Machinery International (B) Harvard Case Solution & Analysis

Machinery International (B) Case Solution

Introduction

The case talks about the exposure of foreign currency risk in relation to the Machinery International Company and provide discussion on the various alternatives available with it for hedging purpose. Machinery International is a US based Multinational Corporation that supplies electronic products all over the world with the help of its subsidiaries located in a number of foreign countries.

The vice president of the company, Thomas Matthews after reviewing the two standards relating to the accounting requirement for a derivative instructed his assistant to generate a report which could cover the different possible hedging and derivatives options for the company using an illustrative example. Jim Taylor by considering the royalty payments of a subsidiary to its parent company generated an illustrative example which covers the hedging solution which could be mitigated against the translation risk.

1.     Why would Machinery International enter into the forward exchange contract?

Machinery International is required to enter into the forward exchange contract in order to hedge against the translation risk. The company is a multinational corporation where its head office is located in United States and the subsidiaries in the number of foreign countries. The company expects to receive royalty payments from its subsidiaries on a time to time basis which is exposed to the change in foreign currency. From the report of Jim Taylor, it can be seen that a royalty payment is being made to Machinery International through an inter-company foreign currency denomination.

The hedging could result in the mitigating the currency exposure when converting its royalty payment of its subsidiary from British Pound to US dollar. In the case if the dollar is appreciated then the company could face losses. Therefore, the company is interested in considering a forward contract by locking the spot rate at January 1, 2001 which could help the company significantly. In addition to this, the other benefit of considering the forward contract is that it can be customized according to the requirement of the company unlike the future contract which is fixed.

From the perspective of Machinery International, the contract is completely according to the requirement since the company is confident that the value of dollar will going to appreciate in the future moreover by using the properties of a forward contract the company can easily customize it according to its royalty payment from its subsidiary.

2.     Is the forward exchange contract a derivative?

Forward exchange contract are basically the foundation for all the different types of derivatives. It provides the privacy for both the buyers as well as the sellers by meeting their demands in a customizable way. From the definition of a derivative as taken from Financial Accounting Standard FAS 133, it can be seen that the derivative instrument is the one which satisfy the following three characteristics:

  1. It is based on the value of the underlying asset
  2. No initial investment is required
  3. Requirement of net settlement

In the given case, by looking at the forward exchange contract all the essential requirements of a derivative is met according to the Financial Accounting Standard FAS 133, the underlying asset is the Royalty Payments which is made by the subsidiary to its parent company. In the given situation, the subsidiary is in a currency of British Pound whereas the parent company’s currency is US dollars.

Notional amount in the given case is BP 1,000,000. It can be seen from the overall situation that the contract does not require any initial investment which satisfy the definition of a derivative instrument. Lastly from the underlying asset which is Royalty Payment is liquid in nature which satisfies the last requirement of net settlement of Derivative. Therefore, it can be concluded that the Forward Exchange Contract is a Derivative...................

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