Zaz plc, a UK Company is in the process of negotiating an order amounting €2.8 million with a large German retailer on 6 month's credit. If…

CA Final · Advanced Financial Management · MTP · May 2025
Zaz plc, a UK Company is in the process of negotiating an order amounting €2.8 million with a large German retailer on 6 month's credit. If successful, this will be first time for Zaz has exported goods into the highly competitive German Market. The Zaz is considering following 3 alternatives for managing the transaction risk before the order is finalized. (i) Mr. Peter the Marketing head has suggested that in order to remove transaction risk completely Zaz should invoice the German firm in Sterling using the current €/£ average spot rate to calculate the invoice amount. (ii) Mr. Wilson, CE is doubtful about Mr. Peter's proposal and suggested an alternative of invoicing the German firm in € and using a Forward Contract to hedge the transaction risk. (iii) Ms. Karen, CFO is agreed with the proposal of Mr. Wilson to invoice the German first in €, but she is of opinion that Zaz should use sufficient 6-month Sterling Future contracts (to the nearest whole number) to hedge the transaction risk. Following data is available Spot Rate € 1.1960-€1.1970/£ 6-months forward points 0.60-0.55 Euro Cents. 6-month Future contract is currently trading at € 1.1943/£ 6-month Future contract size is £62,500 After 6-month Spot rate and Futures rate € 1.1873/£ You are required to (A) Calculate (to the nearest £) the £ receipt for Zaz plc, under each of 3 above proposals. (B) In your opinion which alternative you consider to be most appropriate.

Suggested Answer and Working Notes:

(a) Receipt under three proposals (i) Proposal of Mr. Peter Invoicing in £ will produce = € 2.8 million / 1.1965 = £ 2.340 million (ii) Proposal of Mr. Wilson Forward Rate = € 1.1970 - 0.0055 = 1.1915 Using Forward Market hedge Sterling receipt would be = € 2.8 million / 1.1915 = £ 2.35 million (iii) Proposal of Ms. Karen The equivalent sterling of the order placed based on future price (€1.1943) = € 2.8 million / 1.1943 = £ 2,344,470 (rounded off) Number of Contracts = £ 2,344,470 / 62,500 = 37 Contracts (to the nearest whole number) Thus, € amount hedged by future contract will be = 37 × £ 62,500 = £ 23,12,500 Buy Future at € 1.1943 Sell Future at € 1.1873 € 0.0070 Total loss on Future Contracts = 37 × £ 62,500 × € 0.0070 = € 16,188 After 6 months Amount Received € 28,00,000 Less: Loss on Future Contracts € 16,188 € 27,83,812 Sterling Receipts On sale of € at spot = € 27,83,812 / 1.1873 = £ 2.3446 million (B) Proposal of option (ii) is preferable because the option (i) & (iii) produces least receipts. Further, in case of proposal (i) there must be a doubt as to whether this would be acceptable to German firm as it is described as a competitive market and Zaz is moving into it first time.

Topics: Foreign Exchange Exposure and Risk Management

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