Chapter 24 - I Derivatives and Risk Management
Chapter Coverage • Our coverage in this chapter will be limited to the use of derivatives in managing working capital risk.
REASONS TO MANAGE RISK (in Working Capital) Consider a food canning chain like Del Monte. Del Monte faces uncertainty in the … • future cost of corn, gasoline, and canning material. • future cost of financing. • future value of dollar collections from foreign customers.
Can these future risks be hedged (i.e., reduced)? Yes, through the use of futures or forward contracts, and with options.
Example • Patriot Boats Corporation (PBC), a U.S. company, sold six new barges to the French government with payment of 120 million euro (€) due in 90 days. PBC is concerned that when the collection is made 90 days from now, the euro will weaken and convert to fewer dollars.
Right now, the spot rate is $2.00/€. Some market analysts are forecasting that the euro will weaken to $1.95/€, while others are forecasting the euro will strengthen to $2.04/€ ninety days from now. • PBC is concerned about the risk, and is considering three ways to manage the risk.
Alternative #1 – Do nothing (i.e., don’t hedge) • Do nothing … just wait and collect and hope the euro is not weaker. • What would be the value of PBC’s collection in dollars if the euro is weaker? What if it is stronger?
Alternative #2 – Hedge using forward contracts • Hedge by taking a short position in 90-day forward euro contracts at a rate of $1.995/€. • What would be the value of PBC’s collection in dollars if the euro is weaker? What if it is stronger?
Note that this would be the value of the collection under either scenario since the forward contract would lock in the exchange rate (regardless of what happens in the foreign exchange market).
Alternative #3 – Buy put options on the euro • Hedge the risk by purchasing 90-day put options on the euro at a strike price of $2.00/€ and a premium of $0.01/€. • What would be the value of PBC’s collection in dollars if the euro is weaker? What if it is stronger?
If the euro weakens to $1.95/€, PBC would exercise its puts and sell the collected euros through the put options at $2.00/€. Its collection would bring …
If the euro strengthens to $2.04/€, PBC would not exercise the puts, and convert its collected euros to dollars at the spot rate of $2.04/€, collecting …
Problem summary Action Scenario A Scenario B Do nothing $234.0 mil $244.8 mil Hedge (forward contracts) $239.4 mil $239.4 mil Hedge (put options) $238.8 mil $243.6 mil
Decision? • Suppose that PBC believes there is a 40% chance the euro will weaken to $1.95/€, and a 60% chance it will strengthen to $2.04/€. • Which alternative would you recommend based on these expectations?
The alternative with the highest expected conversion value in dollars is the do nothing alternative. • The alternative that involves the greatest risk is the do nothing alternative.
The alternative with the least expected conversion value in dollars is the hedging with puts alternative. • The alternative that involves the least risk is the hedging with forward contracts alternative.
Another problem summary Altern. Expected Best Worst #1 $240.48 $244.8 $234.0 #2 $239.40 $239.4 $239.4 #3 $239.28 $243.6 $238.8 • Which method of managing the risk should the company use? It depends on the company’s degree of aversion to risk.
Another problem: Sports Exports Company • Jim Logan, owner of the Sports Exports Company, will be receiving about 10,000 British pounds (£) about one month from now as payment for exports produced and sent by his firm. • Jim is concerned about his exposure to exchange rate risk.
Jim believes the pound will either depreciate (weaken) by 3 percent over the next month, or the pound will appreciate (strengthen) by 2 percent over the next month. • There is a 70% chance that the pound will weaken, and a 30% chance the pound will strengthen.
The spot rate of the pound is $1.65/£. • One-month forward contracts are available at a rate of $1.643/£. • One-month put options are available with an exercise (strike) price of $1.645/£ at a premium of $0.025/£.
What will be the value of the collection under either scenario if Jim does not hedge?
What will be the value of the collection under either scenario if Jim hedges with put options?
What will be the value of the collection under either scenario if Jim hedges with futures contracts?
Additional Problem:Airbus • Airbus sold an aircraft, A400, to Delta Airlines, a U.S. company. Airbus expects to collect $30 million in six months. • Airbus is concerned with what the dollar collection will be worth in euros when it collects, and will hedges its risk in some fashion.
The current spot exchange rate is 0.52 €/$. • Six-month forward contracts are available at 0.51 €/$. • Six-month put options on U.S. dollars are available with a strike price of 0.515 €/$ at a premium of 0.01 €/$. • There is a 50/50 chance that in six months the euro will strengthen to 0.48 €/$ or weaken to 0.53 €/$.
What are the possible values of the collection in euros if Airbus decides to hedge using a forward contract? • What is the expected value of the collection if Airbus hedges with forward contracts?
What are the possible values of the collection if Airbus hedges with put options on U.S. dollars? • What is the expected value of the collection if Airbus hedges with put options?
BORROWING FUNDSU.S. Lender vs Foreign Lender • Assume you need to borrow $1 million for one year: U.S.France Interest rate 9% 6% spot1-yr forward E.R. ($/€) 2.0002.057 • Is the French loan tempting?
If the difference in interest rates reflects differences in the expected inflation rates between the two countries, then the US is expected to have the higher rate of inflation? • Lenders in the US are charging a higher inflation premium (an extra 3% over European lenders).
If the US dollar is expected to have a higher rate of inflation, then the US dollar is expected to get weaker relative to the Euro. • That is, it will take more dollars to buy a Euro in the future.
What is the interest rate your company pays if it borrows in the U.S.? 9% • What effectively is the interest rate it pays if it borrows the funds in France?
If your company borrows in France, the gain from the lower interest rate is wiped out by the depreciation of the US dollar.
Interest Rate Parity Theory • What is the Interest Rate Parity Theory? • What does the Interest Rate Parity Theory suggest the 1-year forward rate should be in the earlier problem?
The Interest Rate Parity Theory does not always fully explain the difference between spot and forward rates. • Although international capital markets are fairly efficient, they are not perfect. • Also, the actual rate of inflation in each country may turn out to be different from what is expected.
In-Class Exercise • Assume you need a one-year $10 million loan. U.S. banks are quoting an interest rate of 9%, while London banks are quoting 7%. The spot exchange rate is $1.900/£, and the one-year forward exchange rate is $1.920/£. If you are a U.S. corporation, which loan option offers effectively the lower interest rate?
What does the interest rate parity theorem suggest the 1-year forward exchange rate should be?
Another problem:Hopkins Company • Hopkins Company sold goods to a Swiss company, and will receive a payment of 2 million Swiss francs (SF) in 3 months. • Hopkins believes the spot rate 3 months later could be as high as 0.72 $/sf or as low as 0.67 $/sf. • Hopkins is considering how to manage its exposure to foreign exchange risk.
The 3-month forward contract rate of Swiss francs is 0.68 $/sf is available. • Put options are also available with an exercise price of 0.69 $/sf at a premium of 0.03 $/sf. Would Hopkins prefer a put option hedge to no hedge? Explain.
What are the possible collection values in dollars if Hopkins hedges with options?
What are the possible collection values in dollars if Hopkins does not hedge?