CASE on EXCHANGE RATE RISK MANAGEMENT

Hofflander INDUSTRIALS

(copyrighted:)

When Ted Bush entered his office on Saturday, April 10, 200x, he received an email indicating the acceptance of his firm’s offer to supply Jerry Martin, a Swiss distributor, with approximately a little more than US$1,000,000 of electrical equipment in the form of remote controls for industrial garage door openers (payable in Swiss francs). The mail also indicated that Mr. Martin would wire the required deposit of SF100,000 directly to Hofflander Industrials’ Houston bank that day. With stagnant sales recently, this was the best news Martin got in quite some time.

Bush, president and owner of Hofflander Industrials, had been working hard to return the firm to profitability and hoped exports would provide the firm with that impetus. His firm had been doing very poorly caused by a downturn in the local economy and his failure to find new business at home. Given the decline in the construction of industrial buildings and warehouses, business for remote controls had been very sluggish. To use idle capacity, Bush decided to develop an export market. So far, he had made some export sales but mostly these were small orders and the sales were all denominated in U.S. dollars.

Encouraged by help from the Texas Chamber of Commerce, he joined a group of businessmen in January, accompanying the Governor to drum business in Switzerland. He met Jerry Martin in Zurich, who indicated an interest in becoming the Swiss distributor if costs were reasonable and invoicing was done in Swiss francs rather than U.S. dollars. He asked Bush to prepare a firm offer.

On January 12, 200x, Bush offered to sell Martin a shipment of industrial garage door openers for SF 1,225,000. The offer requested the following payment schedule:

SF 100,000 as cash down payment at the time the offer was accepted by Martin;

SF 500,000 to be paid three months after the offer was accepted by which time half the

                   order would have been shipped.

SF 625,000 to be paid in six months after the offer was accepted, by which time the

                    remainder of the order should have been shipped.

Bush called his bank to check Martin’s credit rating and was told that his rating and business were very well respected in Switzerland and so Bush decided not to request any letter of credit (LC) guaranty beyond the initial down payment. Bush arrived at the price of SF 1,225,000 by first pricing the order in dollars on January 12 and then basing it on the spot exchange rate on January 12 – SF1.2027 per dollar. He estimated his costs on the assumption that export costs would run nearly the same as for existing domestic sales.

When Bush received the acceptance of the order on April 10, he noted that the dollar had already weakened against major currencies and that day the Swiss franc was trading at SF 1.1527 per dollar. He figured that at that rate his order of SF 1,225,000 was worth $1,062,722, nearly $44,200 more than when the bid was made, He was happy but wondered whether things could reverse course when he receives future payments in Swiss francs in three and six months respectively. In making the offer to Martin, Bush had not allowed himself a big profit margin and wondered if he could lose money if Swiss francs depreciate rather than appreciate.

On April 10, Bush decided to consult his bank and ask for advice about foreign exchange risk. His banker, Ms. Lewis, suggested several courses of action:

1. Remain uncovered and do nothing. If the Swiss franc does go back to the January 12 levels, he still would not lose a lot of money.
2. Cover the exposure in the forward exchange market.
3. Cover the exposure in the futures market.
4. Cover the exposure in the options market.
5. Cover in the money markets.

She suggested that while the final expense could not be determined in all outcomes before-hand, their outcomes could be simulated over a range of potential ending exchange rates when Swiss franc receipts arrive on July 10 and October 10, respectively. Of course, if cash inflows in francs could be matched by outflows in francs, the problem of hedging through derivatives would not be an issue. The alternatives are:

1. Remain uncovered: While this means waiting until the sales proceeds were received, it offered the maximum risk but also the greatest potential gain if the dollar weakens vis-à-vis the franc as it did from January to April. However, over the same time period, Ms. Lewis showed Bush that the Swiss franc had ranged from SF 1.1442 to SF 1.3290 per dollar. If the SF declines to SF 1.30 on July 10 and October 10, the two future SF proceeds will amount to $384,615 and $480,769. However if the SF appreciates to SF 1.12 per dollar, the corresponding proceeds would be approximately $446,429 and $558,036 respectively. The rates over the last six months have fluctuated as follows:

October 10                  SF 1.3290                              

October 20                  SF 1.2900                              

October 30                  SF 1.2850                               

November 10              SF 1.3100                              

November 20              SF 1.2200                              

December 30               SF 1.2100                             

December 10               SF 1.2800                             

December 20               SF 1.1700                             

December 30               SF 1.1800

January 10                   SF 1.2027

January 20                   SF 1.2277

January 30                   SF 1.2577

February 10                SF 1.2827

February 20                 SF 1.3011

February 29                 SF 1.2411

March 10                     SF 1.2117

March 20                     SF 1.1817

March 30                     SF 1.1770

April 10                       SF 1.1527

1. Cover in Forward Exchange Rates:  If Bush were risk averse and wished to eliminate currency exposure, he could buy forward contracts from the bank. Ms. Lewis explained to him that in a forward contract, one agrees to buy or sell foreign currency at a predetermined price with delivery to be made at a specified date in the future up to one year later. It would assure Bush of a fixed number of dollars at a price locked in today with the bank. Ms. Lewis looked at her screen and quoted her a three month forward rate of SF1.1377 per dollar and a six month forward rate of SF1.1277 per dollar, which meant more dollars in the future than at present.

