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Chapter 24 I

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Our coverage in this chapter will be limited to the use of derivatives in ... Airbus sold an aircraft, A400, to Delta Airlines, a U.S. company. ... – PowerPoint PPT presentation

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Title: Chapter 24 I


1
  • Chapter 24 - I
  • Derivatives and Risk Management

2
Chapter Coverage
  • Our coverage in this chapter will be limited to
    the use of derivatives in managing working
    capital risk.

3
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.

4
  • Can these future risks be hedged (i.e., reduced)?
    Yes, through the use of futures or forward
    contracts, and with options.

5
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.

6
  • 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.

7
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?

8
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?

9
  • 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).

10
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?

11
  • 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

12
  • 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

13
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

14
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?

15
  • 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.

16
  • 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.

17
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.

18
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.

19
  • 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.

20
  • 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/.

21
  • What will be the value of the collection under
    either scenario if Jim does not hedge?

22
  • What will be the value of the collection under
    either scenario if Jim hedges with put options?

23
  • What will be the value of the collection under
    either scenario if Jim hedges with futures
    contracts?

24
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.

25
  • 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 /.

26
  • 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?

27
  • 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?

28
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?

29
  • 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).

30
  • 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.

31
  • 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?

32
  • If your company borrows in France, the gain from
    the lower interest rate is wiped out by the
    depreciation of the US dollar.

33
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?

34
  • 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.

35
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?

36
  • What does the interest rate parity theorem
    suggest the 1-year forward exchange rate should
    be?

37
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.

38
  • 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.

39
  • What are the possible collection values in
    dollars if Hopkins hedges with options?

40
  • What are the possible collection values in
    dollars if Hopkins does not hedge?
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