Question

XYZ ltd. has imported raw material of Euro 14 million from Germany with the credit of 30 days. The finance officer of XYZ ltd. wants to hedge this transaction for foreign exchange risk exposure. The prevailing interest and exchange rates in the markets are: Spot Rate: Euro 80.49/ INR Forward Rate: Euro 80.79/ INR 30 day Put Option on INR EURO 0.012 / Euro at 1% premium 30-day Call option on INR EURO 0.024/ Euro at 1% premium EURO interest rate: 7% INR interest rate: 14% Based on the above data, answer the following questions: a. Explain different hedging options available to XYZ ltd?

Answer 1

XYZ ltd. can employ hedging strategies such as forward contracts, options contracts, money market hedge, and natural hedging to safeguard against foreign exchange risk from the Euro-denominated import transaction.

Step-by-step explanation:

XYZ ltd. can explore multiple hedging options to mitigate its foreign exchange risk exposure stemming from the import of raw materials priced in Euros. The following are the hedging alternatives available:

Forward Contracts: Entering into a forward contract to buy Euros at a predetermined rate (Euro 80.79/ INR) for settlement in 30 days.

Options Contracts: Purchasing a 30-day put option to sell Euros at a strike price of EURO 0.012 per Euro, albeit with a 1% premium, thus offering the right, but not the obligation, to sell Euros at this rate.

Money Market Hedge: Utilizing the differential in interest rates between EURO and INR by borrowing in one currency and investing in another to cover the future payment obligation.

Natural Hedge: If possible, invoicing future contracts in INR or generating revenue in Euros to balance the currency exposure.

Each option serves to mitigate risk, whether by locking in a rate, ensuring a worst-case scenario with the put option, leveraging interest rate differentials, or balancing the exposure with incoming cash flows in the affected currency.