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CASE on EXCHANGE RATE RISK MANAGEMENT Hofflander INDUSTRIALS (copyrighted) When Ted Bush entered hi



When Ted Bush entered his office on
Saturday, April 10, 200x, he received an email indicating the acceptance of his
firm’s offer to supply Jerry Martin, a Swiss distributor, with approximately a
little more than US$1,000,000 of electrical equipment in the form of remote
controls for industrial garage door openers (payable in Swiss francs). The mail
also indicated that Mr. Martin would wire the required deposit of SF100,000
directly to Hofflander Industrials’ Houston bank that day. With stagnant sales
recently, this was the best news Martin got in quite some time.

Bush, president and owner of Hofflander
Industrials, had been working hard to return the firm to profitability and hoped
exports would provide the firm with that impetus. His firm had been doing very
poorly caused by a downturn in the local economy and his failure to find new
business at home. Given the decline in the construction of industrial buildings
and warehouses, business for remote controls had been very sluggish. To use
idle capacity, Bush decided to develop an export market. So far, he had made
some export sales but mostly these were small orders and the sales were all
denominated in U.S. dollars.

Encouraged by help from the Texas Chamber
of Commerce, he joined a group of businessmen in January, accompanying the
Governor to drum business in Switzerland. He met Jerry Martin in Zurich, who
indicated an interest in becoming the Swiss distributor if costs were reasonable
and invoicing was done in Swiss francs rather than U.S. dollars. He asked Bush
to prepare a firm offer.

On January 12, 200x, Bush offered to sell Martin
a shipment of industrial garage door openers for SF 1,225,000. The offer
requested the following payment schedule:

SF 100,000 as cash down payment at the time
the offer was accepted by Martin;
SF 500,000 to be paid three months after
the offer was accepted by which time half the
order would have been
SF 625,000 to be paid in six months after
the offer was accepted, by which time the
remainder of the order
should have been shipped.

Bush called his bank to check Martin’s
credit rating and was told that his rating and business were very well
respected in Switzerland and so Bush decided not to request any letter of
credit (LC) guaranty beyond the initial down payment. Bush arrived at the price
of SF 1,225,000 by first pricing the order in dollars on January 12 and then
basing it on the spot exchange rate on January 12 – SF1.2027 per dollar. He
estimated his costs on the assumption that export costs would run nearly the
same as for existing domestic sales.

When Bush received the acceptance of the
order on April 10, he noted that the dollar had already weakened against major
currencies and that day the Swiss franc was trading at SF 1.1527 per dollar. He
figured that at that rate his order of SF 1,225,000 was worth $1,062,722,
nearly $44,200 more than when the bid was made, He was happy but wondered
whether things could reverse course when he receives future payments in Swiss
francs in three and six months respectively. In making the offer to Martin, Bush
had not allowed himself a big profit margin and wondered if he could lose money
if Swiss francs depreciate rather than appreciate.

On April 10, Bush decided to consult his
bank and ask for advice about foreign exchange risk. His banker, Ms. Lewis,
suggested several courses of action:

Remain uncovered and
do nothing. If the Swiss franc does go back to
the January 12 levels, he still would not lose a lot of money.
Cover the exposure in the forward
exchange market.
Cover the exposure in the futures
Cover the exposure in the options
Cover in the money

She suggested that while the final expense
could not be determined in all outcomes before-hand, their outcomes could be
simulated over a range of potential ending exchange rates when Swiss franc
receipts arrive on July 10 and October 10, respectively. Of course, if cash
inflows in francs could be matched by outflows in francs, the problem of
hedging through derivatives would not be an issue. The alternatives are:

Remain uncovered: While this means
waiting until the sales proceeds were received, it offered the maximum
risk but also the greatest potential gain if the dollar weakens vis-à-vis
the franc as it did from January to April. However, over the same time
period, Ms. Lewis showed Bush that the Swiss franc had ranged from SF 1.1442
to SF 1.3290 per dollar. If the SF declines to SF 1.30 on July 10 and
October 10, the two future SF proceeds will amount to $384,615 and
$480,769. However if the SF appreciates to SF 1.12 per dollar, the
corresponding proceeds would be approximately $446,429 and $558,036
respectively. The rates over the last six months have fluctuated as

October 10 SF
October 20 SF
October 30
SF 1.2850
November 10 SF
November 20 SF
December 30 SF
December 10 SF
December 20 SF
December 30 SF
January 10 SF
January 20 SF

January 30 SF
February 10 SF
February 20 SF
February 29 SF
March 10 SF
March 20 SF
March 30 SF
April 10 SF

Cover in Forward Exchange Rates: If Bush were
risk averse and wished to eliminate currency exposure, he could buy
forward contracts from the bank. Ms. Lewis explained to him that in a
forward contract, one agrees to buy or sell foreign currency at a
predetermined price with delivery to be made at a specified date in the
future up to one year later. It would assure Bush of a fixed number of
dollars at a price locked in today with the bank. Ms. Lewis looked at her
screen and quoted her a three month forward rate of SF1.1377 per dollar and
a six month forward rate of SF1.1277 per dollar, which meant more dollars
in the future than at present.

