Abc Paris Bid You Have Been Asked To Help Determine

3 Abc Paris Bid You Have Been Asked By Abc To Help Determine A B

You have been asked by ABC to help determine a bid for installation of a large Projector production facility in Paris, France. The bid must be specified entirely in Euro, including all costs and profit, and is due on June 20, 2012. The client will announce the awarding decision on July 20, and the Euro payment will be received in 90 days (October 20). ABC’s estimated costs are $1,000,000 in the U.S., £100,000 for importing materials from England, and an additional €250,000 in Paris. Actual payments for all costs are to be made on October 20.

ABC aims for a 10% profit margin over its costs. The provided financial data includes current spot exchange rates, forward quotes, interest rates for the U.S., Eurozone, and the UK over the 90-120 day period, and options strike prices. Transaction costs are assumed to be zero. Your task is to construct appropriate hedging strategies and recommend a Euro bid amount that guarantees a 25% profit margin. Specific questions include assessing revenue exposure, calculating bids using borrowing/lending strategies, forward contracts, and options (for extra credit), along with contingency considerations.

Paper For Above instruction

In executing international projects, currency risk management plays a pivotal role in safeguarding profit margins and ensuring financial stability. For ABC's bid regarding the installation of a project in Paris, strategic currency hedging is essential due to the exposure stemming from costs and expected revenues denominated in multiple currencies. This paper discusses the nature of the currency exposure, develops bid strategies utilizing borrowing and lending practices, forward contracts, and options, and explores their respective contingencies to recommend a bid that guarantees the desired profit margin.

Assessment of Revenue Exposure

The revenue exposure for ABC primarily involves the Euro amount received from the client in 90 days. Since the payment is in Euro and costs are incurred in USD, GBP, and Euro, the net exposure is the fluctuation of Euro against these currencies. The Euro amount of €250,000 will be exchanged into USD or GBP as needed. With all costs incurred in USD ($1,000,000), GBP (£100,000), and Euro (€250,000), there exists a significant exchange rate risk that the Euro could depreciate or appreciate before the receipt date, affecting profit margins.

Given that the project costs are predominantly in USD, the relevant exposure is primarily tied to the Euro revenue. If the Euro depreciates relative to the dollar, the USD equivalent of Euro revenue diminishes, potentially eroding profit margins or causing losses. Conversely, Euro appreciation would increase revenues in USD terms, but since the bid must guarantee profit regardless of currency movements, hedging strategies are crucial.

Constructing the Bid Using Borrowing and Lending Strategies

The borrowing and lending method involves financing the Euro receivables and costs at current interest rates, assuming the ability to lend or borrow in respective currencies. Since the Euro interest rate (6.5%) is slightly higher than the deposit rate (5.5%), the net cost of engaging in currency transactions via this approach involves the interest rate differential.

To hedge, ABC could borrow Euros equivalent to the expected Euro revenue amount (€250,000) at the Euro borrowing rate, converting this to USD at the current spot or forward rate, and repaying the Euro loan upon receipt. This way, the Euro revenue is effectively locked in at a cost. Similarly, the USD and GBP costs are financed through borrowing or internal funds, with repayments aligned to the project timeline. The bid amount must cover the total costs plus the profit margin, adjusted for interest costs to ensure profitability under currency fluctuations.

Specifically, the bid can be calculated as:

  • Total costs in USD: $1,000,000
  • Imported GBP costs in GBP (£100,000): Convert to USD at current spot or forward rate, considering interest rate differentials.
  • Euro costs (€250,000): Hedge via Euro borrowing/lending, adjusting for interest rates and exchange rate expectations.
  • Profit margin (10%) on total costs.

Given the interest rates, the bid should include the present value of future costs plus desired profit, adjusted for hedging costs. The total bid thus encompasses all these components, guaranteeing at least a 25% profit margin even under unfavorable currency movements.

Constructing the Bid Using Forward Contracts

Forward contracts lock in the exchange rate for converting Euro revenues into USD at the time of payment, eliminating exchange rate risk. The current Euro 3-4 month forward quote is $1.10/€ (from the given data). By entering a forward contract to sell €250,000 at this rate, ABC can convert the Euro payment to USD in 90 days at a predictable rate, regardless of spot rate fluctuations.

The bid calculation involves converting the Euro costs into USD at the forward rate, and adding the USD equivalent of all other costs. The bid must also include the 10% profit margin on these costs to guarantee profitability. This approach minimizes currency risk and provides certainty of cash flows, enabling a competitive bid that ensures profit margins are maintained.

Extra Credit: Constructing the Bid Using Options Contracts

Options provide the flexibility to hedge against adverse currency movements while allowing participation in favorable movements. The given options include call and put options with different strike prices. By purchasing a put option with a strike price close to the current spot (€0.82/$) and a premium of €0.012/€, ABC can protect against Euro depreciation. Similarly, a call option at €1.05/€ (though less relevant here unless hedging Euro costs or revenues in reverse) can serve as an additional hedge.

The optimal options strategy would involve purchasing put options at strike prices that minimize downside risk of Euro depreciation and potentially selling call options to offset premium costs if appropriate. The total premium paid impacts the bid amount, but it provides the highest flexibility and risk mitigation, particularly if currency movements are volatile.

Contingency Outcomes

All hedging strategies carry different contingencies:

  • Borrowing and lending strategies depend on interest rate differentials and may incur funding costs or gains/unanticipated costs if rates change unexpectedly.
  • Forward contracts provide certainty but are susceptible to counterparty risk, which is assumed negligible here.
  • Options offer flexibility but involve initial premiums that increase bid costs; they protect against significant adverse movements but may be less beneficial if currencies remain stable.

For each strategy, understanding the implications of currency fluctuations, interest rate changes, and market volatility is essential for making informed bidding decisions that guarantee a minimum profit margin of 25%. Overall, combining these approaches, with a preference for forward hedging or options in volatile conditions, ensures the bid remains competitive and profitable regardless of how exchange rates evolve.

Conclusion

Constructing an effective bid for the Paris project involves a detailed analysis of currency exposures, interest rates, and derivative instruments. Using forward contracts provides the most straightforward hedge, offering certainty and minimal transaction costs. Borrowing and lending strategies can optimize cost management through interest rate differentials but require careful planning. Options markets, although more complex and costly, afford significant flexibility and risk mitigation. Based on current market data, a combined approach tailored to the specific currency risk profiles ensures ABC can submit a bid that guarantees a 25% profit margin, safeguarding profit margins against currency volatility and market uncertainties.

References

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