Question

A Colorado company imports copper from The Copper Co., a reliable and long time supplier based in Peru.  Payment is in Peru sol (symbol is "S/"), with a current exchange rate of S/4.00/$; The company is concerned that changes in the exchange rate could have cause its costs to rise. Given that trading partners want to continue their longtime relationship, they agree on a risk sharing arrangement. As long as the spot rate on the date of an invoice is between S/3.50/$ and S/4.50/$, Colorado company will pay in Peru sol based on the spot rate. If the exchange rate falls outside this range, Colorado company will still pay in Peru sol, but will share the difference in the spot rate equally with Peru Copper. The risk-sharing agreement will last for six months, at which time the exchange rate limits will be reevaluated.

Colorado company enters into a contract to buy copper products from The Copper Co. for S/8,000,000 during the next six months. If the exchange rate stayed at S/4.00/$ that would equate to $2,000,000.

Assume the exchange rate is S/3.00/$ (dollar now buys less sol than it did at time of contract) and Colorado company owes 8,000,000 to The Copper Co.

1. How much would Colorado Company owe to The Copper Co. in U.S. dollars without the risk sharing agreement?

2. How much would Colorado Company owe to The Copper Co. in U.S. dollars with the risk sharing agreement?

3. In this scenario, does Colorado company pay more or less with the risk sharing agreement?

Answer 1

1). Without the risk sharing agreement, Colorado company would owe

8,000,000/3 = USD 2,666,666.67 to The Copper Co.

2). The extra amount in USD due to the exchange rate being S3.00/$, is

2,666,666.67 - 2,000,000 = 666,666.67 USD

This amount is equally divided between both companies as per the risk sharing agreement so

Colorado Company will owe 2,000,000 + (666,666.67/2) = USD 2,333,333.33

3). Colorado Company pays less with the risk sharing agreement as it has to pay USD 2,333,333.33 whereas without the agreement, it would have to pay USD 2,666,666.67.