XYZ Ltd., an Indian company engaged in both export and import business, has secured a service contract in the United States. Under the terms of the…

(a) (i) I do not agree with the view of the Head of the Treasury Department.The expected forward exchange rates indicate that the Indian Rupee is likely to appreciate against the US Dollar over the coming months. In the case of the company's import payment, an appreciation of the Rupee would be beneficial, as fewer Indian Rupees would be required to settle the USD liability. Therefore, leaving the import exposure unhedged may enable the company to benefit from the expected appreciation of the Rupee.However, the present case relates to an export receivable denominated in US Dollars. If the US Dollar continues to depreciate against the Indian Rupee, as suggested by the expected forward rates, the amount ultimately received in Indian Rupees will be lower than the amount that could be realized at the current spot exchange rate. Consequently, leaving the export receivable unhedged would expose the company to the risk of an adverse exchange rate movement and a reduction in its INR realization.(ii) Two suitable hedging strategies for managing the foreign exchange risk in the given scenario are as follows:(a) Rolling Forward Hedge: Since a single forward contract for a continuous period of 18 months is not available, the company may adopt a rolling forward hedge by successively entering into six-month forward contracts until the date of receipt.(b) Money Market Hedge: The company may also hedge its foreign exchange exposure by using a money market hedge, involving borrowing, investing, and converting funds in the respective money markets to lock in the value of the future foreign currency receivable.(iii) To determine the most appropriate hedging alternative for the company, the amount receivable in Indian Rupees after 18 months under each hedging strategy should first be computed, as follows:(a) Rolling Forward HedgeAs on dateXYZ Ltd. will enter into a 6-month forward contract to sell USD @ of INR 91.90.After 6-monthsXYZ Ltd. will cancel the existing forward contract to sell USD at INR 91.90 by offsetting it at the prevailing spot buying rate and simultaneously enter into a fresh six-month forward contract to sell USD at the forward rate of INR 91.60.Profit on Cancellation of Forward ContractSelling of USD as per Contract RateINR 91.90Buying of USD as per Spot RateINR 91.70Profit on Cancellation of Contract per USDINR 0.20Amount of ContractUSD 1000000Total ProfitINR 200000After 12-monthsXYZ Ltd. will cancel the existing forward contract to sell USD at INR 91.60 by offsetting it at the prevailing spot buying rate and simultaneously enter into a fresh six-month forward contract to sell USD at the forward rate of INR 90.90.Profit on Cancellation of Forward ContractSelling of USD as per Contract RateINR 91.60Buying of USD as per Spot RateINR 91.50Profit on Cancellation of Contract per USDINR 0.10Amount of ContractUSD 1,000,000Total ProfitINR 100,000After 18-monthsXYZ Ltd. will make delivery as per the contact rate of INR 90.90 per USD and accordingly overall receipt of amount in INR shall beDelivery of USD as per Contract Rate per USDINR 90.90Amount of ContractUSD 1,000,000Amount receivedINR 90,900,000Add: Profit on cancellation of contract after 6-monthsINR 200,000Add: Profit on cancellation of contract after 6-monthsINR 100,000Total Amount receivedINR 91,200,000(b) Money Market HedgeBorrow USD sterling for 18-months. The borrowing has to be such that at the end of 18-months, the amount becomes USD 1 Million, Say, the amount borrowed is USD x. Thereforex (1 + 0.07/2) = USD 1,000,000 or x = USD 901,943or x [1 + 0.07] [1 + 0.07] = USD 1,000,000 or x = USD 902,975Convert the borrowed sum into rupees at the spot rate. This gives a sum of:USD 901,943 × INR 92 = INR 82,978,756 or USD 902,975 × INR 92= INR 83,073,700The sum thus obtained is placed in the money market at 6.20 per cent to obtain at the end of 18-months:S = INR 82,978,756 × (1 + 0.064/2) = INR 91,202,346Or INR 83,073,700 x [1 + 0.064] × [1 + 0.064/2] = INR 91,218,910The sum of USD 1 Million received from the client at the end of 18-months is used to refund the loan taken earlier.Advice: Since the total amount receivable under both hedging alternatives is almost identical, either of the two strategies may be recommended to XYZ Ltd. for hedging its foreign exchange risk.However, the Money Market Hedge is the more preferable alternative, as it involves fewer transactions and lower operational complexity compared with the Rolling Forward Hedge, which requires the company to repeatedly cancel and renew forward contracts at regular intervals.Note: Alternatively, interest accumulation at Deposit Rate on profit under Rolling Forward contracts can also be considered