Question

Dealeo Foods Inc. purchases vitamins from a supplier abroad. The invoices received by Dealeo are denominated in the foreign currency. Dealeo understands that fluctuations in foreign currency exchange rates may adversely affect the company’s earnings. The CFO of Dealeo wants you to investigate derivative instruments and determine whether or not the use of a foreign currency forward contract or foreign currency options is best to hedge the company’s exposure to foreign currency exchange risk.

REQUIRED:

Suppose you chosed any country other than the US...

1. Draft a memo to explain to the CFO the advantages and disadvantages of using a foreign currency forward contract and foreign currency options for hedging. Based on the history of the exchange rates, how might these options impact Dealeo?

2. Make a recommendation on the hedging instrument that you believe the company should use. Justify/support your recommendation.

NOTE: Please cite any sources used, FASB Codification and any other sources.

Answer 1

1. Foreign Currency forward forward contract is an effective method for hedging and protect against the risk of foreign currency exchange. It has certain advantages as follows :

• Firms can buy now and pay later for the purchase.
• The current exchange rate can be locked in for the future period.
• Exposure can be hedged and risk can be minimized.
• It is very simple and inexpensive to manage and maintain.

Disadvantages of forward contract foreign currency :

• The party would not enjoy the gains if the currency fluctuates and moves in their favor.
• Capital is tied in small capital required at the time of locking.

2) Dealeo can go for Back-to-Back hedging where any open position can be immediate;ly closed by purcahsing the commodity at the spot price. So Dealeo would buy sufficient amount of vitamins from the supplier before the customer comes in and satisfy the requirements of the customer.