John Lieberman is the Manager of Foreign Exchange at Chiquita International, a foods company based in Cincinnati, USA. In late 1994 John was concerned with how to finance the growing international trade of his company's subsidiary, Frutas Amazonas, which was located in Iquitos, Peru. Frutas Amazonas exported bananas to North America and to Europe, especially Spain and France.
John was looking at ways to fund the exports of Frutas Amazonas to Spain, the subsidiary's biggest market in Europe. These sales were invoiced in Spanish pesetas. Currently, the Peruvian unit had Pta500,000 worth of receivables due in 3 months. In the past, these had been financed in U.S. dollars, partly because dollar rates had been much lower than Spanish interest rates. Now, however, with U.S. rates rising and Spanish rates lower, Lieberman thought peseta funding might be the more attractive approach, particularly given the exchange risk involved in funding peseta receivables with U.S. dollars.
So now he was considering three possibilities:
1. Continue funding in U.S. dollars. Given his economist's forecast that the peseta might get stronger in the next three months, from $1=128 pesetas to $1=126 pesetas, this could be the cheapest
2. Switch funding to pesetas, despite the slightly higher cost
3. Borrow in dollars, but hedge the exchange risk in the forward market.
How should he evaluate these choices? He had only the following information (for three month loans):
|Eurodollar 3-month loan rate||5 9/16%|
|Europeseta 3-month loan rate||7 15/16|
|Spot exchange rate today||Pta128.210 per USD|
|3-month forward rate||Pta129.005 per USD|
|Forward discount, % per annum||-2.5|
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