Financial Risk Manager Part 1
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A Canadian company harbors an ambitious plan to launch a project in the U.S. in twelve months. The company uses the Canadian dollar as the functional currency, and the project would most likely be executed in U.S. dollars. However, the company's top management is worried that the CAD will weaken against the USD in the months leading up to the beginning of the project, which might, in turn, increase the amount the company will have to pay for the project. As the company's risk manager, which of the following business strategies would work best regarding the foreign exchange risk?
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A
Launching the project earlier than planned.
B
Take a hedging position in the form of a currency futures contract.
C
Advise the company to purchase stock index futures.
D
Immediately pay for some upfront costs of the project.
Explanation:
Explanation
The correct answer is B - Take a hedging position in the form of a currency futures contract.
Why Option B is Correct:
- A lot can change in 12 months. If the USD appreciates significantly against the CAD, the project will become more expensive, and its internal rate of return will decrease.
- To hedge that risk, the company could take a position in a currency futures contract to lock in the value of the CAD versus the USD.
- Currency futures contracts are specifically designed to hedge foreign exchange risk by allowing companies to fix exchange rates for future transactions.
Why Other Options are Incorrect:
Option A is incorrect: Launching the project earlier than planned may help for some time but the company will still suffer when the CAD depreciates over the USD. This doesn't address the fundamental currency risk.
Option C is incorrect: Purchasing stock index futures is used to hedge against the risk of fluctuation in market prices, not currency risk. Stock index futures are unrelated to foreign exchange movements.
Option D is incorrect: Paying for some upfront costs of the project immediately may reduce future costs however, the company will still suffer from the effects of the currency depreciation. This approach doesn't provide comprehensive protection against currency fluctuations.
Key Risk Management Insight:
The company faces transaction exposure - the risk that currency movements will affect the cost of future cash flows denominated in foreign currency. Currency futures provide an effective hedge by allowing the company to lock in an exchange rate today for a future transaction.
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