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COVER PAGE

Title : Case Analysis – Hedging Foreign

Currency Transaction Exposure

Subject : International Financial Management

Level / Semester : III / Oct 2010

Programme : MBA - FULL TIME

Subject Tutor : Mr. S.P. Srinivasan

Name of Student : Vivekanandan M

Student’s Registration Number : GPBL-B/F10/15

Date of Submission : Dec 05, 2010

Word Count : 2192 words

Word Limit : 2000 words

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Checklist

Students Name Vivekanandan M

Registration Number GPBL-B/F10/15

Date of submission of the Assignment 01/12/2010

Is the cover page in the correct format as indicated in the “Guidelines to writing Assignments”?

Yes

Have I done a complete spell-check of the Assignment? Yes

Have I done a complete word count for the Assignment? Yes

Does the table of contents include numbers? Yes

Are the pages numbered correctly? Yes

Are the figures numbered correctly? NA

Are the tables/charts numbered correctly? Yes

Are the captions for the tables and charts proper? Yes

Are the references/bibliography listed in the Assignment? Yes

Are the references cited correctly in the text? NA

All references material has been cited from the books & the University of Wales online library. Any other internet source

quoted is with the permission of the module tutor.

NA

Are the references in the text in the proper format as indicated in the “Guidelines to Writing Assignments”

Yes

Has the soft copy of the Assignment been enclosed? Yes

Declaration:

All material written in this assignment is my own and I have not used any material, content or information of others claiming them to be mine. Wherever materials have been used, proper citation has been done in the text. I am fully aware of the rules and regulations governing plagiarism. Should at any point of time my work be suspected/investigated and established to have been plagiarized, I am aware of the consequences. I have read the Student’s Handbook in detail. ___________________ Signature of the student Date: 05/12/2010

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TABLE OF CONTENTS PAGE No.

List of Tables 1

Introduction 2

Answer-1 2

Answer-2 4

Answer-3 5

Answer-4 5

Answer-5 7

Answer-6 8

Answer-7 8

Bibliography 10

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LIST OF TABLES PAGE No.

Table 1 - Computation of percentage change in # CAD/ 1

USD 3

Table 2 – Computation of profit margin during 2005, because

of exchange rate movement

3

2

Introduction

This case study is about hedging foreign currency exchange rate risk. Assessing transaction

exposure and comparing hedging techniques to effectively manage unwanted exposure.

This report presents the solution and recommendation for the questions asked as part of the

case study.

Answer-1: Calculate percentage change in # CAD/USD exchange rate between the order

month and the invoice month for all transactions. USD cost difference per transaction

between the estimate used by Packmore and the invoice paid by Scott. Effect of

exchange rate movement on profit margin during 2005.

Order Date Spot Rate used at time of

order #of CAD/ 1 US

Absolute value

of Appreciation

Annualised value of

appreciation in %

Jan-04 1.33 0.75188 9.022556

Feb-04 1.34 -2.23881 -26.8657

Mar-04 1.31 4.580153 54.96183

Apr-04 1.37 -0.72993 -8.75912

May-04 1.36 -0.73529 -8.82353

Jun-04 1.35 -1.48148 -17.7778

Jul-04 1.33 -0.75188 -9.02256

Aug-04 1.32 -3.78788 -45.4545

Sep-04 1.27 -3.93701 -47.2441

Oct-04 1.22 -2.45902 -29.5082

Nov-04 1.19 0.840336 10.08403

Dec-04 1.2 3.333333 40

Jan-05 1.24 0 0

Feb-05 1.24 -1.6129 -19.3548

Mar-05 1.22 3.278689 39.34426

Apr-05 1.26 0 0

May-05 1.26 -2.38095 -28.5714

Jun-05 1.23 -0.81301 -9.7561

Jul-05 1.22 -2.45902 -29.5082

Aug-05 1.19 -1.68067 -20.1681

Sep-05 1.17 0.854701 10.25641

Oct-05 1.18 -0.84746 -10.1695

Nov-05 1.17 0 0

Dec-05 1.17

Table 1: Computation of percentage change in # CAD/ 1 USD

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Table-1 shows the percentage change in # CAD/USD exchange rate between the order month

and the invoice month for the years 2004 and 2005. During 2004, CAD has appreciated

against USD and a similar trend followed during the year 2005.

