Question Details

Which alternative should Laguna Co. select in order to minimize its overall exchange rate risk 


1. Hedging Continual Exposure. Consider this common real-world dilemma by many firms that
rely on exporting. Clearlake Inc. produces its products in its factory in Texas, and exports most of
the products to Mexico each month. The exports are denominated in pesos. Clearlake Inc.
recognizes that hedging on a monthly basis does not really protect against long-term movements
in exchange rates. It also recognizes that it could eliminate its transaction exposure by
denominating the exports in pesos, but that it still would have economic exposure (because
Mexican consumers would reduce demand if the peso weakened). Clearlake Inc. does not know
how many pesos it will receive in the future, so it would have difficulty even if a long-term
hedging method was available. How can Clearlake realistically deal with this dilemma and reduce
its exposure over the long-term? [There is no perfect solution, but in the real world, there rarely
are perfect solutions.]
2. Sources of Supplies and Exposure to Exchange Rate Risk. Laguna Co. (a U.S. firm) will be
receiving 4 million British pounds in one year. It will need to make a payment of 3 million Polish
zloty in one year. It has no other exchange rate risk at this time. However, it needs to buy supplies
and can purchase them from Switzerland, Hong Kong, Canada, or Ecuador. Another alternative is
that it could also purchase one-fourth of the supplies from each of the 4 countries mentioned in the
previous sentence. The supplies will be invoiced in the currency of the country where they are
imported from. Laguna Co. believes that none of the sources of the imports would provide a clear
cost advantage. As of today, the dollar cost of these supplies would be about $6 million regardless
of the source that will provide the supplies.
The spot rates today are as follows:
British pound = $1.80
Swiss franc = $.60
Polish zloty = $.30
Hong Kong dollar = $.14
Canadian dollar = $.60
The movements of the pound and the Swiss franc and the Polish zloty against the dollar are highly
correlated. The Hong Kong dollar is tied to the U.S. dollar and you expect that it will continue to
be tied to the dollar. The movements in the value of Canadian dollar against the U.S. dollar are not
correlated with the movements of other currencies. Ecuador uses the U.S. dollar as its local
currency.
Which alternative should Laguna Co. select in order to minimize its overall exchange rate risk?




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