Hedging Options for Global Sales: Forward Contract, Money Market Instruments, and Put Options

This report explores various options for hedging global sales risks, including forward contracts, money market instruments, and put options. It provides calculations for guaranteed proceeds and future spot exchange rates of indifference between option and market hedge.

RUNNING HEAD: HEDGING 1
UNIVERSITY NAME
STUDENT NAME
STUDENT ID
COURSE
DATE

HEDGING 2
EXECUTIVE SUMMARY.
The purpose of this report is to determine various options regarding the global sales and the
company’s interest with controlling various risks associated with their business. They therefore
want to establish a useful hedge option to implement in order to cushion and minimize such
risks. This report therefore will compute various proceeds if the company decides to hedge
through use of either forward contract, money market instruments or through use of put options.
It also determines the future spot rate that the company will be indifferent between the option
and the money market option.

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Table of Contents
INTRODUCTION.......................................................................................................................................4
PROCEEDS FROM AMERICAN SALE FORWARD CONTRACT.........................................................4
HEDGE USING MONEY MARKET INSTRUMENTS.............................................................................4
HEDGING USING PUT OPTIONS AND EXPECTED EURO PROCEEDS FROM AMERICAN SALE6
FUTURE SPOT EXCHANGE RATE OF INDIFERRENCE BETWEEN OPTION AND MARKET
HEDGE.......................................................................................................................................................7
CONCLUSION...........................................................................................................................................8
REFERENCES............................................................................................................................................9

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INTRODUCTION
Future contract is a custom-made contract involving two parties coming together to sell or buy a
commodity at a defined price which is set at that moment. Airbus Company at the moment can
sell the aircraft to Delta airlines at any price depending on price fluctuations currently in the
market. By doing this, Airbus company can make huge profits if the price is high. On another
hand, Airbus company risks making losses if the price falls.
PROCEEDS FROM AMERICAN SALE FORWARD CONTRACT
If the Airbus Company is opting to sell the aircraft in a forward contract, it means its price will
be fixed in future. By doing this, Airbus company will in future sell the aircraft to Delta airlines
at a locked value hence eliminating the risk of fall in prices (Street et al,2012).
By selling with forward contract, a later increase in prices will mean the purchasing party will
only pay the contracted amount to the seller which will end up in underpayment in regard to the
current prices (Brock, Hommes&Wagener, 2009).
The guaranteed proceeds from the sale of The Airbus by the American company using $1.10/€ as
a forward exchange rate is calculated by dividing the billed $30million which is payable at a
period of 6 months by the forward exchange rate for the period of 6 months which at the moment
is $1.10/€.
Calculations:
Guaranteed proceed = $30,000,000 (payable within 6 months)/ $1.10/€
= (30,000,000) ÷ ($1.10/€)
= € 27,272,727.27
HEDGE USING MONEY MARKET INSTRUMENTS
Money market instruments are short term securities giving businesses to banks and government
with huge amount of capital with low cost within a short period of time. Money market hedge is
a way of mitigating foreign exchange risks in a market where short term financial instruments
with high liquidity are traded. These instruments include treasury bills and commercial papers.

HEDGING 5
This strategy of hedging may not be cost effective for large corporations in terms of risk
mitigation, however it’s the best for small ventures or investors specialized in retailing and
looking to invest against currency risk. Money market hedging is convenient way of protection
against currency fluctuations.
If the airbus is going to invest in money market hedging when expecting future payments from
Delta Airlines, it must consider the following factors:
a) Airbus should borrow U.S. dollars (foreign currency) equivalent to the expected
receivable payments so that the foreign currency loan with interest will be equal to
expected payment.
b) After borrowing loan on a foreign currency, Airbus Company should convert the loan to
the domestic currency at the spot exchange rate. In this case the domestic currency is
Euros
c) The domestic currency is then placed to deposit using the prevailing rate charged on
interest.
d) After a period of 6 months, Airbus should repay the loan upon receiving the receivable
foreign currency.
(Caldentey& Haugh, 2009)
The proceeds are shown in the calculations below:
Present value for foreign currency receivable (Dollar)
=the billed $30,000,000 payable divided by 1.03
= 30,000.000 / 1.03
= $ 29,126,214
Guaranteed proceed (Euro)
€ = PV (present value /spot Exchange rate)
€= $29,126,214 /$ 1.05
€ =27,739.251.43

