Question 5

Malma is a HK manufacturer that has recently changed suppliers and has started importing one of its key components from Germany. The Finance Director has suggested that the company hedge all future Euro foreign currency transactions however the Managing Director thinks that the Euro is very stable and that this is a cost that could be avoided.

The first shipment has arrived and Malma are due to pay 2,700,000 Euros in 3 months’ time. The following information has been provided in order to assess the use of a forward contract and a money market hedge:

Current spot exchange rate           0.1285 – 0.1290 Euro / HK$

3 month future exchange rate       0.1288 – 0.1294 Euro / HK$

Annual Euro borrowing rate          6% per annum

Annual Euro deposit rate               3% per annum

Annual HK deposit rate                  4% per annum

Annual HK borrowing rate             7% per annum

Malma currently has a cash surplus.

Required:

a) Calculate the HK$ payment for Malma using 

i) a forward contract

ii) a money market hedge. 

b) Which method would you recommend Malma use?

c) Outline the key features of currency forward contracts and compare this with one internal method of hedging against currency exposure.

d) Discuss how exchange rates move if interest rates in two countries are different and conclude whether this would support the Managing Director’s view of not hedging the transaction. (You should use the average figures above to illustrate your answer).