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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. Their 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 French francs.
Shrewsbury’s controller, Elton Peters, is concerned with whether the pound will appreciate versus the franc over the next three months, thus eliminating all or most of the profit when the French franc 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 FF/£ is FF7.8709, thus the invoice amount should be FF2,518,688. Mr. Peters also learns that the 90-day forward rates for the pound and the French franc versus the U.S. dollar are $1.5458/£1.00 and FF5.0826/$1.00, respectively. The banker offers to set up a forward hedge for selling the franc receivable for pound sterling based on the FF/£ cross forward exchange rate implicit in the forward rates against the dollar.
What would you do if you were Mr. Peters?
Suggested Solution to Shrewsbury Herbal Products, Ltd.
Note to Instructor: This elementary case provides an intuitive look at hedging exchange rate exposure. Students should not have difficulty with it even though hedging will not be formally discussed until Chapter 13. The case is consistent with the discussion that accompanies Exhibit 4.5 of the text.
Suppose Shrewsbury sells at a twenty percent markup. Thus the cost to the firm of the £320,000 order is £256,000. Thus, the pound could appreciate to FF2,518,688/£256,000 = FF9.8386/£1.00 before all profit was eliminated. This seems rather unlikely. Nevertheless, a ten percent appreciation of the pound (FF7.8709 x 1.10) to FF8.6580/£1.00 would only yield a profit of £34,909 (= FF2,518,688/8.6580 – £256,000). Shrewsbury can hedge the exposure by selling the French francs forward for British pounds at F1/4(FF/£) = F1/4($/£) x F1/4(FF/$) = 1.5458 x 5.0826 = 7.8567. At this forward exchange rate, Shrewsbury can “lock-in” a price of £320,578 (= FF2,518,688/7.8567) for the sale. The forward exchange rate indicates that the French franc is trading at a premium to the British pound for forward purchase, thus the forward hedge allows Shrewsbury to lock-in a greater amount (£578) for the sale than if payment was made up front.
Mini Case 2: Case study of Shrewsbury Herbal Products, Ltd.
1. Possibility of obtaining half of cash now and another half after three months
If I ware Mr, Peters, I will first of all look to the possibility of getting half of cash now and another half after three months. As a matter of fact, in the real business scenarios, business men usually would have a proportion of the deal money when the contract is signed and the rest outstanding to be paid upon the delivery of the final goods because production in particular manufacturing business will incur production cost and labor cost and cash flow would usually come from the contractual money if possible. According to this normal business behaviors, if I ware Mr, Peters I will at the very beginning try to negotiate with the large wholesaler in the central France for giving our company a half of contractual amount based on the current exchange rate. And because the amount of money to be paid in the next three month is halved, the risk of exchange rate changes would also be controlled and could be acceptable to the company to some degree.
2. Evaluation of the possibility of significant exchange rate turbulences
Figure 1 Exchange Rate Of 1 GBP against euro
Source: uk.reuters.com 2012
The above figure shows the trend and changes of exchange Rate Of 1 GBP against euro and as of 1st Aug 2012 the exchange rate of 1GBP is 1.2684 euro which is very different from the given 1.437 and this change suggests that the euro had appreciated significantly. But let us go back to the case and assume that we do not know the later change of the exchange rate, nevertheless, the chart above provided hints to us that exchange rate could change overtime but within a short period of time, like three month, the change could be very small.
Let us do a calculation, by reviewing the above chart, we can see that the most obvious change from Sep 2011 to Jul 2012 happened from March to June when the exchange rate changed from 1.20 to about 1.25. Therefore, historical data show us that according to the experience, within a recent three month, UK sterling against the euro could change by 4.1667% (0.05/1.2) which means that the UK sterling could appreciate or depreciate against the euro by approximately 4%. As a result, I will do a calculation and measurement that if news like collapse of EU would not be likely, and 4% depreciation is acceptable, I will accept the conditions provided by the large wholesaler.
In addition to the past historical data showing the exchange rate change trends, I will also consult with the economies regarding the possibility of happening of events that could lead to sudden drop of euro or preference of sterling by international investors. Again, if the possibility of significant exchange rate turbulences is low, the offer provided by the wholesaler would be acceptable.
3. Analysis of the forward hedge selling option
The priority of adopting the forward hedge selling option offered by the banker is to maintain the value of the money and reduce the loss if significant exchange rate turbulences happen rather than making a profit from the hedge selling.
Based on the current exchange rate which is GBP 1 = EUR 1.4537,
GBP 320,000 = EUR 465,184
And therefore the offer valued GBP 320,000 based on the current exchange rate could be acceptable.
Under the three month forward exchange rates,
USD 1.899 = GBP 1
USD 1.3154 = EUR 1
And therefore, GBP 1/1.899 = EUR 1/1.3154
And forward exchange rate would be GBP 1 = EUR 1.44367
And because the banker offers to set up a forward hedge for selling the euro receivable for pound sterling based on the GBP 1 = EUR 1.44367 exchange rate, as the company would get EUR 465,184, as a result based on the forward hedge for selling the euro after three months, the company would get:
465,184 / 1.44367 = GBP 322,223
Because based on the deal with the banker, our company would receive GBP 322,223 compared to the original GBP 320,000 and therefore the deal has eliminated the risk of suffering from appreciation of sterling against the euro.
Under such conditions, I will sign the deal with the banker and also with the wholesaler for the three month contract to be in EUR 465,184.
4. Concluding remarks
Regarding Mr. Peters’ situation, since the detailed understanding of the company is lacking, decisions are open for questions and assumptions and in my understanding, there are more to be concerned rather than caring about the exchange rate development in the perspective of doing business in the long term basis. Take this wholesaler contract as an example, as said, the wholesaler is a very large intermediary in Euro Zone, this could include the information that if this is the first time partnership between the wholesaler and the Shrewsbury, it could mean more than one time profit making or loss suffering. Even this time, there could be risks of suffering loss or reduced profit making, there could be chance that the future cooperation with this large wholesaler could be very profitable because of this client’s possible large scale of purchasing. In another word, we can not focus only on the eminent loss or profit and how much are they, what we need to ensure finally is the long term profitability which is more sustainable and maximize the company value creation.
Grauwe, P. D. 2007, Economics of Monetary Union. London: Oxford University Press Inc. p. 102
Mankiw, N. G. & Taylor, M. P. 2005, Economics. New York: Cengage Learning EMEA. p. 786
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