1. Cover in the futures market: On Bush’s insistence of alternate choices, Ms. Lewis showed him her computer screen focusing on futures contracts. She explained to him and pros and cons of using the futures contracts vis-à-vis the forwards. She mentioned the fact that if his shipment was delayed and the corresponding SF payments delayed as well, the forward contract would create problems for Martin. The futures traded on CME on April 10 (spot rate SF1.1527/$) showed the following quotes for Swiss francs in cents per SF:

Swiss Franc (CME) – Francs 125,000 francs: $ per franc

                                     Open          Close        Change

September                   0.8440        0.8518       +0.0078

December                    0.8677        0.8702       +0.0025         

She explained to Bush that to use the futures market, he would have to open an account with a broker and tie up some funds in a margin account. This would then be debited or credit due to daily marking to the market. If his account fell, he could get margin calls but he could also withdraw money from the margin account if the account had a balance exceeding the required maintenance margin. Work with settle prices (day’s close price).

1. Cover in the options market: Ms. Lewis also pointed out to Martin the advantages of buying an insurance policy in the form of OTC options contracts, available from the bank itself. She explained that while options are traded on the Nasdaq OMX Stock exchange, she could arrange an option contract tailored to meet Bush’s customized requirements and asked her derivatives desk to show the various possibilities to Bush. She also explained the pros and cons of using options and futures to hedge.

Trade Date: April 10, 200x:

                         Amount SF 500,000                              Amount SF625.000                 

                       Expiration date: July 10              Expiration date: October 10

Strike price          Call               Put                           Call                   Put 

 0.865             $0.0145/SF     $0.0089/SF               $ 0.0165/SF          $0.0100/SF

 0.870             $0.0115/SF     $0.0119/SF               $ 0.0135/SF          $0.0140/SF

 0.875             $0.0105/SF     $0.0129/SF               $ 0.0115/SF          $0.0160/SF

1. Cover in the Money Market: As if Bush was not confused already, Ms. Lewis laid out a five option to him. She said that her bank could arrange for Hofflander Industrials to borrow Swiss francs from its Swiss or New York office. The loan would be in the form of an overdraft in Swiss francs and would be at a fixed rate for both three-month and six-month maturities at 100 basis points above Swiss franc LIBOR. She again went to her computer screen and found the following quotes for SF LIBOR and $ LIBOR on April 10.

                                                         3 months               6 months

SF LIBOR:                                        2.6%                        3.0%

$   LIBOR                                          3.4%                        3.8%

Bush mentioned to Ms. Lewis that since he had not done well in business over the last six months of the recession, he would need money for working capital to finance the production of the product over the next six months. He figured he needed $450,000 for working capital. Ms. Lewis told him that given his low credit rating presently and the credit crunch in the market due to the recession, the cost of borrowing $450,000 for working capital might cost him 150 basis points over the six month $ LIBOR. Ms. Ray told him that she could not promisebut given his past business relationship with the bank, she could arrange for a six month $ loanat 5.3% (which is 150 basis points over the six month LIBOR of 3.8%). She could also arrange to invest his money at the $ LIBOR in London if he so chose.

Other Considerations: Ms. Lewis converted the down payment of SF100,000 at the spot rate of SF1.1527 to net him approximately $86,753 in cash. These funds could be used to finance his working capital or pay off other short-term loans, which might have been at a higher rate.            

Mr. Bush walked out of Ms. Lewis’s office a confused man. He was amazed at the options available to him. He suddenly runs into you (a family friend) and finds out that you are doing your MBA specializing in Finance. He hires you instantaneously to present a comparative analysis for him of all the available choices by the end of the day, outlining a strategy for him to pursue. Prepare a consulting report/strategy for Bush and make your suggestions to him as to which line of action should he pursue.

Evaluate and compare all five choices listed above:

1.      Remain unhedged

2.      Forward hedge

3.      Futures hedge

4.      Options hedge

5.      Money market hedge.

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Make any reasonable assumptions you need.

Some suggested assumptions and hints:

1.      Forecast the expected spot rate for July 10 and October 10. There are several ways to do this. You could run a regression with time trend and forecast it. Or you could use a moving average approach. Or you could use a probability distribution approach to forecast the future spot rates on those days.

2.      Assume Hedge Ratio = 1 in futures case. This means change in spot rate will be equal to change in futures price on July 10 (for September maturity) and October 10 (for December maturity). Let us take the September maturity for example. On April 10, you are given the spot rate and the futures price for September contract. On July 10, you will receive the money and do not need the hedge. So you offset the hedge by offsetting the futures contract at t* (July 10) for September contract. But you do not know this. However, you do know the expected future spot rate on July 10. So, if you assume that the Hedge ratio = 1, you can find the futures price at t* for September maturity since change in spot = change in futures.

3.      Use only one exercise price for options. I suggest you use the closest to at-the-money option exercise price. 

4.   Issue of working capital is important but not the main focus of this case. Discuss it if it helps your analysis.