Cloth plc is the parent of the enterprise and has a manufacturing subsidiary, Tweed Inc, which is based in the US. Tweed Inc purchases 60% of its manufacturing inputs from the parent company, and the remaining 40% from an unrelated New Zealand company Darwin Wools Limited. Tweed Inc sells 40% of its output to retailers in the Eurozone, 40% to retailers in the UK, and exports the remaining 20% to retailers in Canada. Tweed Inc is negotiating with their New Zealand supplier, Darwin Wools Limited, to purchase a consignment of wool. The order is for 1 million kilos of wool. Darwin Wools Limited has insisted that they receive New Zealand Dollars (NZ$). Tweed Inc agree to pay NZ$ 500,000 for the wool in 6 months’ time, though are concerned that the US$/NZ$ exchange rate might change adversely. The following market information is available: Current spot exchange rate US$1/ NZ$1.49 Forward rate (6 months) US$1/ NZ$1.42 NZ borrowing rate 2.00% p.a. NZ investment rate 1.00% p.a. US borrowing rate 3.00% p.a. US investment rate 2.50% p.a. Call option exercise price US$1/ NZ$1.40 Put option premium $10,000 Required: a) Identify and calculate the costs of not hedging and the alternative strategies available for hedging this risk and advise which strategy would have produced the best outcome assuming the actual spot rate in 6 months’ time is US$1/ NZ$1.45. b) As mentioned above, a significant number of Tweed Inc’s exports are made to the Eurozone. Explain how a depreciation of the Euro against the US dollar might impact on the company’s competitive position and what action might Tweed Inc take as a result of the depreciation? c) Define economic exposure and explain, in detail, the techniques a company could use to reduce foreign exchange risk.
Cloth plc is the parent of the enterprise and has a manufacturing subsidiary, Tweed Inc, which is based in the US. Tweed Inc purchases 60% of its manufacturing inputs from the parent company, and the remaining 40% from an unrelated New Zealand company Darwin Wools Limited. Tweed Inc sells 40% of its output to retailers in the Eurozone, 40% to retailers in the UK, and exports the remaining 20% to retailers in Canada.
Tweed Inc is negotiating with their New Zealand supplier, Darwin Wools Limited, to purchase a consignment of wool. The order is for 1 million kilos of wool. Darwin Wools Limited has insisted that they receive New Zealand Dollars (NZ$). Tweed Inc agree to pay NZ$ 500,000 for the wool in 6 months’ time, though are concerned that the US$/NZ$ exchange rate might change adversely. The following market information is available:
Current spot exchange rate US$1/ NZ$1.49 Forward rate (6 months) US$1/ NZ$1.42
NZ borrowing rate 2.00% p.a. NZ investment rate 1.00% p.a.
US borrowing rate 3.00% p.a. US investment rate 2.50% p.a.
Call option exercise price US$1/ NZ$1.40 Put option premium $10,000
Required:
a) Identify and calculate the costs of not hedging and the alternative strategies available for hedging this risk and advise which strategy would have produced the best outcome assuming the actual spot rate in 6 months’ time is US$1/ NZ$1.45.
b) As mentioned above, a significant number of Tweed Inc’s exports are made to the Eurozone. Explain how a
c) Define economic exposure and explain, in detail, the techniques a company could use to reduce foreign exchange risk.
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