Hedging a commitment with an option. Wellington Manufacturing manufactures industrial ovens used primarily in the process of coating or painting metals.
The ovens are sold throughout the world, and units are manufactured to customers’ specifications. On June 15, the company committed to sell two ovens to a major transnational customer. One of the ovens has a selling price of $549,600 and is to be paid for with foreign currency A (FCA). The other unit has a selling price of $297,975 and is to be paid for with foreign currency B (FCB). Both units were shipped, FOB shipping point, on September 15, and payment is due within 30 days of shipment. In order to hedge against exchange rate risks, Wellington acquired two put options on June 15 with notional amounts equal to the respective foreign currency selling prices. The options expire on October 15, and customer remittances are also received on October 15. Relevant information concerning the options and exchange rates is as shown:
1. Assuming that the time value of the options is excluded from the determination of hedge effectiveness, determine the gain or loss to be recognized on each of the commitments. The firm commitment is measured based on changes in the spot rate over time.
2. Assuming that the costs of the FCA unit and the FCB unit are $440,000 and $235,000, respectively, calculate the gross profit margin on each of the units that would have been experienced with and without the hedge.