On May 16, 1995, Mr. John Christopher, the assistant treasurer of TCAS, Inc., pondered several foreign exchange hedging ahernatjves that had been oudined by the account manager from his lead bank. Mr. ChristOpher had called his account manager, Judy Wright, to ask for her advice regarding a Canadian dollar contract Mr. Christopher had negotiated with a Canadian company. Ms. Wright, after first cvaluaring macroeconomic fundamentals and determining what her bank's lending rates were likely to be based on this outlook, was now ready to advise Me. Christopher of the various alternatives to hedge the foreign currency risk.
Company Background
TeAS (Transnationa! Corporate Advisory Services), Inc. was founded in 1982 as a financial rraining alld consulcing firm incorporated in Delaware. hs primary assets and produces were the knowledge and skills of the three foullding partners. All three had worked for the Continenral Illinois Narional Bank for about twelve years but left rhe bank before its problems in 1984. The expertise of the three founders was multinational business management including the financial, production, and marketing aspects of doing business globally.
In 1988, TCAS merged with Computer Software and Systems Company to
exrend its products to include managemem information systems. TCAS, Inc. was involved in developing specialized software and building custom-designed, local area personal compurer networks [or small- and medium-sized companies. Because of the dramatic changes in computer technology and communication during the decade of the \ 980s, the deregulation of financial markets, and the increased emphasis on globalization, TeAS, Inc. experienced rapid growrh in net income and assets. However, beginning in 1993, TCAS began to face sharply increased competition from much larger corporations rhat began to sell very competitively priced services. As a resull of these developments, TCAS's net income narrowed dramatically in 1993 and 1994. The company was heavily in debt and had only a few conrracts in hand. TeAS was headquartered in Phoenix, Arizona, and its customer base to date had been comprised totally of us companies. TCAS decided that it was time to "go international."
John Christopher recognized that the submission of rhe bid in Canadian dollars to a Canadian customer was fundamentally a risky step for TCAS. He also realized
Total current assets 950.0 Property. plant and equipme'nt
CoST 2240.0 less Accumulated depreciation (330.0)
Goodwill and int<lngibles 520.0
TOTAL ASSETS 3380.0
LIABILITIES Current liabilities
Bank loans 810.0 Accounts payable 480.0 NOTes payable 120.0
Long-term liabilities Debt 620.0
TOTAL LIABILITIES 2030.0 Equity and retained earn ings l.li.Q.,Q
TOTAL LIABILITIES AND EQUITY 3380.0
that) in order (Q survive, (he company had w expand its rraditional customer base. John Christopher was surprised when TeAS was awarded the bid. He knew that his foreign exchange worries had JUSt begun and he was in need of expert help.
82 TCAS, Inc. A06·98-0021
The Bid
TeAS had bid Canadian dollar C$2,900,OO for the delivery and the installation of a new management information software system and an extensive local area nerwork (LAN) computer system. The bid had been put wgether by the accouming department and accurately reAeered costs. The bid was tendered on March 21 by FAX and was accepted on May 15. Tn accordance with the terms of the con traer, the Canadian government agency (Canadian Crown Corporation) had telexed a leerer of acceptance of the bid and wired 10% of the purchase price as a deposit on the morning of May 16. Also under the terms of the comract, TCAS would have to secure a performance bond from a third-parey vender if awarded the bid. The performance bond would cost .75% of the oumanding contract value.
The remainder of the purchase price was due at the time the system was to be delivered and installed. which under the terms of the contract was to be within 90 days (the Canadian company had insisted on the 90 days and TCAS needed the extra time over the normal 45-day credit period) after the bid was accepted. The TCAS production manager had assured Mr. Christopher that there would be no problems in meeting this delivery schedule for the hardware, although the produCt was not currently in inventory. The software was already developed and available. Consequently, Mr. Christopher expected £0 receive a certified check for C$2,610,OOO on August 16.
In preparing the bid, TCAS allowed for a tight mark-up ofonly 5% (see Exhibit 2) to improve the chances of winning [he bid. Through past experience, TCAS knew that once it made the fi rst sale, the qual iry of i(s product usually ensured additional purchases by [he same company. Since the Canadian government agency had stipulated that the bid be in Canadian dollars, TCAS had used the opening spm rate existing on March 21, which was 1US$ =0 Canadian $1.4096.
