Forward contracts and options

Pembroke Pulp and Paper Inc. (PPPI) operates a pulp and paper mill that produces and sells newsprint. The primary inputs to production are raw materials, composed largely of wood fibres and recycled materials, as well as chemicals and additives. The company also consumes significant amounts of fuel oil, natural gas, and electricity in its processes. The chemicals and additives are paid for in U.S. dollars.

About 70% of the company’s annual sales are to customers in the United States. Most customer sales contracts are for fixed volumes of newsprint, with the selling price tied to a market price. This is standard for the industry, as many customers will not commit to fixed-price arrangements.

In addition to other debt with fixed interest rates, the company has a short-term line of credit bearing interest at prime plus 2%.

You, CPA, work as an associate with Campbell and Associates LLP, a financial and business advisory firm. PPPI’s board of directors has engaged Campbell and Associates to assist in assessing and managing its risk exposures. It is February 15, 2021, and you have been asked by your boss, Heather Larimer, to assist on this engagement for PPPI.

The board of PPPI wants its specific exposure risks identified and a discussion of the implication of each of these risks. Specifically, for the foreign currency risk, the board would like further analysis on PPPI’s net exposure in U.S. dollars. To assist with this calculation, a forecast of revenues and variable expenses for the next 10 months (March 1 to December 31, 2021) has been provided in Appendix I.

The board is looking at forward contracts and options to manage their foreign currency risk. The CFO of PPPI has been able to obtain quotes from the Bank of Northern Savings for foreign exchange forward contracts and options on U.S. dollars maturing in September 2021 (Appendix II). The board would like a calculation detailing the impact on PPPI’s contribution margin if 75% of the net U.S. dollar exposure is hedged with either the forward contract or the options. A recommendation should be made as to which of these risk management tools should be used for 2021.

Discuss how forward contracts and options can be used as risk management tools to hedge PPPI’s foreign currency exposure.

Discuss how forward contracts and options can be used as risk management tools to hedge PPPI’s foreign currency exposure.