Page 11 - SCS May 2018 - Day 2 Suggested Solutions

SUGGESTED SOLUTIONS

power. Therefore it would depend on the volume of content Couchweb purchase. In addition
Couchweb may have to accept a higher price from such suppliers, as they are compensating for
having to take the exchange rate risk. Finally, it would also mean that Couchweb may not benefit
from any upside in the exchange rate.

The most popular method of external hedging is using forward contracts. This would allow
Couchweb to fix the exchange rate that it would use in the future. It would give complete
certainty over the payment Couchweb would have to make, however it would take away upside
potential.

Couchweb could also simply exchange money into the currency required, open a bank account in
that currency and earn interest in that account until the payment is due. This is a called a money
market hedge (MMH). It takes away currency risk as the money exchange is done immediately.
Many companies will hold cash in a foreign bank account for convenience, especially if that
currency is used frequently. For instance, Couchweb may decide to do most of its business in a
“third currency” such as the US$. Other than the fact that its suppliers may not be based in US$
denominated countries, the ease of using a third currency and the netting opportunities it
presents can make it very convenient.

Couchweb could use an exchange to set up futures or options. Futures are similar to forward
contracts as they enable Couchweb to fix the future value of a transaction. However, by doing so,
just as with forward contracts, Couchweb would not be able to take advantage of any upside
change to the exchange rate. Taking out an option would allow Couchweb to choose the
financially best outcome on the day of payment/receipt: the result offered through exercising the
option or just using the prevailing market exchange rate. This offers Couchweb the “best of both
worlds” as it can choose what is best when the credit period comes to an end. However, options
carry an expensive non-refundable set up cost when they set up earlier in the credit period, which
can in some instances outweigh the advantage of setting up such a hedge.

Economic risk

Whereas with transaction risk the invoice amount for payment/receipt is known, economic risk
covers the long term currency exposure Couchweb may have due to its global presence.

For instance, let’s say that Majik Media are based in the USA and Couchweb has regular payments
to make in US$ as it has various contracts with them for different programmes and movies. It
expects to have to pay these for several years, although the exact amount is likely to vary over a
five year period as deals end and new contracts are set up. Couchweb knows that it will have to
exchange H$ into US$; however, it does not know what the long term currency movement may be
(is the H$ likely to appreciate/depreciate?). Nor does it know the exact amount they are paying in
future years (making it more difficult to hedge). This form of currency risk is known as economic
risk.

Economic risk can also affect Couchweb in another way: competitiveness. It will set subscription
prices in advance based on its pricing model. The costs may be increasing due to exchange rate
changes and therefore payments to suppliers, so Couchweb would also like to increase its
subscriber prices. Competitors that are dealing with suppliers and currencies less affected by
exchange rates may be able to charge less. Couchweb may need to decide whether to reduce its
margins in order to compete.

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