Crosswell International Trade: Currency Risk Exposure and Hedging

This report examines the currency risk faced by Material Hospitalar, a Brazilian distributor, in its trade dealings with Crosswell International, a U.S.-based company, where transactions are denominated in U.S. dollars. It highlights the transaction risk arising from fluctuating exchange rates, specifically the potential losses Material Hospitalar could incur during the 90-day waiting period due to a strengthening USD against the Brazilian Real. The report then discusses various hedging methods, including forward contracts, currency futures, and options, as strategies Material Hospitalar can employ to mitigate these risks. It explains how each method works, providing examples of how they can protect the company from adverse currency movements, although hedging benefits one party at the potential expense of the other. The analysis concludes that forward contracts, currency futures, and options are the most suitable hedging techniques for Material Hospitalar to manage its currency exposure.

Running head: INTERNATIONAL INVESTMENT AND TRADE
International Investment and Trade
Name
Institution

INTERNATIONAL INVESTMENT AND TRADE 2
Question: Discuss the exposure to currency risk that Material Hospitalar faces in its dealing
with Crosswell International and examine the methods of hedging it could engage with to
protect itself from this risk.
Introduction
Material Hospitalar, a distributor of healthcare products throughout Brazil, seek to
distribute Precious Diapers product manufactured by the U.S based Crosswell Company. The
trade between the U.S and Brazil is denominated by the U.S dollar. Therefore, Crosswell
would not be affected by currency risks. On the other hand, Material Hospitalar which would
be trading in the U.S dollar hence exposing it currency risk through transactions. Currently,
the exchange rate between the two currencies is 2.50 Brazilian real (R$) per U.S. dollar ($).
This study is composed of two sections. The first section discusses the currency risk the
Croswell is likely to be exposed to. While the second section discusses the hedging methods
that Crosswell can apply to protect itself from the impact of currency risks.
Transaction currency risk facing Crosswell
Currency risk arises from fluctuating foreign exchange rates which affect transactions
between two companies/ countries which use different currencies. The appreciation or
depreciation cause gains or losses for an organisation which directly impact its profitability,
market value, and net cash flow. Transaction risk occurs when a company has committed to
receive or make payments of its cash flows in a foreign currency (Buckley, 2018). In the
proposal, Material Hospitalar's deal with Crosswell is in U.S dollars hence the former would
suffer a currency risk. Sales made in the Brazil market would be converted from Brazilian
real to USD which would lead to financial losses. Transaction risk arises during the 90 days
waiting period when the order has to be processed and the full payment received (Buckley,
2018). Material Hospitalar will lose if the USD (foreign currency) strengthens against the

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Brazilian real (home currency) or the latter weakness against the former as illustrated in the
table below.
Spot Rate BRL
Received
from sales
USD
received
after
exchange
Current
Scenario
US$1= 2.5 BRL 948,156 379,262.40
After 90 days US$1= 2.9 BRL 948,156 326,950.34
At the current scenario, Material Hospitalar would receive 948, 156 BRL from full
sales of precious diapers in the Brazilian market. Using an exchange rate of US$1= 2.5 BRL
the amount is equivalent to USD 379,262.40. The trends in the finance market show that the
USD is likely to strengthen against the BRL. After 90 days, One U.S dollar is expected to
trade at 2.9 BRL. Therefore, the 948,156 BRL would be equivalent to USD 326, 950.34.
Material Hospitalar is likely to lose USD 52,312.06 as a result of the foreign exchange
(currency) risk (Madura, Hoque, & Krishnamrti, 2018).
Changes of the foreign exchange rates would exposure Material Hospitalar to
transaction risks. The company is likely to lose from the unpredictable fluctuation of the
exchange rates. Considering that the contract price is predetermined, there is little Material
Hospitalar can do to protect its future cash flows. However, hedging refers to a technique that
can be used by Material Hospitalar to minimise the probability of suffering losses as a result
of exposure to transaction risks. Although hedging is used to reduce the impact of transaction
risks, it won't benefit the two companies; Material Hospitalar would benefit at an expense of
Crosswell (Graham, 2014).

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Managing currency risks
Hedging can be executed through derivatives. Derivate refers to a contract used by
transacting companies to secure the price of the product (s) under contract. Some of the
common derivative methods used in hedging are swaps, forward and futures contracts and
options. However, the two most used derivative methods are futures, forwards and options.
Both the options and futures techniques are similar because they allow the parties involved to
agree on a price at which a product would be bought or sold at a future date (Graham, 2014).
However, the two techniques differ in the way they are applied. For example, while future
hedging is highly standardised, forward hedging in flexible and comprises of non-fixed terms
and conditions which can easily be negotiated. There have been constant fluctuations in the
exchange rate between the USD and BRL which would give Crosswell advantage to use
future over forward hedging (Johnson, 2017).
a) Forward contracts
Forward contracts refer to binding contracts entered by trading parties where they agree
to sell/buy a product at an agreed price/ forward rate at a future specified date. In the
agreement, Material Hospitalar will import precious diapers from the U.S and sell them in
Brazil at a full price of 948,156 BRL. Material Hospitalar will exchange the sales into USD.
The company enters a binding agreement to exchange 1USD at 2.5 BRL as a way of reducing
the currency risk. Material Hospitalar would receive 379,262.40. If after 90 days the
exchange rate stands at 2.9 BRL against one USD, Material Hospitalar would receive a lower
amount of USD 326,950.34 which represents a loss of USD 52,312.06. However, the forward
rate of 2.5 BRL per USD that was predetermined in the agreement between Material
Hospitalar and the bank would protect the former against incurring the loss (Bychuk &
Haughey, 2011).

