brian butler: tbird int'l finance class 03
DESCRIPTION
Series of lectures from Brian Butler, given during fall 2008 session at Thunderbird Global MBA, Miami campus:This lecture 03: learn to utilize hedging techniques to eliminate currency risks for international business.TRANSCRIPT
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Contact Information:
Brian David ButlerMiami Campus FacilitatorInternational Economics & Trade (Prof. Grosse)
Email: [email protected]: 786-457-0984Blog: http://blog.globotrends.com/ Wiki: http://kookyplan.pbwiki.com/brianbutler
Connect professionally:http://www.linkedin.com/in/briandbutlerhttp://www.linkedin.com/e/gis/69362
Connect personally:http://www.facebook.com/people/Brian_Butler/293500110
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Review:
• If ECB announces that they will raise interest rates by ½% …what do you expect to happen to the FX rate (dollar – euro)?
• Rate hike…immediate up,….expect down…• Make sure everyone knows / understands• Vs. what you read in ALL financial newspapers
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Purpose of class:
-not to become currency traders1. Learn how FX markets work2. Learn prediction techniques3. Learn NOT to use these techniques!4. Better use HEDGING!
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Why hedge? (don’t be these guys!)
Sadia, the blue-chip food giant, admitted on Friday that it had lost R$760m ($416m) on currency derivatives – equivalent to nearly a third of last year’s annual profits. The firm promptly sacked its chief financial officer, Adriano Lima Ferreira.
Aracruz, the paper and pulp firm, also said it had made large losses on currency bets but did not specify the amounts. Isac Zagury, its CFO, resigned.
http://www.ft.com/cms/s/0/39d256f8-8e87-11dd-9b46-0000779fd18c.html?nclick_check=1
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Why hedge? (don’t be these guys!)
Taesan LCD was a small but profitable South Korean flat-panel TV parts maker with annual revenues of about Won600bn ….but in October, it suffered investment losses of Won80.64bn ($64m) on currency option trading in the first half of the year amid the currency's sharp decline against the dollar.
Taesan is not alone. A number of small and mid-sized enterprises in the country are facing heavy losses from currency trades that went the wrong way.
http://www.ft.com/cms/s/0/1f8d6840-94d2-11dd-953e-000077b07658.html?nclick_check=1
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Concept Review: Options• Gives you the right to purchase / sell a currency
at a certain price (from now, up till an expiration date). You have the right to purchase (or sell), but you don’t have to.
• On the other hand, the other party to this "options" contract is required to buy (or sell) if you ask them to. These "options" can be bought and sold in a market (much like the "futures" can).
source: http://kookyplan.pbwiki.com/Foreign-exchange-Options
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Currency Options (Sept 3, 2008)US $/€ (PSX)STRIKE CALLS PUTSPRICE Sept Oct Sept Oct
1440 1.85 2.50 0.96 1.831450 1.30 1.98 1.41 2.30
1460 0.86 1.54 1.96 2.85
1470 0.55 1.17 2.64 3.48
Previous day’s data: vol.: approx 2,500 calls, 3,000 puts
US $/pound (PSX)1800 0.70 1.52 3.15 4.35
1810 0.45 1.20 3.90 5.00
1820 0.27 0.94 4.75 5.75
1830 0.16 0.72 5.59 6.55
Previous day’s data: vol.: approx. 300 calls; 500 putsSource: http://www.phlx.com/market/WorldCurrencyOptions.asp? , Sept 4, 2008.
Bid rates
Bid rates
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• Example 1: Call option – for A/P
• If you expect to make a payment in the next 3 months, then you might want to purchase a "call option", which will give you the right to buy foreign currency (for you to make your payment) at a specified price. This way, you will be protected if the currency FX rate suddenly changes. At least you will be able to purchase the foreign currency at that price, and to make your payment as needed.
source: http://kookyplan.pbwiki.com/Foreign-exchange-Options
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• Example 2: Put option for A/R
• If, on the other hand, you are waiting for a foreign currency payment to arrive, and you are afraid that a sudden change in the FX rate might decrease the amount of money you will receive, you might want to purchase a "put option" which will give you the right to sell the foreign currency at a certain price (over the specified time period).
source: http://kookyplan.pbwiki.com/Foreign-exchange-Options
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Currency Options – how to read this chart?US $/€ (PSX)
STRIKE CALLS PUTSPRICE Mar JUN Mar JUN
1440 1.85 2.50 0.96 1.831450 1.30 1.98 1.41 2.30
1460 0.86 1.54 1.96 2.85
1470 0.55 1.17 2.64 3.48
Source: http://www.phlx.com/market/WorldCurrencyOptions.asp? , Sept 4, 2008.
