Risk Management and Financial Instruments. Cases and Practices
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1 Risk Management and Financial Instruments Cases and Practices
2 Content 1. Decision Case: Zapa Chemical and Buba 2. Delphi s Currency Swap 3. Ikea s Yen Exposure International Financial Management 2
3 1. Decision Case: ZAPA Chemical & Buba Eiteman, Stonehill & Moffett, pp
4 Zapa Chemical and Buba a. What is Zapa Chemical s original exposure? Sale proceeds of approximately DM 7.6 million Effect of exchange rate movements if the DM depreciates, the equivalent dollar value decreases as well (and vice versa) Problem date for repatriation of funds is initially unclear only vague estimate: sometime in November Hedging decision to hedge or not to hedge, which hedging instrument International Financial Management 4
5 Zapa Chemical and Buba b. What are the hedge alternatives for Zapa Chemical s exposure? Remain uncovered Maximum risk approach (full exposure) Spot exchange rate: DM1.4649/$ $ 5,188,067 Forward cover Sell DM forward 120-day forward rate: DM1.4957/$ (annual discount of 6.2%) $ 5,081,233 Foreign currency option Buy put option on DM Strike price: DM1.5152/$ (or $0.66/DM) [out of the money] Premium: 1.40 cents per DM (0.0140/0.66 = 2.1%) Total outlay for protection: $106,400 (= $ million) Worst Case: $ 4,908,264 (=7.6 million/ $106,400(1+( %120/360)) International Financial Management 5
6 Hedge Alternatives US dollars (millions) Uncovered Forward cover Put option on DM DM/$ Steph decides to buy the put-option in order to be able to participate in exchange rate currency gains. International Financial Management 6
7 Zapa Chemical and Buba c. Should Stephanie Mayo sell the put option protection already in place? Background First, US dollar declined rapidly ( : all-time low DM1.39/$) Then, US dollar appreciated ( : DM1.51/$) Volatility still high Sale of put option would expose ZAPA to adverse XR movements 3 months until repatriation in December Increased option value reflects not only the favorable XR movement, but also the increased volatility (risk!) Possible solution to avoid exposure: sell put and enter into forward agreement International Financial Management 7
8 Zapa Chemical and Buba Comparison of different hedging strategies (DM/$ ) Sep 18 th (DM/$ ) Dec 15 th No change of hedging strategy ( ) $5,061,605 (1.5152) $5,015,839 Worst Case Sale of option & enter into forward (1.5255) $4,981,973 (1.5255) $4,981,973 Sale of put option + $ 148,200 Sale of put option + $ 149,427 [$148,200( /360)] $5,130,173 $5, 131,400 Sale of put option & forward hedge (at DM /$) lead to higher outcome than option hedge in the worst case as well as at the current spot rate. Forward hedge does not allow to benefit from falling US dollar. Why not uncovered position or replacing option? 1) 106,400(1+( %120/360); International Financial Management see slide no. 5 8
![033125 90 /360)] $5,130,173 $5, 131,400 Sale of put option & forward hedge (at DM 1.](/docs-images/40/8831222/images/page_8.jpg "5255/$) lead to higher outcome than option hedge in the worst case as well as at the current spot rate. Forward hedge does not allow to benefit from falling US dollar.")
9 Zapa Chemical and Buba d. How have the events of September altered Stephanie s view of the DM/$ exchange rate? Initially, Stephanie expected the dollar to fall further: Buba was driving interest rates up to slow monetary growth Interest rate differentials (US: %; Germany: 9.750%) September turbulence: Uncertainty in Europe due to French vote on Maastricht Treaty Stress in the EMS (devaluation pressure on LIT and GBP); GBP and LIT withdrawn from ERM Spanish peseta devalued 5% After the dollar had fallen, risen, and fallen again, she wished to reevaluate her put option position. International Financial Management 9
10 Zapa Chemical and Buba e. How has the volatility of the put option changed between August and September? Volatility of the put option has increased August: premium oscillated between $0.5 and $1.50 per DM September: premium oscillated between $0.5 and $2.50 per DM International Financial Management 10
11 Zapa Chemical and Buba f. What benchmarks would you use to measure the hedging effectiveness? How would this alter Stephanie s hedging? ZAPA considers Treasury a cost center (not a profit center!). Primary responsibility: conservative management of exposure. Management was appreciative when the expenses of running the cost center were lower (p. 239). Consequence: Cost as a benchmark to measure hedging effectiveness Standard portfolio theory: 2 maximize the expected value µ, minimize the variance ( σ = risk ) Cost center benchmark: minimize risk - Steph might prefer cheaper and less speculative forward hedge - Yet company policy: because of losses caused by forward contracts in the past, F/E options were used whenever possible (p.239) International Financial Management 11
12 2. Delphi s Currency Swap Eiteman/Stonehill/Moffett, p
13 Delphi s Currency Swap Delphi: US based MNE operating in many countries in pursuit of a more diversified sales base Wishes to diversify the currency of the denomination of its debt portfolio Decision: Enter into cross-currency interest rate swap 7 years maturity, notional principle of $50 million Pay euro, receive dollars International Financial Management 13
14 Delphi s Currency Swap a. What would be the annual swap payments on a $50 million notional principal, 7 year maturity currency swap? Interest Interest to to receive receive in in $ Interest Interest to to pay pay in in Euro Euro Exhibit 14.8, p.386 International Financial Management 14
