Chapter 24 I

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• Chapter 24 - I
• Derivatives and Risk Management

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Chapter Coverage

• Our coverage in this chapter will be limited to
  the use of derivatives in managing working
  capital risk.

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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.

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• Can these future risks be hedged (i.e., reduced)?
  Yes, through the use of futures or forward
  contracts, and with options.

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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.

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• 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.

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Alternative 1 Do nothing (i.e., dont hedge)

• Do nothing just wait and collect and hope the
  euro is not weaker.
• What would be the value of PBCs collection in
  dollars if the euro is weaker? What if it is
  stronger?

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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 PBCs collection in
  dollars if the euro is weaker? What if it is
  stronger?

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• 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).

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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 PBCs collection in
  dollars if the euro is weaker? What if it is
  stronger?

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• 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

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• 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

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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

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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?

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• 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.

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• 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.

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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 companys degree
  of aversion to risk.

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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.

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• 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.

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• 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/.

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• What will be the value of the collection under
  either scenario if Jim does not hedge?

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• What will be the value of the collection under
  either scenario if Jim hedges with put options?

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• What will be the value of the collection under
  either scenario if Jim hedges with futures
  contracts?

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Additional ProblemAirbus

• 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.

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• 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 /.

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• 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?

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• 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?

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BORROWING FUNDSU.S. Lender vs Foreign Lender

• Assume you need to borrow 1 million for one
  year
• U.S. France
• Interest rate 9 6
• spot 1-yr forward
• E.R. (/) 2.000 2.057
• Is the French loan tempting?

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• 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).

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• 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.

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• 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?

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• If your company borrows in France, the gain from
  the lower interest rate is wiped out by the
  depreciation of the US dollar.

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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?

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• 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.

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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?

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• What does the interest rate parity theorem
  suggest the 1-year forward exchange rate should
  be?

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Another problemHopkins 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.

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• 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.

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• What are the possible collection values in
  dollars if Hopkins hedges with options?

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• What are the possible collection values in
  dollars if Hopkins does not hedge?