125.320 International Finance: Analysis of Currency Hedging

Question:

On February 14, 2012 Brandon Tyler, Assistant Treasurer at Allied Digital (AD), sits in his office, talk to himself, “I must get this hedging memo done, and get out of here. Foreign exchange options? I had better get the story straight before someone in the Finance Committee starts asking questions. Let’s see, there are two ways in which I can envisage us using options now. One is to hedge a dividend due on September 15th from AD Germany. The other is to hedge our upcoming payment to Matsumerda for their spring RAM chip statement. With the yen at 78 and increasing I’m glad we haven’t covered the payment so far, but now I’m getting nervous and I would like to protect my posterior. An option to buy yen on June 10 might be just the thing.

Allied Digital is a $12 billion sales company engaged in, among other things, the development, manufacture, and marketing of microprocessor-based equipment. Although

  • of the firm’s sales are currently abroad, the firm has full-fledged manufacturing facilities in only three foreign countries, Germany, Canada, and Brazil. An assembly plant in Singapore exists primarily to solder Japanese semiconductor chips onto circuit boards and to screw these into Brazilian-made boxes for shipment to the United States, Canada, and Germany. The German subsidiary has developed half of its sales to France,the Netherlands, and the United Kingdom, billing in euros. AD Germany has accumulated a cash reserve of €900,000, worth $1,177,9 0 at today’s exchange rate. The Hamburg office has automatic permission to repatriate €3 million September 15th. The firm has an agreement to buy three hundred thousand RAM chips at ¥8000 each semi-annually, and it is this payment that will fall due on June 10th.

Brandon Tyler in his office has been printing spot, forward and currency options and futures quotations from the company’s Bloomberg terminal.

The option prices are quoted in U.S. cents per euro. Yen are quoted in hundredths of a cent. Looking at these prices, Brandon realizes that he can work out how much the euro or yen would have to change to make the option worthwhile. Brandon makes a mental note that AD can typically borrow in the Eurocurrency market at LIBOR + 1% and lend at LIBID.

Task:

“I’ll attach these numbers to my memo,” mutters Brandon, but the truth is he has yet to come to grips with the real question, which is when, if ever, are currency options a better means of hedging exchange risk for an international firm than traditional forward exchange contracts or future’s contracts. Please assist Brandon in his analysis of currency hedging for his report to AD’s Finance Committee.

Show which hedging is better (forward, money market or option). Why? Detail calculation and explanation required.

Hints:

  • Find the euro receivable and the yen payable
  • In table 3, you find the 7-month forward rate. For payable, you need 4-month forward rate from Table 2.
  • Borrowing and lending interest rates are given in the tables “Euro Money Rates”, “Japanese Yen Money Rates” and “USD Money Market Rates”.
  • The assignment mentions that AD can borrow in the Eurocurrency market at LIBOR + 1%, you have to add 1% with the rate you pick from table 3.
  • Since you’re given both bid and ask, you borrow at ask rate and lend it bid rate.
  • Remember that these interest rates are annualized. So, when you calculate PV or FV of borrowing or investment you need to take account actual number of days for hedging period, that means, interest rates need to be multiplied with (actual number of days/360).
  • The option premium is given in cents per euro or cents per yen on the last table.
  • If you want to buy a call or a put, you pay the “ask” since the dealer wants to sell at that premium.

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