Baker Adhesives is trying to venture into international markets. It has found a new client, Novo, Situated in Brazil. However, Novo is willing to pay all the money in the local currency real. Doug Baker is getting worried about the exchange rate risks posed by the sale as the payment is destined to be at a future date. Doug baker wants to use some options dictated by his banks. However, Doug wants to discover whether it would be beneficial for Baker, in dollar terms, to cater to these options or not. Currently, Baker adhesives can either use a hedge in the forward or the money market.
PV of expected cash flows
Hedging using forward market
Hedging with money market
How profitable is the original sale to Novo once the exchange-rate changes are acknowledged? How might the exchange-rate risk, which affected the value of the order, have been managed?
Assuming Baker agrees to the new Novo sale, determine the present value of the expected future cash inflow assuming: (1) there is no hedge, (2) the company hedges using a forward contract, and (3) the company hedges using the money market. Finding a present value is necessary for the following reason: With no hedge or a with forward-contract hedge, the cash flow will occur at the time of payment by Novo. With the money-market hedge, Baker receives a cash flow immediately.
Are the money markets and forward markets in parity?
How profitable will the follow-on order be? Would you make this new sale?