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Risk ManagementSection BRisk ManagementForeign Exchange RiskCurrency Options

ACCA · Question 28 · Risk Management

Section B - Case 3: LithiumX

Scenario: LithiumX is a cross-border mining company based in the US. It expects to receive €2,000,000 in exactly 3 months from a European client.
Spot exchange rate: €1.1500 - €1.1550 / $1
3-month forward rate: €1.1600 - €1.1640 / $1
US interest rates: 4% borrow, 2% deposit (annual)
Euro interest rates: 5% borrow, 3% deposit (annual)

LithiumX is also bidding on a new contract in Japan. If they win the contract, they will receive ¥500 million in 6 months. If they lose, they receive nothing. The contract award date is in 1 month.

Question: Which hedging instrument is most appropriate for the potential Japanese Yen receipt?

Answer options:

A.

Forward Contract

B.

Money Market Hedge

C.

Currency Option

D.

Currency Swap

How to approach this question

Identify the nature of the cash flow. It is contingent (uncertain). Forward contracts and money market hedges are binding. Options provide flexibility for uncertain cash flows.

Full Answer

C.Currency Option✓ Correct
Because the receipt of the ¥500 million is contingent on winning the contract, LithiumX faces uncertainty. If they use a forward contract or money market hedge, they are legally bound to deliver Yen. If they lose the contract, they would have to buy Yen on the spot market to fulfill the hedge, exposing them to massive risk. A currency option gives them the right, but not the obligation, to sell Yen. If they lose the bid, they simply let the option lapse (losing only the premium paid).

Common mistakes

Selecting a forward contract because it is the most common hedging tool, ignoring the 'contingent' nature of the cash flow.
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