Exhibit-1 Exhibit-2 Gain/Liability Order Date Cost Estimate

at time of

Order US $

(thousands)

Payment Month Invoice Paid in US $

(thousands)

Gain Liability

Jan-05 $213.90 Apr-05 $210.50 $3.40

Feb-05 $219.40 May-05 $215.91 $3.49

Mar-05 $197.66 Jun-05 $196.05 $1.61

Apr-05 $203.43 Jul-05 $210.10 ($6.67)

May-05 $224.96 Aug-05 $238.19 ($13.23)

Jun-05 $264.35 Sep-05 $277.91 ($13.56)

Jul-05 $254.38 Oct-05 $263.00 ($8.62)

Aug-05 $252.28 Nov-05 $256.59 ($4.31)

Sep-05 $252.26 Dec-05 $252.26 $0.00

Oct-05 $242.47 - -

Nov-05 $269.41 - -

Dec-05 $256.41 - -

Total $8.50 ($46.39)

Net ($37.89)

Table 2: Computation of profit margin during 2005, because of exchange rate

movement

As shown in Table-2, during the year 2005, due of appreciation of USD against CAD for the

first 3 months, St. Louis Chemicals paid less amount (than the order amount) to Norcand

Chemical. Thus the profit margin for St. Louis Chemicals for the first 3 months will be

greater than the projected profit margin for the first 3 months.

From April 2005, the USD started depreciating against CAD, which made St. Louis

Chemicals pay more amount (than the order amount) to Norcand Chemical. St. Louis

Chemicals paid USD 37890 more to Norcand Chemical during the year 2005, because of

exchange rate fluctuation. Exchange rate fluctuation during 2005 has decreased the profit of

St. Louis Chemicals by USD 37890. With increased sales and decreased profit, profit margin

for the current financial year will be less when compared to the previous financial year.

Less profit shall lead to decrease in the stock price of the firm and less valuation of the firm.

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Answer-2: For Dec-2005 order, determine the distribution of the USD cost to St. Louis

Chemical in Mar-2006.

Dec-2005 spot rate is 1.17 CAD/USD. The percentage change in CAD/USD (indirect quote)

exchange rate follows a normal distribution. Expected percentage change between the spot

rate in 90 days and the current spot rate is 0%, but the 90 days standard deviation in the

percentage change between the spot rate in 90 days and the current spot rate is equal to 4%.

a) Probability distribution for variance

The probability of CAD reaching 1.17 for 1 USD with variance is given by,

P(68.4%) =

= 0 4%

1.17 0.0468

(i.e) 1.1232 to 1.2168

So the distribution of USD cost to St. Louis Chemical is, between 300000/1.1232

and 300000/1.2168.

(i.e) between USD 246548 to USD 267094

So the maximum loss that could be incurred by St. Louis Chemical because of

exchange rate fluctuation is (267094 – 256410) = USD 10683

b) Probability distribution for 80% confident level

The probability of CAD reaching 1.17 for 1 USD at 80% confidence level is given

by,

P(80%) =

= 0 4%

= 0

1.17 0.0512

(i.e) 1.1188 to 1.2212

So the distribution of USD cost to St. Louis Chemical is, between 300000/1.1188

and 300000/1.2212.

(i.e) between USD 245660 to USD 268144

So the maximum loss that could be incurred by St. Louis Chemical because of

exchange rate risk is (268144 – 256410) = USD 11734

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Answer-3: Discuss with Williams the extent of exchange rate risk faced by St. Louis

Chemical arising from the Dec-2005 order transaction (CAD 300000) using a 90-day

Value-at-Risk methodology based on a 95% confidence level.

