International Financial Management - uni-muenster.de management a… · Professur für BWL, insb. I nternationale W irtschaft International Financial Management 4 Zapa Chemical and

Risk Management and Financial Instruments

Cases and Practices

Professur für BWL, insb. Internationale Wirtschaft International Financial Management 2

Content

1. Decision Case: Zapa Chemical and Buba

2. Delphi’s Currency Swap

3. Ikea’s Yen Exposure

1. Decision Case: ZAPA Chemical & Buba

Eiteman, Stonehill & Moffett, pp. 237-242


Zapa Chemical and Bubaa. 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 decreasesas 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


Zapa Chemical and Buba

• 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 (= $0.014 * 7.6 million)

Worst Case: $ 4,908,264 (=7.6 million/1.5152 – $106,400*(1+(0.033125%*120/360))

b. What are the hedge alternatives for ZapaChemical’s exposure?


Hedge Alternatives

1.60 1.50 1.40

5.1

4.95.0

Put option on DM

Uncovered

Forward cover

US dollars (millions)

DM/$

Steph decides to buy the put-option in order to be able to participate in exchange rate currency gains.



• Background– First, US dollar declined rapidly (01.09.92: all-time low DM1.39/$)– Then, US dollar appreciated (16.09.92: DM1.51/$)– Volatility still high

• Sale of put option would expose ZAPA to adverse XRmovements– 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

c. Should Stephanie Mayo sell the put option protection already in place?


Zapa Chemical and BubaComparison of different hedging strategies

•Sale of put option & forward hedge (at DM 1.5255/$) 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.•Why not uncovered position or replacing option?

1) 106,400*(1+(0.033125%*120/360);see slide no. 5

$4,981,973

+ $ 148,200

No change of hedging strategy

Sale of option & enter into forward

(1.5015 ) $5,061,605 (1.5152) $5,015,839

(1.5255) (1.5255) $4,981,973

+ $ 149,427[$148,200*(1+0.033125

*90 /360)]

$5,130,173 $5, 131,400

Sep 18th Dec 15th(DM/$ ) (DM/$ )

Sale of putoption

Sale of putoption

Worst Case



• Initially, Stephanie expected the dollar to fall further:– Buba was driving interest rates up to slow monetary growth– Interest rate differentials (US: 3.3125%; 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.

d. How have the events of September altered Stephanie’s view of the DM/$ exchange rate?


Zapa Chemical and Bubae. 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



• 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:

maximize the expected value µ, minimize the variance ( = risk )2σ

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)

f. What benchmarks would you use to measure the hedging effectiveness? How would this alter Stephanie’s hedging?

2. Delphi‘s Currency Swap

Eiteman/Stonehill/Moffett, p. 394-395


Delphi’s Currency SwapDelphi:

• 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


Delphi’s Currency Swapa. What would be the annual swap payments on a

$50 million notional principal, 7 year maturity currency swap?

Interest to pay in EuroInterest to

pay in Euro

Interest to receive in $Interest to

receive in $

Exhibit 14.8, p.386


Delphi’s Currency Swapa. Calculate the annual cash flows associated with

the currency swap:

Notionalprincipal

€ Cash Flow(to pay)

Exchange rate

Notional principal

$ Cash Flow (to receive)

Swap Year 7Year 1 – 6annually

Year 0

5.86 % $2,930,0005.86 %

$2,930,000105.86 %

$52,930,000105.86 %

$52,930,000($50,000,000)($50,000,000)

(€43.103.448)(€43.103.448) 4.05 % €1,745,6904.05 %

€1,745,690104.05 %

€44.849.138104.05 %

€44.849.138

$1.16/€$1.16/€


Delphi’s Currency Swapb. 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/€

(previously 4.05%)(previously 5.86%)

• Necessary Calculations:– PV of remaining cash flows in Dollar– PV of commitment in Euro – Settlement


Delphi’s Currency Swapb. Net present value of the swap

€ Present Value

(to pay)Int. rate: 5.35%

Swap Year 7Year 4 Total

$ Present Value

(to receive)Int.rate: 4.40%

$52,625,033$52,625,033$2,930,000/1.0441

$2,930,000/1.0441

$52,930,000/1.0444

$52,930,000/1.0444

$2,930,000/1.0442

$2,930,000/1.0442

$2,930,000/1.0443

$2,930,000/1.0443

41,132,542 €x $1.02/€

=$41,955,193

41,132,542 €x $1.02/€

=$41,955,193

€44.849.138/1.05354

€44.849.138/1.05354

€1,745,690/1.05351

€1,745,690/1.05351

€1,745,690/1.05352

€1,745,690/1.05352

€1,745,690/1.05353

€1,745,690/1.05353

Year 5 Year 6

+ 10,669,840

+ 10,669,840

Delphi receives a net payment of $10,669,840 (due to changes in interest rates and Dollar appreciation)

Delphi receives a net payment of $10,669,840 (due to changes in interest rates and Dollar appreciation)

3. Ikea’s Yen Exposure

Eiteman/Stonehill/Moffett, pp. 766-767


Ikea’s Yen ExposureGeneral Definition of a Range Forward

• Definition of a range forward in the case of a longposition: – 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)