Cover in the futures market:On Bush’s
insistence of alternate choices, Ms. Lewis showed him her computer screen
focusing on futures contracts. She explained to him and pros and cons of
using the futures contracts vis-à-vis the forwards. She mentioned the fact
that if his shipment was delayed and the corresponding SF payments delayed
as well, the forward contract would create problems for Martin. The
futures traded on CME on April 10 (spot rate SF1.1527/$) showed the
following quotes for Swiss francs in cents per SF:

Swiss Franc (CME) – Francs 125,000 francs: $ per franc

Open Close Change
September 0.8440 0.8518 +0.0078
December 0.8677 0.8702 +0.0025

She explained to Bush that to use the
futures market, he would have to open an account with a broker and tie up some
funds in a margin account. This would then be debited or credit due to daily
marking to the market. If his account fell, he could get margin calls but he
could also withdraw money from the margin account if the account had a balance
exceeding the required maintenance margin. Work with settle prices (day’s close

Cover in the options market:Ms. Lewis
also pointed out to Martin the advantages of buying an insurance policy in
the form of OTC options contracts, available from the bank itself. She
explained that while options are traded on the Nasdaq OMX Stock exchange,
she could arrange an option contract tailored to meet Bush’s customized
requirements and asked her derivatives desk to show the various
possibilities to Bush. She also explained the pros and cons of using
options and futures to hedge.

Date: April 10, 200x:

Amount SF 500,000 Amount SF625.000
Expiration date: July 10 Expiration date: October 10
Call Put Call Put
0.865 $0.0145/SF $0.0089/SF $ 0.0165/SF $0.0100/SF
0.870 $0.0115/SF $0.0119/SF $ 0.0135/SF $0.0140/SF
0.875 $0.0105/SF $0.0129/SF $ 0.0115/SF $0.0160/SF

Cover in the Money Market:As if Bush
was not confused already, Ms. Lewis laid out a five option to him. She
said that her bank could arrange for Hofflander Industrials to borrow
Swiss francs from its Swiss or New York office. The loan would be in the
form of an overdraft in Swiss francs and would be at a fixed rate for both
three-month and six-month maturities at 100 basis points above Swiss franc
LIBOR. She again went to her computer screen and found the following
quotes for SF LIBOR and $ LIBOR on April 10.

3 months 6
2.6% 3.0%
$ LIBOR 3.4% 3.8%

Bush mentioned
to Ms. Lewis that since he had not done well in business over the last six
months of the recession, he would need money for working capital to finance the
production of the product over the next six months. He figured he needed $450,000
for working capital. Ms. Lewis told him that given his low credit rating
presently and the credit crunch in the market due to the recession, the cost of
borrowing $450,000 for working capital might cost him 150 basis points over the
six month $ LIBOR.Ms. Ray told him that she could not promisebut
given his past business relationship with the bank, she could arrange for a six
month $ loanat 5.3% (which
is 150 basis points over the six month LIBOR of 3.8%). She could also arrange
to invest his money at the $ LIBOR in London if he so chose.

Other Considerations: Ms. Lewis converted the down payment of SF100,000 at the spot rate
of SF1.1527 to net him approximately $86,753 in cash. These funds could be used
to finance his working capital or pay off other short-term loans, which might
have been at a higher rate.

Mr. Bush walked out of Ms. Lewis’s office
a confused man. He was amazed at the options available to him. He suddenly runs
into you (a family friend) and finds out that you are doing your MBA
specializing in Finance. He hires you instantaneously to present a comparative
analysis for him of all the available choices by the end of the day, outlining
a strategy for him to pursue. Prepare a consulting report/strategy for Bush and
make your suggestions to him as to which line of action should he pursue.

Evaluate and
compare all five choices listed above:

1. Remain unhedged
2. Forward hedge
3. Futures hedge
4. Options hedge
5. Money market hedge.


Make any reasonable assumptions you need.
Some suggested assumptions and hints:

1. Forecast the expected spot rate for July 10 and October 10. There
are several ways to do this. You could run a regression with time trend and
forecast it. Or you could use a moving average approach. Or you could use a
probability distribution approach to forecast the future spot rates on those

2. Assume Hedge Ratio = 1 in futures case. This means change in spot
rate will be equal to change in futures price on July 10 (for September
maturity) and October 10 (for December maturity). Let us take the September maturity
for example. On April 10, you are given the spot rate and the futures price for
September contract. On July 10, you will receive the money and do not need the
hedge. So you offset the hedge by offsetting the futures contract at t* (July 10)
for September contract. But you do not know this. However, you do know the expected
future spot rate on July 10. So, if you assume that the Hedge ratio = 1, you
can find the futures price at t* for September maturity since change in spot =
change in futures.

3. Use only one exercise price for options. I suggest you use the closest
to at-the-money option exercise price.

4. Issue of working capital
is important but not the main focus of this case. Discuss it if it helps your


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