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The Material Hospitalar would not benefit if the USD strengthens against the BRL. For
example, if the new foreign exchange rate between the USD and BRL is 2.2, the 948,156
BRL received from the dales would be equivalent to USD 430,980. Forward contracting
would hinder the company from maximising its return. It should be noted that hedging is
applied to offer certainty on the future cash flows; the forward contract would have served its
purpose (Dafir & Gajjala, 2016).
b) Currency futures
The precious diapers is a product that Material Hospitalar buys from Crosswell to sell in
the future market. Material Hospitalar expects to receive USD 379,262.40 in 90 days from
the sales of Precious diapers. The current exchange rate is USD/ BRL 2.50. However, the
importer few that the exchange rate will strengthen to USD/BRL 2.20 in three months' time.
Therefore, Material Hospitalar should enter into a currency futures contract with the bank
where USD would be bought at 2.50 BRL and sold at 2.20 BRL. Therefore, the Material
Hospitalar would recover the loss incurred through currency risks from the profit made
through the futures contract. In other words, the company would lose today to gain more in
the future. Under futures contracts, hedging is determined by market factors instead of parties
entering into a predetermined agreement (Bychuk & Haughey, 2011).
c) Options
Under option hedging, Material Hospitalar would have the power to sell or buy
precious diapers in the future at a given fixed foreign exchange rate. The right to sell precious
diapers as a fixed exercise price is referred to as put option while the right to buy precious
diapers as a fixed exercise price is referred to a call option (Kouvelis, Dong, Boyabatli, & Li,
2011).

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Material Hospitalar is expecting to receive USD 379,262.40 from the sales of precious
diapers in three months. If the USD strengthens against the BRL, Material Hospitalar will
receive more dollars. Likewise, if USD weakens against the BRL, Material Hospitalar will
receive fewer dollars. The current foreign exchange rate is USD/BRL 2.5 and the rate is
expected to appreciate to USD/BRL 2.9. At USD/BRL 2.5, Material Hospitalar would receive
USD 379,262.40 from the sales. At USD/BRL 2.9, Material Hospitalar would receive USD
326,950.34 from the sales. In such a case, the company would exercise the call option at a
foreign exercise rate of USD/BRL 2.5 to limit the impact of currency risk (Janakiramanan,
2014).
Likewise, when the USD/ BRL exchange rate depreciate to USD/BRL 2.2, Material
Hospitalar would receive USD 379,262.40 at USD/BRL 2.5 and USD 430,980.00 at
USD/BRL 2.2. Therefore, the company would exercise the put option at a foreign exercise
rate of USD/BRL 2.2 to maximise its returns.
Conclusion
Material Hospitalar, a distributor of healthcare products throughout Brazil, seek to
distribute Precious Diapers product manufactured by the U.S based Crosswell Company.
Although Material Hospitalar is based in Brazil, it will be trading in US dollars. In other
words, the company would be exchanging the amount received from BRL to USD which
would expose it to transaction currency risks. However, several hedging mitigation methods
have been discussed. Having conducted an evaluation of the possible hedging techniques,
forward contracts, currency futures, and options have been identified as the most appropriate
to be used by Material Hospitalar.

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References
Buckley, P. J. (2018). International Business. Chicago: Oxford University Press.
Bychuk, O. V., & Haughey, B. (2011). Hedging Market Exposures: Identifying and
Managing Market Risks. New York: John Wiley & Sons.
Dafir, S. M., & Gajjala, V. N. (2016). Fuel Hedging and Risk Management: Strategies for
Airlines, Shippers and Other Consumers. New York: John Wiley & Sons.
Graham, A. (2014). Hedging Currency Exposure. New York: Routledge.
Janakiramanan, S. (2014). Derivatives and Risk Management. New Delhi: Pearson Education
.
Johnson, B. (2017). Option Strategy Hedging and Risk Management: An In-Depth Article
Introducing an Interactive Analytical Framework for Hedging Option Strategy Risk.
New York: Trading Insights.
Kouvelis, P., Dong, L., Boyabatli, O., & Li, R. (2011). Handbook of Integrated Risk
Management in Global Supply Chains. New York: John Wiley & Sons.
Madura, J., Hoque, A., & Krishnamrti, C. (2018). International Financial Management.
Sydney: Cengage AU.