15 Delphi s Currency Swap a. Calculate the annual cash flows associated with the currency swap: Swap Year 0 Year 1 6 Year 7 annually Notional principal $ Cash Flow (to receive) ($50,000,000) ($50,000,000) % $2,930,000 $2,930, % $52,930,000 $52,930,000 Exchange rate $1.16/ $1.16/ Notional principal Cash Flow (to pay) 4.05 ( ) 4.05 % ( ) 1,745,690 1,745, % International Financial Management 15
16 Delphi s Currency Swap b. What is the net present value of the swap agreement when unwinding Delphi s currency swap after 3 years? Assumptions: Change of interest rates Four-year fixed rate of interest in Euros: 5.35% Four-year fixed rate of interest in Dollar: 4.40% Change of exchange rate from $1.16/ to $1.02/ Necessary Calculations: PV of remaining cash flows in Dollar PV of commitment in Euro Settlement (previously 4.05%) (previously 5.86%) International Financial Management 16
17 Delphi s Currency Swap b. Net present value of the swap Swap Year 4 Year 5 Year 6 Year 7 $ Present Value (to receive) Int.rate: 4.40% $2,930,000/ $2,930,000/ $2,930,000/ $2,930,000/ $2,930,000/ $2,930,000/ $52,930,000/ $52,930,000/ Delphi Delphi receives a net net payment of of $10,669,840 (due (due to to changes in in interest rates rates and and Dollar Dollar appreciation) Total $52,625,033 $52,625, ,669,840 10,669,840 Present Value (to pay) Int. rate: 5.35% 1,745,690/ 1,745,690/ 1,745,690/ 1,745,690/ 1,745,690/ 1,745,690/ / / ,132,542 41,132,542 x x $1.02/ $1.02/ = = $41,955,193 $41,955,193 International Financial Management 17
18 3. Ikea s Yen Exposure Eiteman/Stonehill/Moffett, pp
19 Ikea s Yen Exposure General Definition of a Range Forward Definition of a range forward in the case of a long position: Buying a put option with a strike rate below the forward rate, for the full amount of the long currency exposure (100% coverage) Selling a call option with a strike rate above the forward rate, for the full amount of the long currency exposure (100% coverage) International Financial Management 19
20 Ikea s Yen Exposure Ikea s purchase is invoiced in Japanese yen Exposure: 90-day account payable of Use of currency option to manage exposure Need to finance option purchases by writing offsetting positions construction of a range forward Current market conditions Spot exchange rate: /$= $ / 90-day forward rate: /$= $ / 90-day Eurodollar deposit rate: % 90-day Euroyen deposit rate: % 90-day yen/dollar volatility quote: 11.8% International Financial Management 20
21 Ikea s Yen Exposure Range Forward in the Ikea Case Definition of a range forward in the case of a short position: Buying a call option with a strike rate above the forward rate, for the full amount of the short currency exposure (100% coverage) Selling a put option with a strike rate below the forward rate, for the full amount of the long currency exposure (100% coverage) International Financial Management 21
22 Ikea s Yen Exposure Construct and diagram a range forward that is +/-2% (+/- 3.5%) around the forward rate Alternative a) +/- 2% Forward rate: /$= $ / - Upper bound: /$= $ / (Strike price Call) - Lower bound: /$= $ / (Strike price Put) Alternative b) +/- 3.5% - Forward rate: /$= $ / - Upper bound: /$= $ / (Strike price Call) - Lower bound: /$= $ / (Strike price Put) International Financial Management 22
23 Range Forward Diagram US$ Account payable Uncovered Buy a call -25,935,807-25,542,251-25,027,809 Sell a put Range forwards -24,540,738-24,181,712 2% 3.5% Forward cover forward rate $/ International Financial Management 23
24 Ikea s Yen Exposure a. What precisely would Ikea like the spot rate to be at the end of the 90-day period? Strike price of the lower bound of the collar $ / = $ / (=110.04/$) (-2%) $ / = $ / (111.66/$) (-3.5%) b. If the ending spot exchange rate were $0.0096/, what would be the net proceeds of Ikea? Calculate option premiums with currency option model (ch. 24, appendix A, pp ) International Financial Management 24
25 Ikea s Yen Exposure Calculation of Option Premiums Currency Option Pricing Theory European call option [ ] r d T European put option d1 = ln F E + σ C P σ 2 T Premium payments = FN( d1) EN( d2) [ ] r d T F( N( d1) 1) E( N( d2) 1 e = ) 2 T e d 2 = d1 σ T Call Put Strike -2% Strike + 2% Strike - 3,5% Strike + 3,5% $/ 0, , , , $/ 0, , , , International Financial Management 25
26 Ikea s Yen Exposure b. (ctd.) US dollar proceeds if ending spot exchange rate is $0.0096/ /$ Call Option Strike Rate /$= $ / Call Call option option exercised exercised +/- 2% +/-3.5% Dollar proceed -$ 25,538,580 -$ 25,920,000 $ / = = $0.0096/ Outlay for call option - $ 367,246 -$ 246, / / Writing of put option $ 363,575 $ 246, / / Net dollar proceed -$25,542,251 -$25,920,254 Call Option Strike Rate /$= $ / Call Call option option not not exercised exercised / / / / International Financial Management 26
27 Ikea s Yen Exposure c. Minimum US dollar proceeds Call Option Strike Rate /$= $ / Call Option Strike Rate /$= $ / Call Call option option exercised exercised +/- 2% +/-3.5% Dollar proceed -$ 25,538,580 -$ 25,935,553 $ / $ / Outlay for call option - $ 367,246 -$ 246, / / Writing of put option $ 363,575 $ 246, / / Net dollar proceed -$25,542,251 -$25,935,807 As As in in part part b) b) Call Call option option exercised exercised / / / / $15,553 $15,553 more more than than in in part part b) b) International Financial Management 27
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