Dec-2005 spot rate (indirect quote) is 1.17 CAD/USD. The Dec-2005 order is expected to cost USD 256410 in 90 days. Maximum loss is determined by the lower boundary of the

probability distribution. The percentage change in CAD/USD (indirect quote) exchange rate is assumed to follow normal distribution. The expected percentage change between the spot

rate in 90 days and the current spot rate is assumed to be 0%, but the 90 day standard deviation in the percentage change between the spot rate in 90 days and the current spot rate is assumed to be equal to 4%.

a) Probability distribution for 95% confident level

The probability of CAD reaching 1.17 for 1 USD at 95% confidence level is given

by,

P(95%) =

= 0 4% * 1.1.7)

= 0

1.17 0.07722

(i.e) 1.09278 to 1.24722

So the maximum loss to St. Louis Chemical is,

= 300000/1.09278 - 300000/1.17

= 274529 – 256410

= USD 18119

The maximum loss that could be incurred by St. Louis Chemical for Dec-2005 order

payment due to exchange rate exposure risk is USD 18119

Answer-4: Strengths and weakness of paying Norcand at the time of delivery rather

than waiting 60 days until the invoice is due.

a) Probability distribution for 95% confident level

The payment time is reduced to 60 days. So the variance for 60 days is,

8 / Square root (6) = 3.266

The probability of CAD reaching 1.17 for 1 USD at 95% confidence level is given

by,

P(95%) =

= 0 3.266%)

6

= 0

1.17

(i.e) 1.116111 to 1.223889

So the maximum loss to St. Louis Chemical is,

= 300000/1.116111 - 300000/1.17

= 268790 – 256410

= USD 12380

This shows that reduction in the payment time to 60 day also decreases the maximum

loss that could be incurred by St. Louis Chemical. [Maximum loss for 90 day payment

period is shown in Answer-3].

Strengths of paying Norcand at the time of delivery rather than waiting 60 days until

the invoice are due:

Both St. Louis Chemicals and Norcand will have only 30 days exchange rate exposure

risk or transaction risk instead of 90 days exposure.

If St. Louis Chemicals have a good forecasting system to forecast the exchange rate

and if the system predicts that CAD will appreciate, then St. Louis Chemicals can

borrow money from Bank and immediately pay the amount to Norcand.

Working capital for Nocand will decrease.

Weakness of paying Norcand at the time of delivery rather than waiting 60 days until

the invoice is due:

There will be variation in accounts payable/invoice raised for the buyer - St. Louis

Chemicals.

There will be variation in accounts receivable/quotation for the seller - Norcand.

Both the company’s profit margin and balance sheet will have some variation.

Working capital for St. Louis Chemicals will increase.

The cash flow for the firm will be affected because of risk that arise due to an

unexpected change in exchange rate

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Answer-5:

Money Market Hedge – Money market hedging is a hedging technique to minimise or

eliminate the financial risk due to exchange rate fluctuation. Money market hedge involves

taking a money market position to cover a future payable or receivable position.

In Money Market Hedge on Payables , MNC can create a short term deposit in foreign

currency that it will need in the future. Even if MNC does not have excess cash, it can use

money market hedge to hedge payables.

In Money Market Hedge on Receivables , the MNC that expects receivables in a foreign

currency, it can hedge this position by borrowing the currency now and converting it to USD.

The receivables will be used to pay off this loan.

St. Louis Chemicals can follow the following money market hedging technique to eliminate

the risk associated with Dec 2005 order valued at CAD 300,000. The spot rate is 1.17

CAD/USD. St. Louis Chemicals can borrow USD for 3 months at an annual rate of 7.25%.

St. Louis Chemicals can earn an annual rate of 2% on a 3 month CAD time deposit for

transaction below one million.

