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HEDGING TRANSACTION EXPOSURE

HEDGING TRANSACTION EXPOSURE. Jennifer Nguyen Carlos Castillo. Case Background. Popescu, Hagi & Associates (PHA) Consulting firm Deals in specialized derivatives DW, Inc. Computer manufacturer No previous consistent hedging program Hires PHA to implement a plan.

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HEDGING TRANSACTION EXPOSURE

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  1. HEDGING TRANSACTION EXPOSURE Jennifer Nguyen Carlos Castillo

  2. Case Background • Popescu, Hagi & Associates (PHA) • Consulting firm • Deals in specialized derivatives • DW, Inc. • Computer manufacturer • No previous consistent hedging program • Hires PHA to implement a plan

  3. Part I: The Hedging Problem • June 1996: • DW orders Japanese parts valued at JPY 200,000,000 • Delivery due in 2 months • Payment due 30 days from delivery • July 5, 1996 • Notification of October delivery • No date set, but expected October 28 • Spot rate = .009062 USD/JPY

  4. Historical Data • Based on percentage changes in monthly USD/JPY exchange rates from January 1971 to June 1996 • 306 observations • Mean = .004423 • St Dev = .032948 • Minimum = -0.09844 on 11/30/1978 • Maximum = .134453 on 02/28/1973

  5. Sensitivity Analysis • Best Case Scenario • JPY 200,000,000 x .009062 USD/JPY x (1 - .09844) = USD 1,633,982 • Worst Case Scenario • JPY 200,000,000 x .009062 USD/JPY x (1 + .134453) = USD 2,056,082 • VAR interpretation: DW should have USD 2,056,082 to cover the payment

  6. Distribution Assumption

  7. Distribution Assumption • VAR Interpretation • 95% CI: DW should have USD 1,918,349 to cover the payment • 97.5% CI: DW should have USD 1,937,458 to cover the payment • 99.5% CI: DW should have USD 1,959,552 to cover the payment • Standard – 97.5% confidence interval

  8. PHLX Options - Calls • Calculating number of contracts: • PHLX standard size of JPY 6,250,000 • Underlying position = JPY 200,000,000 • Contract size = JPY 200,000,000/6,250,000 = 32 contracts • Premium Cost • JPY Dec 93 @ .75 = USD 15,000 • JPY Dec 96 @ .42 = USD 8,400

  9. PHLX Cost Scenarios: JPY Dec 93

  10. PHLX Cost Scenarios: JPY Dec 96

  11. OTC Call Cost Scenarios

  12. Forward Cost Scenario • 6 month Forward point: .000238 • .009062 + .000238 = .0093 • JPY 200,000,000 x .0093 USD/JPY = USD 1,860,000 • Forward rate is regardless of spot rate at expiration

  13. Comparison: Total Cost in USD

  14. Recommendation • Based on the Total Cost associated with each derivative, we would recommend DW partake in the OTC option with strike price of .0091

  15. Part II: Effective Total Cost • November 22, 1996 • Parts arrived on October 27th • Payment is due in five days • Spot Rate = .008973 USD/JPY

  16. I: 3 month forward? • July 5, 1996: • 3 month Forward Point: .000109 • Spot rate = .009062 • Long position in forward contract • At Forward Expiration: • JPY 200,000,000 x (.009062 USD/JPY + .000109 pts) = USD 1,834,200 • The JPY 200,000,000 could then be invested with a short term interest rate in Japan to recoup costs between October expiration and November payment date.

  17. II: December Futures? • July 5, 1996: • Dec IMM Futures = .009241 • Long position in futures contract • November 22, 1996: • Dec IMM Futures = .008993 • Spot rate = .008973 • Short the futures contract

  18. II: December Futures? • Effective Total Cost: • Long July cost = USD 1,848,200 • Short Nov gain = USD 1,798,600 • Net loss of futures = USD 49,600 • Discount loss from Dec to Nov = USD 234 • Bought JPY 200,000,000 on November 22 @ .008973 = USD 1,794,600 • Total Effective Cost = 1,745,234

  19. III: Unhedged • November 22, 1996 • Spot rate = .008973 • JPY 200,000,000 x .008973 USD/JPY = USD 1,794,600

  20. IV: OTC Option • Call Option Strike Price .0091 @ .96 • Premium Cost = USD 19,200 • Opportunity Cost = USD 453 • At November Expiration: Exercise? • No, because spot price is below strike • Effective Total Cost: • (JPY 200,000,000 x .008973 USD/JPY) + USD 19,653 = USD 1,814,253

  21. V: PHLX Dec Call Options • JPY Dec 93 • Premium Cost = USD 15,000 • Opportunity Cost = USD 424 • On November 22, 1996: • Sell calls at .81 = USD 16,200 • Effective Total Cost: • (JPY 200,000,000 x .008973 USD/JPY) + USD 15,424 – USD 16,200 = USD 1,793,824

  22. V: PHLX Dec Call Options • JPY Dec 96 • Premium Cost = USD 8,400 • Opportunity Cost = USD 238 • On November 22, 1996: • Sell calls at .15 = USD 3,000 • Effective Total Cost: • (JPY 200,000,000 x .008973 USD/JPY) + USD 8,638 – USD 3,000 = USD 1,800,238

  23. Effective Total Cost Summary

  24. Hedging Transaction Exposure Q & A?

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