The US Dollar and the Canadian Dollar
On May 16, \ 995, the day after the bid was accepted, the value of the US dollar closed at 1US$ = C$I.3594. The Canadian$/US$ exchange rate had moved erratically
Conversion to C$ al March 21 S Ot rate or 1US$ = Canadian $ \ .40% C '2 00 000
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wi[hin a relatively narrow range over the pas[ several months a5 reHeered in the following table:
Month Arg. CStlUS$ January 3 1.4027 February 7 1.3978 March 7 1.4168 April 4 1.4005 May 2 1.3553
The Canadian dollar had remained relatively Slable againSl the US$ until mid-Aped 1995. Ie declined (Q the low registered on May 2 and recovered slightly by mid-May. Mr. Christopher was concerned thar the Canadian dollar might depreciate agains{ rhe US$ during the next 90 days before he received his final payment from the Canadian government agency. Mr. Christopher wanted to know what a)rernatives were available to him to reduce the foreign exchange risk associated with {he outstanding Canadian dollar conrracc
Foreign Currency Exposure Management
Judy Wrighr explained to Mr. ChristOpher [he alternaeives available co manage the foreign exchange risk brought about by the Canadian dollar COntract. First, Mr. Christopher could do nothing. Over the 55 days since the bid was tendered, the US$ had depreciated by Canadian $0.0502 from Canadian dollar 1.4096 to Canadian dollar 1.3594, or 3.6% in absolute terms. This exchange rate change, if ir held steady for me 90 days, would improve TCAS's mark-up from 5% to 8.6% when the Canadian dollars were convened into US dollars. Further depreciation of the US dollar could not be ensured, Judy explained, based on her review of macroeconomic fundamenrak
Foreign Currency Exposure Management Alternatives
The evaluation ofexpeC{ed macroeconomic developments confirmed Mr. Christopher's concerns about a possible depreciaeion of [he Canadian dollar. Ms. Wright explained that a foreign currency hedge would be an appropriate response to the foreign exchange risk faced by TCAS, Inc. Since TCAS had an outstanding Canadian dollar comracr, a hedge could be accomplished by anyone of rhe following techniques:
1. Forward contract-This involved arranging to deliver Canadian $2,610,000 90 days in the future for conversion into US$ ae a predetermined exchange rare. Thus, Mr. Christopher could Contract tOday with Ms. Wright to deliver the Canadian dollar convened at today's guo red three-month forward rate of 1US$ == Canadian $1.3653.
84 TCAS, Inc. A06-98-0021
2. Foreign curren? loan-This created a Canadian $ obligation 90 days hence. TCAS could borrow Canadian $ from Ms. Wright's bank for 90 days and then use the proceeds on completion of the contract to repay the principal and acctlled interest. The loan proceeds would be convened immediately into US$ at the prevailing Spot rate of exchange. Any gains or losses on the receivable due CO a change in the value of the Canadian $/US$ exchange tate would be offset by equivalent losses or gains on the loan itself. Ms. Wright thought that such a loan could be made at 2.25% above the present Canadian prime tate of 10.25% plus an arrangement fee of 0.125%. The US prime race was at 8.875%. TCAS paid a spread of 2.125% over prime in the US market and would pay a similar spread in Canada
3. Foreign currency options-This instrument would give TeAS the right co either purchase (call) or sell (put) an asset at a specified price at a date in the future (European style) or anytime between the purchase date and a date in the future (American style). The buyer of an option has the right bur not the obligation to
exercise the oprion. The buyer of an option has a choice whether to exercise rhe option aod either receive the asset (call) or deliver the asset (put) or to allow the option to expire unexercised. The seller (writer) of the option must stand ready to fulfill an option obligation and surrender an asset on demand (call) or receive an asset on demand (pur). Since TCAS had a Canadian dollar Contract, it could hedge this foreign currency exposure by buying a Canadian dollar put or writing a Canadian dollar call. Buying a Canadian dollar pur option would protect TCAS from an unFavorable downward movement in the Canadian dollar exchange rate while allowing the company to beneot from any further appreciation in the Canadian dollar. The purchase of a currency option would require that Mr. ChristOpher pay Ms. Wright an option premium at the time the contract was entered into. At the time. the 90-day currency options premium rates on a strike of 1 Canadian dollar'" US$ .7200 (or implied 1USdollar '" Canadian dollar 1.3888) were: call premium-US dollar O.0356/Canadian dollar; pur premium -= US dollar O.0225/Canadian dollar. Note that the options are quoted as the US dollar price of one Canadian dollar which is the reciprocal of the Canadian dollar price of one US dollar. Writing a Canadian dollar call oprion would allow TeAS to benefit if there was little or no change in the value of the Canadian dollar. Instead of paying a premium, TCAS would receive the premium.
