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Executive Summary
The luxury sports car seller companyUSASuperCars has signed a contract with five different customer countries, namely the UK, Japan, Canada, South Africa and the USA. The selling price is fixed in local currencies at the exchange rate on the day of the delivery. Considering the fluctuations of exchange rates, HSBC offered a sure sum of money in return for the revenue of the contract. The purpose of this business report is to make a decision as to whether the offer should be accepted or not.
For USASuperCars, some recommendations are made:
· According to a revenue analysis of the contract, the average revenue is $2,192,868 with a standard deviation of $44,668. The offer provided by HSBC is not good enough to accept because there is a high chance to get higher revenue.
· The sales manager is more risk-averse than the CEO towards the HSBC offer.
· If the offer is accepted, the option to pay in three months’ time will be more beneficial to USASuperCars.
The offer also includes both benefits and risks for HSBC. According to the HSBC’s profit and loss analysis, the average profit is $42,868 and there is a 16.86% possibility of incurring a loss. Some recommendations are also provided regarding the risks and options for HSBC:
· In addition to the exchange rate risk, HSBC also faces other risks involved in international trade, such as credit risk, sovereign risk and default risk.
· The option to pay in twelve months’ time will be more beneficial to HSBC.
· It is necessary for HSBC to take some measures to hedge risks instead of converting all the foreign currencies into dollars. The financial techniques of borrowing, currency forward and option are effective and common in financial markets, and may be considered to minimize the influences of risks.
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Table of Contents 1 Introduction 4 2 Discussion of the USASuperCars perspective 4 2.1 Profit analysis for USASuperCars 4 2.2 Decisions onthe HSBC offer 5 2.2.1 Should the HSBC offer be accepted? 5 2.2.2 Which payment method is preferred? 6 2.3 Recommendations for USASuperCars 7 3 Discussion of the HSBC perspective 7 3.1 Risk analysis for HSBC 7 3.1.1 Possibility for HSBC to incur a loss 8 3.1.2 Discussion of other potential risks for HSBC 9 3.2 Which payment method is preferred? 9 3.3 Other options for banks beyondconverting all currencies into dollars 10 3.4 Recommendations for HSBC 11 4 Conclusion 11 References 12 Appendix 13
Introduction
USASuperCars has just signed a contract with five different customer countries, namely the UK, Japan, Canada, South Africa and the USA, to sell 27 luxury sports cars in a year. In this contract, the price is fixed in local currencies at the exchange rate on the day of delivery. Considering the volatility of the exchange rate, both benefits and risks are embedded in this contract. At this time, HSBC has offered a sure sum of $2,150,000 in return for the revenue. The primary purpose of this report is to make a decision as to whether or not USASuperCars should accept this offer by weighing up the benefits and risks. Secondarily, if the HSBC offer is accepted, this report aims to determine which payment schedule is better from the perspectives of both USASuperCars and HSBC, what other potential risks HSBC will be exposed to, and what measures it can take to minimize the exchange rate risk beyond converting all currencies into dollars.
Discussion of the USASuperCars perspective
In this section, the profit analysis for USASuperCars is conducted to help decide whether or not the company should accept the HSBC offer, and if the offer is accepted, which option for payment (in three months or twelve months) is better for the company. At last, recommendations are listed regarding the HSBC offer.
Profit analysis for USASuperCars
The profit analysis is conducted based on the details of the worldwide orders, the quantity and the selling price of luxury cars in local currencies. Considering the exchange rate, the mean and standard deviation rate for converting each currency into dollars is provided as well according to the historical data. The profit is assumed to be normally distributed under the assumption that the rates are normally distributed and independent. From calculations (provided in appendix), the average revenue of this contract is expected to be $2,192,868 with a standard deviation of $44,668.
Considering the HSBC offer, further profit analysis is provided as well. In summary, under the normal distribution with a mean of 2,192,868 and standard deviation of 44,668, the possibilities for USASuperCars to receive revenue exceeding $2,200,000 and $2,225,000 are 43.66% and 23.59% respectively. There are 16.86% and 5.14% chances for actual revenue less than $2,150,000 and $2,120,000.Graph 1 presents the profit distribution for the USASuperCars company in this contract.
Graph 1: The profit distribution for USASuperCars
Probability
16.86%
23.59%
Revenue
$2,225,000
$2,192,868
$2,150,000
Decisions on the HSBC offer
This section will discuss whether or not the HSBC offer is worth accepting. It also discusses the preference on payment schedule for USASuperCars.
Should the HSBC offer be accepted?
In order to evaluate the HSBC offer fairly, both benefits and losses for this contract should be considered. The principle is that if the revenue for this contract is very likely to be less than $2,150,000, the offer should be accepted. On the other hand, if there is a high possibility for the company to gain revenue exceeding$2,150,000, this contract should be rejected. Based on the profit analysis in section 2.1, the possibility for USASuperCars to gain revenue less than $2,150,000 is 16.86%. In other words, there is a 83.14% (1-16.86%) chance for USASuperCars to gain revenue exceeding $2,150,000. Therefore, from the perspective of revenue expectations, the HSBC offer is not beneficial, because the possibility of further revenue is more attractive to the company. However, despite the possibility for USASuperCars to gain revenue exceeding $2,150,000, there is still a 16.86% possibility that the company will lose money. In other words, it is still risky for the company to gamble on the future. However, the guaranteed sum of money in return for revenue offered by HSBC can eliminate these potential risks faced by USASuperCars, because it transforms the revenue from unpredictable to predictable. In this situation, the willingness of the sales manager to accept HSBC’s offer indicates that the sales manager is more risk-averse than the CEO, who preferred to reject the HSBC offer.
Which payment method is preferred?
