Farah Jeans of San Antonio, Texas is completing a new assembly plant near Guatemala City. A final construction payment of Q8,400,000 is due in six months [“Q” is the symbol for Guatemalan quetzals]. Farah uses 20% per annum as its weighted average cost of capital. Today’s foreign exchange and interest rate quotations are as follows:
Present spot rate: Q7.0000/$
Six-month forward rate: Q7.1000/$
Guatemalan six-month interest rate: 14.00% per annum
US dollar six-month interest rate: 6.00% per annum
Farah’s treasury manager, concerned about the Guatemalan economy, wonders if Farah should be hedging its foreign exchange risk. The manager’s own forecast is as follows:
Highest expected rate: Q8.0000/$, reflecting a significant devaluation
Expected rate: Q7.3000/$
Lowest expected rate: Q6.4000/$, reflecting a strengthening of the quetzal
What realistic alternatives are available to Farah for making payment? Which method would you select, and why?
To analyze the alternative methods available for Farah to make payment, we need to consider the different exchange rates and interest rates involved.
1. Paying in Cash:
The simplest option for Farah is to pay the Q8,400,000 using their available cash at the current spot exchange rate of Q7.0000/$. This means they would need to convert Q8,400,000 to US dollars by dividing it by the spot exchange rate: Q8,400,000 / Q7.0000/$ = $1,200,000.
2. Using the Forward Rate:
Farah could also choose to lock in the exchange rate by entering into a forward contract. The forward rate is Q7.1000/$. With this option, Farah would still need to convert Q8,400,000 to US dollars, but at the forward rate instead: Q8,400,000 / Q7.1000/$ = $1,183,391.96.
3. Borrowing Locally:
Farah could borrow Q8,400,000 at the Guatemalan six-month interest rate of 14.00% per annum and then convert it into US dollars at the current spot exchange rate. After six months, Farah would need to repay the loan with interest in Quetzals. The interest payable would be (Q8,400,000 * 14.00% * 6/12) = Q588,000. At maturity, Farah would need to convert the principal and interest into US dollars at the spot rate: (Q8,400,000 + Q588,000) / Q7.0000/$ = $1,291,428.57.
4. Borrowing in US Dollars:
Farah could borrow the US dollar equivalent of Q8,400,000 at the US dollar six-month interest rate of 6.00% per annum. After six months, they would need to repay the loan with interest in US dollars. The interest payable would be ($1,200,000 * 6.00% * 6/12) = $36,000. The total repayment amount would be ($1,200,000 + $36,000) = $1,236,000.
Which method to select:
The chosen method would depend on Farah's expectations of the exchange rate movements.
- If they expect the exchange rate to strengthen (Q6.4000/$), they might want to delay the payment and use the lowest expected rate. In this case, borrowing locally or paying in cash at the spot rate would be more favorable.
- If they expect the exchange rate to weaken (Q8.0000/$), they might want to lock in the forward rate to avoid potential losses. Using the forward rate or borrowing in US dollars would be more suitable.
Ultimately, the decision depends on Farah's risk appetite and confidence in their own forecast. It is advised to consult with the treasurer or financial advisor to determine the best approach based on the specific circumstances and market conditions.