4. Foreign eurrmcyfutures-A standardized obligation to purchase or sell a specific amount of currency at a specified date. The buyer or seller of the contract is obliged co take delivery or make delivery of the currency; the position could only be eliminated if the furures position was offset. Most futures positions are offser prior to the last day of trading, leaving the seHer with a profit or loss. Ms. Wright explained that a futures contract could be arranged through the International Monetary Market (IMM) of the Chicago Mercantile Exchange. The August fueures price was 1C '" US$ 0.735. The Cost of a round rum per contract
AOG-98-0021 TeAS, Jne. 85
(the purchase and subsequent sale of a futures contract) was US$ 50.00. Each Canadian dollar future concract represems Canadian $100,000.
5. Pre-sale o£foreigrl contract-Ms. Wright explained that her bank had an export finance subsidiary that would purchase the short-term Canadian dollar contracr from TCAS at a discoulH. The imeresr rate applicable was fixed for the term involved-90 days-at the cost of funding to the Export Finance Subsidiary, which was UBOR currendy at 7.375%, plus a premium based on normal credit criteria. At this time the credit spread for TeAS Wd.S 1.825% over UBOR. TCAS would incur a Rat up-front fee of 0.5%. The US dollar 90-day libor rate was 6.125%.
6. Tunnel forwards-A contractual agreement between the two panies which designates a specific exchange rate band within which TCAS would have to
exchange currencies on a specific future date. It works like a forward exchange contract that fully protects the downside with no up-front premium paid, but the settlement rare falls within a range instead of at a specific rate. The upper and lower limits of the range act as contract settlement rates if the exchange rate exceed the limits of the range of the tunnel. Ms. Wright indicated that at the present time a zero cost cunne! or range forward (where the premium paid on the put is equal to the premium received) could be created with the strike on tbe Canadian dollar pur set at US dollar .7133 and the Strike on the Canadian dollar call set at US$ .7533.
Canadian Economic Performance
After finally gaining momentum in 1994. the economic recovery faltered in early 1995. After growing by .more than 5-112% in 1994, real GOP increased only moderately in the fl rst quarter of 1995 and was expected to decline in the second quaner, before rebounding in the third quarter of 1995. The economic slowdown in the United States dampened the demand for Canadian exports and the tighter monetary conditions moderated domestic demand in Canada. FOHUnate!y, the economic slowdown also resulted in a significant drop in Canadian imports. The short-term interest spreads between Canada and the United Stares had increased from virtually zero in November 1994 w 2% in early April 1995. However, all indications were that the Canadian Central Bank would soon reverse policy direction and push interest rates lower in order to stimulate employment.
I n its February 1995 budget, the federal government in Ottawa, Canada adopted drastic expenditure restraint in order to convince financial markets that deficit reduction targets would be met in spite ofhigher-chan-expected hikes in short-term interest rates. The budget included proposals for major curs in government employment, subsidies to business and agriculture, and transfers to the provi nces.
The most interest-sensitive components of the domeStic economy, durable goods and construction, declined markedly in the first quarter of 1995. The recent run-up in interest rates aborted (he revival of residential investment. The impacr
of this weakening of final demand on the Canadian GOP was offset somewhat by a substancial accumulation of inventories.
The Canadian unemployment race remained broadly stable in the 9-1/2% range. Persistent labor-market slack kept wage inoeases low, and unit labor cOSts hardly rose. Slower outpur groWlh has been associated wi eh smaller productivity gains. Overall, che rate of inflation had begun to ease.
The Banker's Role
Judy Wright knew chat she would need to assist John Christopher in rhe selection of the appropriate hedging alternative. She also knew that she should be able to calk intelligently abollf the likely movements in the Canadian dollar over the nexc three mOnths. Judy Wright asked her bank's economic department to pull rogether a set of numbers that would help her explain the oudook for the Canadian dollar to Mr. Christopher.
What economic and financial data would she request from the economic depanmenr? What analytical framework would she use co interpret the data? How should she beSt explain the economic data to Mr. Chriscopher, and what would be her recommendation for the appropriate hedging strategy?