Bid rates
Premiums: cost of $0.0185 / euro
Strike price: you choose which FX rate you want. $1.440 / Euro
Plus, you would pay commission per contract (62,500 euros / contract)
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• The option premiums are listed as cents per foreign currency unit for each strike price (exercise price) listed on the left.
• So, for the first euro quote of 1.85 for the euro contract priced at $US 1.44/euro, you would pay $US 0.0185 per euro times the 62,500 euros in the contract at the PSX.
• By paying this option premium, it then gives you the right to buy 62,500 euros at that price on the third Wednesday of September.
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Example: If Kodak has a 5 million Euro A/P due in March (180 days), and they want to hedge the risk, how much will it cost? Assume a WACC of 5%, and that they want to lock in the 1440 price….commission = $30 per contract, with 62,500 euros per contract (standard).
1.What is the total you need to pay today? commission + premium?2.What is NPV of this account payable in dollars?
Example; Currency OptionsUS $/€ (PSX)STRIKE CALLS PUTSPRICE Mar Mar
1440 1.85 0.961450 1.30 1.41
1460 0.86 1.96
1470 0.55 2.64
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Answers
• 1. Total pay today: $94,900– Commission: $2400– Premium: $92,500– In % terms = 2.7% fee for using options
Question:– Why pay this fee? (premium) for options…and not
future / forward?
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GE case• ε 50 million is payable to a materials supplier
in 180 days from now. “Now” is January 28, 2002.– spot market (Fin Times): $US 0.8614 / euro– 180-day forward contract (Fin Times): $US 0.8563 / euro– 180-day futures contract (CME): $US 0.8580 / euro– 180-day option contract (PSX): $US 0.855 / euro with a
premium of $US 0.0156 / euro– 180-day euro deposit denominated in dollars pays 2.0225
% per year.– 180-day euro deposit in euros pays 3.42225 % per year.
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GE case• ε 50 million is payable to a materials supplier
in 180 days from now. “Now” is January 28, 2002.– The commission for each futures contract is
$US 30.00.– The commission for each option contract is
$US 30.00.– The commission on a forward contract is $400, for
any amount.
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GE results / Rankings
NPV NPV
using deposit rate ranking using WACC 7% ranking
Forward hedge $ 42,386,767 2 $ 41,367,549 1
Futures hedge $ 42,482,516 3 $ 41,461,275 2
Options hedge $ 43,126,018 4 $ 42,108,347 3
Money market (deposit) hedge $ 42,345,417 1 $ 42,345,417 4
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GE – final questions
• Is it even necessary to hedge?• What % of revenues? 50m/120b = <1%• What % of profits? 50m/17,000m = <1%• Are they operationally hedged? - yes
– Balance A/P with A/R?
• Is there a bankruptcy risk? No… Operational risk? No….
• Is it worth the time and effort to hedge? …probably not!
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Key Questions – always ask:
• Conceptual: do I want the Highest NPV? Or the lowest NPV? – If its an A/P – look for lowest– If it’s an A/R – look for highest
• Don’t forget to add commission (today)• For options – pay premium today (not future)• Memorize:
– euro has 125,000 euros per contract– Options = ½ as many (62,500)
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Procter & Gamble example:
• What should P&G do about its exchange risk on sale of 10million pounds of soap to a customer in England? A/R in 3 months. Assume P&G pays libor +1% on loans. No WACC given…instead, use deposit rate for NPV calc’s. Commission for forward= $2000, and $30 per contract for futures / options…with option premium $0.01 per pound.