Ikea’s Yen Exposure• Ikea’s purchase is invoiced in Japanese yen• Exposure: 90-day account payable of ¥2.7 billion• 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: ¥ 108.20/$= $0.009242/ ¥– 90-day forward rate: ¥ 107.88/$= $0.009270/ ¥– 90-day Eurodollar deposit rate: 3.3750%– 90-day Euroyen deposit rate: 2.1875%– 90-day yen/dollar volatility quote: 11.8%


Ikea’s Yen ExposureRange 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)


Ikea’s Yen ExposureConstruct and diagram a range forward that is +/-2%

(+/- 3.5%) around the forward rate

• Alternative a) +/- 2%– Forward rate: ¥107.88/$= $0.009270/ ¥

- Upper bound: ¥105.72/$= $0.009459/ ¥ (Strike price Call)- Lower bound: ¥110.04/$= $0.009088/ ¥ (Strike price Put)

• Alternative b) +/- 3.5%- Forward rate: ¥107.88/$= $0.009270/ ¥

- Upper bound: ¥104.10/$= $0.009606/ ¥ (Strike price Call)- Lower bound: ¥111.66/$= $0.008956/ ¥ (Strike price Put)


Range Forward Diagram

Uncovered

Forward cover

0.0089 0.0093

US$Account payable

$/¥0.0095

-25,027,809

-24,540,738

-25,542,251

-24,181,712

-25,935,807

0.0091 0.0097

Range forwards

2%

3.5%

0.00927 forward rate

Buy a call

Sell a put


Ikea’s Yen Exposurea. 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

– $0.009270/¥* 0.980 = $0.009088/¥ (=¥110.04/$) (-2%)– $0.009270/¥* 0.965 = $0.008956/ ¥ (¥111.66/$) (-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. 769-772)


Ikea’s Yen ExposureCalculation of Option Premiums

European put option

European call option [ ] TrdedENdFNC −−= )2()1([ ] TrdedNEdNFP −−−−= )1)2(()1)1((

T

TEF

dσ

σ⎟⎟⎠

⎞⎜⎜⎝

⎛+⎟⎠⎞

⎜⎝⎛

=2

ln1

2

Tdd σ−= 12

Strike -2% Strike + 2% Strike - 3,5% Strike + 3,5%$/¥ 0,000315 0,000136 0,000402 0,00009126$/¥ 0,000135 0,000324 0,00009117 0,000425

CallPut

• Premium payments

• Currency Option Pricing Theory


Ikea’s Yen Exposureb. (ctd.) US dollar proceeds if ending spot exchange

rate is $0.0096/ ¥ ~ 104.17 ¥/$

+/- 2% +/-3.5%

Dollar proceed -$ 25,538,580 -$ 25,920,000

Outlay for call option - $ 367,246 -$ 246,415

Writing of put option $ 363,575 $ 246,161

Net dollar proceed -$25,542,251 -$25,920,254

Call Option Strike Rate¥105.72/$= $0.009459/ ¥


~ ¥2.7 billion * ¢0.0136/ ¥~ ¥2.7 billion * ¢0.0136/ ¥

~ ¥2.7 billion * ¢0.0135/ ¥~ ¥2.7 billion * ¢0.0135/ ¥

~ ¥2.7 billion * ¢0.009126/ ¥~ ¥2.7 billion * ¢0.009126/ ¥

~ ¥2.7 billion * ¢0.009117/ ¥~ ¥2.7 billion * ¢0.009117/ ¥

= ¥2.7 billion*$0.0096/¥= ¥2.7 billion*$0.0096/¥~ ¥2.7 billion*$0.009459/¥~ ¥2.7 billion*$0.009459/¥

Call optionexercised


Call optionnot exercisedCall option

not exercised


Ikea’s Yen Exposurec. Minimum US dollar proceeds

+/- 2% +/-3.5%

Dollar proceed -$ 25,538,580 -$ 25,935,553

Outlay for call option - $ 367,246 -$ 246,415

Writing of put option $ 363,575 $ 246,161

Net dollar proceed -$25,542,251 -$25,935,807







~ ¥2.7 billion*$0.009606/¥~ ¥2.7 billion*$0.009606/¥

~ ¥2.7 billion * ¢0.0136/ ¥~ ¥2.7 billion * ¢0.0136/ ¥

~ ¥2.7 billion * ¢0.0135/ ¥~ ¥2.7 billion * ¢0.0135/ ¥

~ ¥2.7 billion * ¢0.009126/ ¥~ ¥2.7 billion * ¢0.009126/ ¥

~ ¥2.7 billion * ¢0.009117/ ¥~ ¥2.7 billion * ¢0.009117/ ¥

~ ¥2.7 billion*$0.009459/¥~ ¥2.7 billion*$0.009459/¥

As in part b)As in part b) $15,553 more than in part b)

$15,553 more than in part b)

International Financial Management - uni-muenster.de management a… · Professur für BWL, insb. I nternationale W irtschaft International Financial Management 4 Zapa Chemical and

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