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
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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
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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 – $106,400*(1+(0.033125%*120/360))
b. What are the hedge alternatives for ZapaChemical’s exposure?
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Hedge Alternatives
1.60 1.50 1.40
5.1
4.95.0
Put option on DM
Uncovered
Forward cover
US dollars (millions)
DM/$
Steph decides to buy the put-option in order to be able to participate in exchange rate currency gains.
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Zapa Chemical and Buba
• 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?
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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
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Zapa Chemical and Buba
• 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?
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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
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Zapa Chemical and Buba
• 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
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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
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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
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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/€
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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
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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 $10,669,840 (due to changes in interest rates and Dollar appreciation)
3. Ikea’s Yen Exposure
Eiteman/Stonehill/Moffett, pp. 766-767
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Ikea’s Yen ExposureGeneral Definition of a Range Forward
• Definition of a range forward in the case of a longposition: – Buying a put option with a strike rate below the
forward rate, for the full amount of the long currency exposure (100% coverage)
– Selling a call option with a strike rate above the forward rate, for the full amount of the long currency exposure (100% coverage)
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Ikea’s Yen Exposure• Ikea’s purchase is invoiced in Japanese yen• Exposure: 90-day account payable of ¥2.7 billion• Use of currency option to manage exposure• Need to finance option purchases by writing offsetting
positions construction of a range forward• Current market conditions
– Spot exchange rate: ¥ 108.20/$= $0.009242/ ¥– 90-day forward rate: ¥ 107.88/$= $0.009270/ ¥– 90-day Eurodollar deposit rate: 3.3750%– 90-day Euroyen deposit rate: 2.1875%– 90-day yen/dollar volatility quote: 11.8%
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Ikea’s Yen ExposureRange Forward in the Ikea Case
• Definition of a range forward in the case of a short position:– Buying a call option with a strike rate above the
forward rate, for the full amount of the short currency exposure (100% coverage)
– Selling a put option with a strike rate below the forward rate, for the full amount of the long currency exposure (100% coverage)
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Ikea’s Yen ExposureConstruct and diagram a range forward that is +/-2%
(+/- 3.5%) around the forward rate
• Alternative a) +/- 2%– Forward rate: ¥107.88/$= $0.009270/ ¥
- Upper bound: ¥105.72/$= $0.009459/ ¥ (Strike price Call)- Lower bound: ¥110.04/$= $0.009088/ ¥ (Strike price Put)
• Alternative b) +/- 3.5%- Forward rate: ¥107.88/$= $0.009270/ ¥
- Upper bound: ¥104.10/$= $0.009606/ ¥ (Strike price Call)- Lower bound: ¥111.66/$= $0.008956/ ¥ (Strike price Put)
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Range Forward Diagram
Uncovered
Forward cover
0.0089 0.0093
US$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
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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 $0.0096/¥,what would be the net proceeds of Ikea?
• Calculate option premiums with currency option model (ch. 24, appendix A, pp. 769-772)
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Ikea’s Yen ExposureCalculation of Option Premiums
European put option
European call option [ ] TrdedENdFNC −−= )2()1([ ] TrdedNEdNFP −−−−= )1)2(()1)1((
T
TEF
dσ
σ⎟⎟⎠
⎞⎜⎜⎝
⎛+⎟⎠⎞
⎜⎝⎛
=2
ln1
2
Tdd σ−= 12
Strike -2% Strike + 2% Strike - 3,5% Strike + 3,5%$/¥ 0,000315 0,000136 0,000402 0,00009126$/¥ 0,000135 0,000324 0,00009117 0,000425
CallPut
• Premium payments
• Currency Option Pricing Theory
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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 -$25,920,254
Call Option Strike Rate¥105.72/$= $0.009459/ ¥
Call Option Strike Rate¥104.10/$= $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*$0.0096/¥= ¥2.7 billion*$0.0096/¥~ ¥2.7 billion*$0.009459/¥~ ¥2.7 billion*$0.009459/¥
Call optionexercised
Call optionexercised
Call optionnot exercisedCall option
not exercised
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Ikea’s Yen Exposurec. Minimum US dollar proceeds
+/- 2% +/-3.5%
Dollar proceed -$ 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 -$25,935,807
Call Option Strike Rate¥105.72/$= $0.009459/ ¥
Call Option Strike Rate¥104.10/$= $0.009606/ ¥
Call optionexercised
Call optionexercised
Call optionexercised
Call optionexercised
~ ¥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)