• Today – September 2008• Due date- December 28, 2008
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Source: Financial Times, September 3, 2008, and http://www.ozforex.com.au/cgi-bin/forwardRates.asp
Foreign Currency Exchange Rates (Bid)
Canadadollar
UK*sterling
Europe*euro
Switzerlandfranc
Japanyen
Spot Rate— (Closing Foreign currency units per US dollar)
1.0625 1.7863 1.4522 1.1090 108.84
Forward Rate—Closing Rates
1 month outright
1.0630 1.7822 1.4498 1.1086 108.652
3 months outright
1.0636 1.7749 1.4454 1.1080 108.281
6 months outright
1.0639 1.7638 1.4391 1.1066 107.716
12 months outright
1.0642 1.7493 1.4283 1.1043 106.453
*(U.S. dollars per foreign currency unit)
Spot rates 0.9412 1.7863 1.4522 0.9017 0.00919
Market Exch Rates as of: Sept 2, 2008
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The investment rates quoted herein are on a 350-day coupon yield basis.
Source: Financial Times, September 3, 2008
International Money Market Rates (Bid Side)
United Statesdollar
Englandsterling
Europeeuro
Switzerlandfranc
Japanyen
Eurocurrency Rate
LIBOR overnight 2.17125 5.05563 4.3025 2.05 0.55
1 month 2.48563 5.38125 4.50813 2.25 0.69875
3 months 2.81313 5.74638 4.95188 2.74333 0.89375
6 months 3.11938 5.88750 5.15438 2.88167 0.97125
12 months 3.21438 5.99750 5.32313 3.16667 1.15438
Three-Month Treasury Bill Rate
1.68
Market Int Rates as of: Sept 2, 2008
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Currency Futures
Open High Low Settle Change High Low Open
Interest
Sources: Wall Street Journal, September 3, 2008
.9212JAPAN YEN (CME)—12.5 million yen; $.00 per yen Sept .9200 .9299 .9164 .0010 179,278Dec .9250 .9345 .9214 .9260 -.0010 23,866
BRITISH POUND (CME)—62,500 pounds; $ per poundSept 1.8169 1.8170 1.7765 1.7806 -.0350 113,955Dec 1.8039 1.8039 1.7655 1.7693 -.0346 3,873
EURO/US DOLLAR (CME)—€125,000; $ per €Sept 1.4680 1.4712 1.4456 1.4504 -.0127 151,887Dec 1.4560 1.4639 1.4389 1.4436 -.0127 7,901
MEXICAN PESO (CME)—MXN 500,000; $ per 10MXNSept .97000 .97175 .95975 .96250 .0078 88,075Dec .94925 .95725 .94750 .94975 .0073 18,769
(Sept 2, 2008)
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Currency Options (Sept 3, 2008)US $/€ (PSX)STRIKE CALLS PUTSPRICE Sept Oct Sept Oct
1440 1.85 2.50 0.96 1.831450 1.30 1.98 1.41 2.30
1460 0.86 1.54 1.96 2.85
1470 0.55 1.17 2.64 3.48
Previous day’s data: vol.: approx 2,500 calls, 3,000 puts
US $/pound (PSX)1800 0.70 1.52 3.15 4.35
1810 0.45 1.20 3.90 5.00
1820 0.27 0.94 4.75 5.75
1830 0.16 0.72 5.59 6.55
Previous day’s data: vol.: approx. 300 calls; 500 putsSource: http://www.phlx.com/market/WorldCurrencyOptions.asp? , Sept 4, 2008.
Bid rates
Bid rates
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General Rules:• A/R (receiving money in future in foreign
currency)– Forward sale of foreign currency– Futures contract to sell foreign currency– Purchase of put options (to sell foreign currency)– Loan hedge
• A/P (paying money in future in foreign currency)– Forward purchase of foreign currency– futures contract to purchase foreign currency– Purchase of call options (to buy foreign currency)– Deposit hedge
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Upcoming Assignments
• 10/18 – next Friday - case must be posted on our website before the deadline (midnight on October 18). Teams 1-16 must analyze the Cemex case; and Teams 17-32 have to analyze the TCAS case.
• Next Class – exam review– Arbitrage (facebook example)– IFE / PPP (exchange rate prediction)– Hedging (GE case / Cemex, etc…)