HEDGING 6
Money market could be an effective way of mitigating risks however depending on
fluctuations in currency, it can be good or bad (Chen, 2012). Money market hedge can be
complicated compared to other regular forwards due to its cumbersome steps. In additional, other
logistical expenses may be incurred for processing subsequent loans and placing it on deposits
(Brousseau, Chailloux & Durré, 2013).
HEDGING USING PUT OPTIONS AND EXPECTED EURO PROCEEDS FROM
AMERICAN SALE
Put options hedge is a device in a stock market entrusting the owner a right and not obligation to
dispose of an asset at a given specific price within a determined date to another party. Put options
are used to prevent stock prices from falling below a specific set price (Barrowclough & Whaley,
2012).
If the market price of stock falls below the specific price of the put option, the buyer or owner of
the Put has the consent and not the obligation to dispose of the item at the specified given price.
The seller of the Put also has the responsibility of acquiring the asset at a strike price.
If Airbus will adopt the Put options hedge to eliminate impending risks having in mind that the
current exchange rate is unbiased predicator of future spot exchange rate, the proceeds will be as
follows: Expected Euro proceeds if Airbus will exercise this option
= strike price multiplied by payable amount
= (€0.95 per $) *($ 30,000,000)
€=28,500,000
Gross Proceeds spent by Airbus will be as follows
GP (gross proceeds) =Premium (€0.02/U.S. dollar) *($ 30,000,000 payable amount)
= (€0.02 × 30,000,000)
€ = 600,000

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GP= Premium (€0.02/U.S. dollar) × ($ 30,000,000 payable amount)
(€0.02 × 30,000,000) = €600,000
Future Cost is calculated by multiplying Exchange Spot Rate with the Gross Proceeds
= Exchange Spot Rate × Gross Proceeds
= (1.025/€ × 600,000)
€ = 615,000.
FUTURE SPOT EXCHANGE RATE OF INDIFERRENCE BETWEEN OPTION AND
MARKET HEDGE
Spot Exchange Rate also known as Spot Price is the current market value quote of a commodity,
currency or a security that can be settled at the immediate time. It is the current value of a
commodity at the time of making a quotation. This market value Is depended on market forces.
willingness of buyers to pay for the commodity and the willingness of sellers to accept the
commodity is a determinant of quotation of a Spot Price (Cheng, 2012).
The demand and supply of an asset in the market is depended on the Spot rate as well as
individuals and businesses transacting in foreign exchange trades and foreign currency.
If Delta Airline will want the aircraft to be delivered within a week, it will be forced to pay the
market value that is quoted at that time for the aircraft to be delivered within a week. However, if
Delta Airline will feel that the Aircraft is delivered at a period of 6 months, but with speculation
of increase in market value then it will not purchase the aircraft on Spot Price. Airbus on the
other side can dispose of the Aircraft to Delta Airline before a period of 6 months only if Delta
Airline is willing to pay at Spot Rate.
The indifferent future Spot Rate calculation is as follows:
Future Spot Rate
= ST (30,000,000) – (€615,000)
€ = 28,432,732

HEDGING 8
The indifferenceof future spot exchange rate is obtained by solving ST
Which is equivalent to: €0.9683/$ or using $1.0327/€.
With the money market hedging, the future value for proceeds is €28,432,732
Therefore:
€27,739,251 * 1.025 =€28,432,732
CONCLUSION.
In conclusion, forward contract will limit the chance of the company to make more profits in
future from increase or rise in the prices of goods and service because of the earlier contract
made between the buyer and the seller. Money market hedging assists the company to minimize
the risks that are associated with losses due to foreign exchange. For this reason, the company
should consider the prevailing economic conditions before hedging using money market. Put
options are the best if stock prices are of concern to an investor.

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REFERENCES
Brock, W. A., Hommes, C. H., & Wagener, F. O. O. (2009). More hedging instruments may
destabilize markets. Journal of Economic Dynamics and Control, 33(11), 1912-1928.
Brousseau, V., Chailloux, A., & Durré, A. (2013). Fixing the fixings: what road to a more
representative money market benchmark? (No. 13-131). International Monetary Fund.
Caldentey, R., & Haugh, M. B. (2009). Supply contracts with financial hedging. Operations
Research, 57(1), 47-65.
Chen, L. (2012). Interest rate dynamics, derivatives pricing, and risk management (Vol. 435).
Springer Science & Business Media.
Cheng, W. G. P. (2012). A Quantitative Research on the Relationship among Onshore Spot
Exchange Rate, Offshore Spot Exchange Rate and Offshore NDF Rate [J]. Journal of
Financial Research, 9.
Street, A., Lima, D. A., Veiga, Á., Fânzeres, B., Freire, L., & Amaral, B. (2012, July). Fostering
wind power penetration into the Brazilian forward-contract market. In 2012 IEEE Power
and Energy Society General Meeting (pp. 1-8). IEEE.