learns the current spot euro/pound rate and three-month forward rates. The banker offers a forward hedge to sell the euros for pounds at an implied forward cross rate. Mr. Peters should accept the forward hedge to lock in receiving £320,000 for the order, eliminating exchange rate risk over the three months until payment. By invoicing at the forward rate rather than spot rate, Shrewsbury ensures receiving the £320,000 amount initially agreed upon.

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153 views2 pages

Currency Risk Management Guide

Mr. Peters, the controller of Shrewsbury Herbal Products, is concerned about exchange rate risk on a large order from France that is to be invoiced in euros. He learns the current spot euro/pound rate and three-month forward rates. The banker offers a forward hedge to sell the euros for pounds at an implied forward cross rate. Mr. Peters should accept the forward hedge to lock in receiving £320,000 for the order, eliminating exchange rate risk over the three months until payment. By invoicing at the forward rate rather than spot rate, Shrewsbury ensures receiving the £320,000 amount initially agreed upon.

Uploaded by

SriSaraswathy
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Chapter 5 Mini Case: SHREWSBURY HERBAL PRODUCTS, LTD.

MINI CASE: SHREWSBURY HERBAL PRODUCTS, LTD.

Shrewsbury Herbal Products, located in central England close to the Welsh border, is an old-
line producer of herbal teas, seasonings, and medicines. Its products are marketed all over the
United Kingdom and in many parts of continental Europe as well.
Shrewsbury Herbal generally invoices in British pound sterling when it sells to foreign
customers in order to guard against adverse exchange rate changes. Nevertheless, it has just
received an order from a large wholesaler in central France for £320,000 of its products,
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 appreciate
versus the euro over the next three months, thus eliminating all or most of the profit when the
euro receivable is paid. He thinks this is an unlikely possibility, but he decides to contact the
firm’s banker for suggestions about hedging the exchange rate exposure.
Mr. Peters learns from the banker that the current spot exchange rate is €/£ is €1.4537,
thus the invoice amount should be €465,184. Mr. Peters also learns that the three-month
forward rates for the pound and the euro versus the U.S. dollar are $1.8990/£1.00 and
$1.3154/€1.00, respectively. The banker offers to set up a forward hedge for selling the euro
receivable for pound sterling based on the €/£ forward cross-exchange rate implicit in the
forward rates against the dollar.
What would you do if you were Mr. Peters?
If Shrewsbury sells at a 20% markup, the cost to the firm will be:
£320,000 * 0.2 = 64,000
320,000 – 64,000 =£256,000.
So, the Pound could appreciate (+) to €465,184/£256,000 = €1.8171/1.00 before all profit
eliminated, which is not really can happen. Regardless a 10% appreciation (+) of the Pound
(€1.4537 x 1.10) to €1.5991/£1.00 would only yield a profit of
€465,184/1.5991 - £256,000 = £34,904.
Shrewsbury can hedge the exposure by selling the Euros forward for British pounds at
F3(€/£) = F3($/£) / F3($/€)
= 1.8990 ÷ 1.3154 = 1.4437.
At this forward exchange rate, Shrewsbury can “lock-in” a price of
€465,184/1.4437 = £322,217 for the sale.
The forward exchange rate indicates that the Euro is trading at a premium to the British pound in
the forward market. So, the forward hedge allows Shrewsbury to lock-in a greater amount
(£2,217) than if the Euro receivable was converted into pounds at the current spot.

Shrewsbury would end up locking-in an amount less than £320,000 if the Euro was trading at
a forward discount. Even though that would cause a loss for the company would depend upon the
extent of the discount and the amount of profit built into the price of £320,000. Only if the
forward exchange rate is even with the spot rate will Shrewsbury receive exactly £320,000.

If Shrewsbury could invoice in £, it could ensure that it receives exactly £320,000 at the end
of 3 month accounts receivable period. However, the French wholesaler may not like that. When
invoicing in Euros, Shrewsbury could establish the Euro invoice amount by use of the forward
exchange rate instead of the current spot rate. In that case, the invoice amount would be:
£320,000 x 1.4437 = €461,984
Now, Shrewsbury can lock-in a receipt of £320,000 if it simultaneously hedges its Euro exposure
by selling €461,984 at the forward rate of 1.4437.
€461,984/1.4437 = £320,000

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