Art plc (Art) is a HK soft drinks manufacturer that imports oranges from Spain. The oranges are the main ingredient in all of Arts product range. The Managing Director has suggested that the company could avoid hedging costs and thereby increase profits by settling these transactions at the spot exchange rate. The Finance Director thinks that this is a risky strategy and has argued that all foreign currency transactions should be hedged however she cannot decide whether a forward contract or a money market hedge would be the best way to do this.

The next shipment of oranges is due to be delivered and has an invoice value of Euro 5m. The Spanish supplier gives Art three months credit from the date of delivery.

The following information has been provided in order to evaluate the views of the two directors: Current spot exchange rate: 0.1100 0.1105 Euro/HK$ 3-month future exchange rate: 0.1110 0.1115 Euro/HK$

Euro deposit rate: 3% per annum HK deposit rate: 2% per annum

Inflation in Eurozone 1.5% per annum Inflation in HK 1% per annum

Art currently has a cash surplus of HK$50m.

Required:

a) Evaluate the two different hedging techniques being considered by the Finance Director to cover this transaction. b) Compare and contrast the theories of Purchasing Power Parity and Interest Rate Parity and using the figures in the question calculate the expected future spot rate using each of these theories. c) Using the answers above evaluate the differing views of the two directors.

(Total: 20 marks)