Answer the question - Essay Example

Hedging strategies for Beazley Development plc Question 2 Beazley Development plc is European firm with its operations mainly in the U.S and the European nations. The company is expecting to sell one of their subsidiaries located in the U.S in the month of August, 2015. A value of $10,000,000 is expected to be realized. Since the company is located in Europe, the value released in required to be converted into Sterling (£). The spot exchange rate of $ against each £ is seen to $1.6462. Accordingly the expected realizable value from the sales is seen to be as follows: Value expected to be realised in $$1,00,00,000Spot exchange rate1.

6462Value expected in ££6074596.039 It is expected that the value of dollars might depreciate or weaken in the future as a result of which more dollars are required to be paid for every pound. This might lead to a loss for the firm (Ederington, 1979). In the following table, the expected values are calculated if the dollar values weaken. Cases where hedging requires to be undertaken (Dollar weakens) MarchJuneSeptemberFutures market contract price1.65511.65651.66Value expected to be realised if future prices are expected (£)6041931.

0016036824.636024096.386Value expected on the basis of the spot exchange prices (£)6074596.0396074596.0396074596.039Difference (£)-32665.03822-37771.40912-50499.65382As per the calculations shown above, it can be seen that when the value of dollars weaken, the expected returns are lower. As a result the firm ends up obtaining lower return in Sterling. Hence it can be seen that the returns available in each of month of March, June and September would be low considering the futures market prices in each of these months.

In order to prevent such a situation it is essential that the company undertakes hedging strategy (Stulz, 1984). Under the hedging technique, it becomes possible to conduct the sales at the current spot price, even at the future date. As a result loss due to weakening of dollar values can be prevented. In the above table it can be seen that if the firm sells at the spot price, set as per hedging, the expected realisable values are higher than the expected realisable values as per future rates.

Hence hedging can be stated to be a suitable strategy when the dollar values actually weaken (Nance, Smith and Smithson, 1993). Alternatively it is also shown in the below table, when the company should not adopt hedging strategies. Case where hedging is not required (Dollar becomes stronger) MarchJuneSeptemberFutures market contract price (assumed) 1.631.621.634Value expected to be realised if future prices are expected (£)6134969.3256172839.5066119951.04Value expected on the basis of the spot exchange prices (£)6074596.

0396074596.0396074596.039Difference (£)60373.2857998243.4668145355.00103Hedging is essentially not required. If the dollar values become stronger, that is when lower proportion of dollars are required to be paid against each dollars. In the above table it can be seen that when the firm future market prices are lower than the spot prices, the expected values are higher (Allayannis and Ofek, 2001). As a result the firm earns a profit without undertaking the hedging technique. Therefore the hedging technique must not be undertaken when the future values of contracts are expected to be lower than the spot exchange rates.

Hence it is important to understand what the future contract prices would be in comparison with the sport prices and accordingly determine whether to undertaken hedging techniques or not. When the dollar values are expected to be strong in the future, hedging strategies are usually not required (Bielecki and Rutkowski, 2002). Reference list Allayannis, G. and Ofek, E., 2001. Exchange rate exposure, hedging, and the use of foreign currency derivatives. Journal of international money and finance, 20(2), pp. 273-296. Bielecki, T. R. and Rutkowski, M., 2002. Credit risk: modeling, valuation and hedging.

New York: Springer Science & Business Media. Ederington, L. H., 1979. The hedging performance of the new futures markets. The Journal of Finance, 34(1), pp. 157-170. Nance, D. R., Smith, C. W. and Smithson, C. W., 1993. On the determinants of corporate hedging. The Journal of Finance, 48(1), pp. 267-284. Stulz, R. M., 1984. Optimal hedging policies. Journal of Financial and Quantitative Analysis, 19(02), pp. 127-140.