Outland Steel has a small but profitable export business. Contracts involve substantial delays in...

Outland Steel has a small but profitable export business. Contracts involve substantial delays in payment, but since the company has a policy of always invoicing in dollars, it is fully protected against changes in exchange rates. Recently the export department has become unhappy with this practice and believes that it is causing the company to lose valuable export orders to firms that are willing to quote in the customer\"s own currency. You sympathize with these arguments, but you are worried about how the firm should price long-term export contracts when payment is to be made in foreign currency. If the value of that currency declines before payment is made, the company may suffer a large loss. You want to take the currency risk into account, but you also want to give the sales force as much freedom of action as possible. Notice that Outland can insure against its currency risk by selling the foreign currency forward. This means that it can separate the problem of negotiating sales contracts from that of managing the company\"s foreign exchange exposure. The sales force can allow for currency risk by pricing on the basis of the forward exchange rate. And you, as financial manager, can decide whether the company ought to hedge. What is the cost of hedging? You sometimes hear managers say that it is equal to the difference between the forward rate and today\"s spot rate. That is wrong. If Outland does not hedge, it will receive the spot rate at the time that the customer pays for the steel. Therefore, the cost of insurance is the difference between the forward rate and the expected spot rate when payment is received. Insure or speculate? We generally vote for insurance. First, it makes life simpler for the firm and allows it to concentrate on its main business. Second, it does not cost much. (In fact, the cost is zero on average if the forward rate equals the expected spot rate, as the expectations theory of forward rates implies.) Third, the foreign currency market seems reasonably efficient, at least for the major currencies. Speculation should be a zero-NPV game, unless financial managers have information that is not available to the pros who make the market. Is there any other way that Outland can protect itself against exchange loss? Of course.It can borrow foreign currency against its foreign receivables, sell the currency spot, and invest the proceeds in the United States. Interest rate parity theory tells us that in free markets the difference between selling forward and selling spot should be equal to the difference between the interest that you have to pay overseas and the interest that you can earn at home.