FIN 355 Week 2 Exchange Rates and Currency Risk Example

A Tile Importer Caught Between the Euro and the Dollar: How Exchange Rates Are Set, Three Kinds of Currency Exposure and a Hedging Program Built Around a Selling Season

[Student Name]

University of Phoenix

FIN/355: International Finance and Trade

Week 2 Assignment

[Instructor Name]

[Date]

The importer, its suppliers and all figures are composites written for a model paper; concepts and research findings come from the sources listed.

A composite company imports porcelain and ceramic tile from factories in Italy and Spain and sells it through two warehouses to builders, contractors and flooring dealers in the Southeast. It buys about €24 million of tile a year and sells about $34 million in the United States. It pays suppliers in euros 60 days after shipment. When the euro rises a few cents, the importer's cost rises the next day, but its prices to builders are set for months. This paper explains the currency risk and designs a response.

How the Euro-Dollar Rate Is Set

Under floating exchange rates, the price of a euro in dollars is set by supply and demand in the foreign exchange market, the largest financial market in the world. Demand for euros comes from Americans buying European goods, services and assets; supply comes from Europeans buying American ones. Interest rates matter because investors move money toward higher returns: when US rates rise relative to European rates, demand for dollars rises and the euro tends to fall. Inflation, economic growth and expectations about central bank policy also move rates (Krugman et al., 2022).

The spot rate is the rate for immediate exchange; the forward rate is agreed today for a future date. The forward rate reflects the interest rate difference between currencies, not a forecast. With the spot rate at $1.08 per euro, a six-month forward might be about $1.09 when euro interest rates are lower than dollar rates.

Three Exposures

Transaction exposure arises from contracted payments: the importer usually has about €4 million of purchase orders and payables outstanding. Translation exposure would arise if it owned a European subsidiary; it does not. Economic exposure is broader: if the euro strengthens for a long period, Italian and Spanish tile becomes more expensive relative to tile from Mexico, Brazil or US producers, and builders may switch. This exposure affects the company's long-term sales even if every order is hedged.

Measuring the Effect

The importer's gross margin is about 24% of sales. If the euro rose 10%, from $1.08 to $1.19, the dollar cost of a year's purchases would rise from about $25.9 million to $28.5 million. If prices could not be raised, gross profit would fall from about $8.1 million to $5.5 million, a drop of about a third. If the euro fell 10%, gross profit would rise by a similar amount. That swing is larger than the company's net income.

A Layered Hedging Program

The company's purchases fall into three groups by certainty, and the program matches tools to each. Confirmed purchase orders, typically €4 million at any time, are hedged fully with forward contracts when orders are placed, fixing their dollar cost. Forecast purchases for the next three months, about €6 million, are hedged at 50% with forwards and 25% with purchased call options, which cap the cost but keep the benefit if the euro falls. Purchases beyond three months are not hedged with contracts but are covered by price reviews.

Options cost a premium, about 1.5% of the amount covered for three-month at-the-money options. The company budgets about $25,000 a quarter for premiums, which it treats as insurance against a sharp rise in the euro during its spring building season. In the framework of Froot et al. (1993), risk management earns its keep by keeping internally generated cash available for planned spending; for the importer, that cash is the working capital needed to stock warehouses before spring.

Testing the Program Against Last Year

The controller back-tested the program against the prior year, when the euro rose about 6% between January and May. Without hedging, the company's cost of spring purchases rose by about $620,000, and it could raise prices only partway. Under the proposed program, about 85% of that increase on confirmed and near-term forecast purchases would have been offset by gains on the contracts, at a cost of about $100,000 in option premiums for the year. The test does not prove the program will always pay, since in a year when the euro falls the company gives up part of the benefit, but it shows the program would have protected margins when they were most at risk.

Operational Hedges

Contracts address transaction exposure; operations address economic exposure. The company has qualified a Mexican tile producer for its standard product lines, priced in dollars, so it can shift some volume if the euro strengthens. It has added a currency adjustment clause to its contracts with large builders, allowing price changes if the euro moves more than 5% over a quarter. It also times price list changes to follow sustained currency moves.

Why Measured Exposure Is Often Smaller

Bartram et al. (2010) examined why studies often find smaller exchange rate exposure in firms' stock returns than their operations suggest and found that firms reduce exposure through pass-through of costs to prices, operational hedging and financial hedging. The importer's program combines all three, which is consistent with how firms that manage exposure well behave.

Accounting and Reporting

The forwards and options are derivatives recorded at fair value. The company designates them as cash flow hedges of forecast purchases, so gains and losses are deferred in other comprehensive income until the tile is sold, which keeps reported margins from swinging with the contracts' values. It documents each hedge relationship when the contract is entered.

Governance of the Program

The owners approved a written policy stating the purpose of hedging, which is to protect margins rather than to speculate, the hedge ratios for each group, the approved banks and a monthly report of contracts outstanding, their fair values and the rates achieved against budget. The controller cannot increase hedge ratios without the owners' approval.

Conclusion

The euro-dollar rate moves with interest rates, inflation and expectations, and a 10% move could change the importer's gross profit by about a third. A layered program, full forwards on confirmed orders, a mix of forwards and options on forecasts and price reviews beyond three months, combined with a second source of supply and currency clauses with large customers, addresses both the contracts in hand and the company's longer-term competitiveness.

References

Bartram, S. M., Brown, G. W., & Minton, B. A. (2010). Resolving the exposure puzzle: The many facets of exchange rate exposure. Journal of Financial Economics, 95(2), 148-173. https://doi.org/10.1016/j.jfineco.2009.09.002

Froot, K. A., Scharfstein, D. S., & Stein, J. C. (1993). Risk management: Coordinating corporate investment and financing policies. The Journal of Finance, 48(5), 1629-1658. https://doi.org/10.1111/j.1540-6261.1993.tb05123.x

Krugman, P. R., Obstfeld, M., & Melitz, M. J. (2022). International economics: Theory and policy (12th ed.). Pearson.