If 1 CAD is invested in bank at 2% interest rate, after 3 months it will become

CAD 1.005

So, to get CAD 300,000 after 3 months, St. Louis Chemicals should invest CAD

300000/1.005 = 298507 in Canadian bank for an interest of 2%.

CAD 298507 is equivalent to USD 298507/1.17 = 255134. So, St. Louis Chemicals

should have excess cash of USD 255134, to be invested in the Canadian Bank. This

will increase the working capital requirement for St. Louis Chemicals, which will

have additional cost associated with it, which will erode the profit margin.

If St. Louis Chemicals does not have excess cash of USD 255134, then it should

borrow USD 255134 (1 + 0.0725/4) = 259758 from the bank. So USD 259758 will be

equivalent to CAD 300000. Thus St. Louis Chemicals spend USD 4624 for

eliminating exchange rate risk for the repayment of Dec-2005 order. So, there will be

a decrease in the profit margin by USD 4624.

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Answer-6:

Forward Rate Hedge – Forward hedge is also a hedging technique to minimise or eliminate

the financial risk due to exchange rate fluctuation. In this technique, Multi National

Corporation (MNC) enters a contract with a commercial bank either to buy or sell a currency

in future, but locks the exchange rate while entering the contract. This is similar to

futures/options contracts. Forward rates are available only for Euro, British Pound, Canadian

Dollar and Japanese Yen for 1-month, 3-month, 6-month and 12-month maturities.

St. Louis Chemicals can follow forward rate hedging to eliminate the risk associated with

Dec 2005 order valued at CAD 300,000. The spot rate is 1.17 CAD/USD. A 3 month forward

rate (indirect quote) at the time of the order is quoted at a bid price of 1.1590 CAD/USD and

an ask price of 1.16 CAD/USD for a transactions valued at one million USD or more.

Since St. Louis Chemicals repayment amount is less than one million, so St. Louis

Chemicals cannot use forward rate hedge for Dec 2005 order.

Answer-7: Recommendations to Williams regarding the exchange rate risk faced by St.

Louis Chemicals

Currently St. Louis Chemicals is paying in CAD, while the local currency is USD. The

difference in date of order and date of payment is 90 days. So St. Louis Chemicals is exposed

to the following 2 types of risks, in addition to economic risk.

a) Transaction risk – fluctuation in exchange rate between the date of order and date of

payment

b) Translation risk – risk of variation of the value of assert and liabilities denominated in

foreign currency.

Following are some of the techniques to manage transaction risk,

1. Invoicing - St. Louis Chemicals can request Norcand to invoice the amount in USD.

2. Leading - St. Louis Chemicals should have proper forecasting techniques to forecast

the exchange rate. If the forecast is, CAD will appreciate, and then St. Louis

Chemicals should borrow money from the bank and immediately pay to Norcand.

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3. Money Market Hedge – St. Louis Chemicals can create a short term deposit in CAD

currency that it will need in the future. If St. Louis Chemicals does not have excess

cash, then it can use money market hedge to hedge payables.

4. Forward rate hedge - St. Louis Chemicals can enter a contract with a Citibank NA to

buy CAD currency in future - 1-month, 3-month, 6-month and 12-month maturities.

5. Currency Option Hedge – Forward hedge and money market hedge can backfire

when the payable currency depreciates or a receivable currency appreciates over the

hedged period. Currency future contracts are contracts specifying a standard volume

of a particular currency to be exchanged on a specific settlement date.

St. Louis Chemicals can buy currency call option for CAD and the amount related to

payables.

6. Forward Hedge - St. Louis Chemicals can negotiate a forward contract to purchase

the amount of CAD needed to cover the payables.

7. Futures Hedge - St. Louis Chemicals can purchase currency future contract for CAD

and the amount related to the payables.

8. Currency swap - St. Louis Chemicals can do a currency swap with Norcand, if

Norcand has borrowed some loan in USD.

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Bibliography

1. Jeff Madura, International Corporate Finance, 8th Edition

2. Prakash G Apte, International Finance, 2nd Edition