Mike just signed a US$1 million contract to sell small engines to a Slovenian manufacturer. Delivery will take place in 1 month, but he does not expect to receive his payment in euros for 3 months. What are the potential risks? What are some of the ways to mitigate these risks?
What will be an ideal response?
Mike has exposed himself to fluctuations in the value of the accounts receivable. The contract that he signed may or may not deliver US$1 million upon completion in 3 months time depending on the value of the US dollar compared to the euro. If the dollar weakens he will receive less than he had planned for, if it strengthens he will receive more. This could disrupt his profit margin projections and impact whether he makes money on the deal or not.
Mike has several options to protect himself from these risks. He could work with his bank to create a forward contract at the time he signs his deal with the Slovenian manufacturer guaranteeing him US$1 million, no matter what the exchange rate is in 3 months. Though this locks in his exchange rate, he could miss out on potential gains if the dollar strengthens against the euro. If he feels this is the case he could purchase a call option on the euro, which will set a floor for the minimum exchange rate while allowing him the chance to profit if the currency moves in his favor.
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