If HSBC’s offer is accepted, the option for payment in three months’ time is more beneficial to the USASuperCars company than the one in twelve months’ time. This conclusion has been reached after evaluating the value of the money for the two different payment schedules. Comparison is conducted considering the influences of inflation and interest rates on the guaranteed sum of money in the offer.
· The effect of inflation
According to the survey conducted by the professional forecasters, the average monthly inflation rate in the US in 2013 is around 2%. In other words, the consumption ability of $2,150,000 in three months equals $2,139,286 at the beginning of the year, while the consumption ability of $2,150,00 in twelve months only equals $2,107,843 at the beginning of the year. In other words, the offer’s sure sum of money in three months is more valuable than the one in twelve months from the perspective of consumption ability.
· The effect of interest rates
In the comparison of the two different payment schedules, the future value of the money should be taken into consideration. For example, if USASuper Car sreceives the money in three months’ time, the money can be reinvested into other profitable projects or put it into banks. The average US one-year T-bill yield can be employed as a benchmark for the interest rates because of free risks. According to the Economic Forecasts online, the average US one-year T-bill yield is forecasted at around 13% in 2013 (Financial Forecast Center, 2012).In other words, if the company receives the money in three months’ time, it can be reinvested with an interest rate of 13%, while no such profit can be made if the payment is due in twelve months’ time.
However, there are also some potential default risks for USASuperCars. More specifically, the bank must be able to afford the payment in a short time despite liquidity issues. However, the possibility of default is quite low, for the purpose of reputation protection.
In summary, after balancing the benefits and risks of the two payment methods, payment in three months’ time is preferred for the USASuperCars company.
Recommendations for USASuperCars
Based on the discussion above, several recommendations can be made to help make a decision on the HSBC offer.
· According to the profit analysis of this contract for USASuperCars, the HSBC offer is not good enough for the company when there is a high possibility for the company to receive higher revenue.
· Considering the risk preference, sales managers are more risk-averse than CEOs in their preference to accept the HSBC offer.
· If the company decided to accept the HSBC offer, the option for payment in three months’ time is preferred by the company, taking into consideration the effects of inflation and interest rates.
Discussion of the HSBC perspective
This section will discuss the possibility for HSBC to incur a loss, as well as other risks, going beyond the exchange rate risk that HSBC will be exposed to if the offer is accepted. On the other hand, other available options for banks to minimize risks are recommended.
Risk analysis for HSBC
If the offer is accepted, the potential exchange rate risk will be transferred from USASuperCars onto HSBC. In other words, this offer has some inherent benefits as well asrisks. Therefore, it is important for the managers of HSBC to evaluate the risks.
Possibility for HSBC to incur a loss
The first risks HSBC needs to consider are those associated with exchange ratesdue to their volatility. More specifically, if the futher revenue exceeds the $2,150,000 guaranteed sum offered, the part exceeding that sum will be taken as profit for the bank. On the other hand, a loss will be incurred if the future revenue is less than $2,150,000. Considering the conflicting interests in this contract, if HSBC incurres a loss, then USASuperCars must enjoy a profit. Therefore, according to the profit analysis in section 2.1, the possibility for the revenue less than $2,150,000 is 16.86%. Therefore, there is a 16.86% possibility for HSBC to incur a loss. Similarly, the expected profit for HSBC is the value of the money exceeding the guaranteed sum of $2,150,000. As a consequence, the average profit for HSBC in this offer is expected to be $42,868 (2,192,868-2,150,000) when the expected revenue of the selling contract is $2,192,868. In summary, the expected revenuefor the bank is $2,192,868 with a 16.86% possibillity ofincurring a loss.
Further assesment is required to evaluate the potential risks for HSBC. Value at risk is defined by banks as a tool for evaluatingthe loss the bank is exposed to at 5%. Based on a normal distribution of uncertain revenue, a loss incurredat 5% is ($30,834.20). In other words, the value at risk for the bank at 5% is ($30,834.20). Graph 2 presents a profit (loss) distribution for HSBC.
Graph 2: the profit (loss) distribution of the HSBC
0.05
Probability
$42,868
0
$30,834.2
Profit
Discussion of other potential risks for HSBC
In addition to the exchange rate risks, HSBC is also exposed to other risks which may arise in the process of international trade. These may include credit risks and soveraign risks. For HSBC, it is crucial to take measures to control all forms of risk in order to maximize profit. The additionalrisks can be characterisedas follows:
· Credit risk. In international trade, credit risk is also called default risk. In this contract, the bank is liable to bear a loss because of buyers’ default problem, for example, if the buyers could not afford the payment due to liquidity troubles. In this situation, HSBC may need to form a agreement with USASuperCars to minimize the default risks.
· Sovereign risk. Another common risk involved in international trade is sovereign risk. In international trade, different government policies and attitudes towards intenational trade play a crucial role in determing its success . In this contract, since there are 5 different countries involved, it is worthwhilefor the management to keep an eye on the policies of the different countries.
· Operational risk. According to the contract, there is delivery included in the selling part, and as a result, operational risk should be considered as well. For example, some damages may happen to the cars during the delivery process and may incur some extra costs. In this situation, the profits decrease correspondingly as well.
Which payment method is preferred?
On the opposite side of the coin, compared to what benefits USASuperCars, HSBC prefers a different payment method. In other words, the payment in twelve months’ time is more beneficial to HSBC. The advantages of payment in twelve months can be discussed from the perspectives of decreasing opportunity cost and default risk.
· Decreasing opportunity cost.The payment in twelve months’ time is more beneficial to HSBC from the pespective of opportunity cost. For example, HSBC couldlend the guaranteedsum of money by way of loans to generate interest, while payment in three months’ time can not generate these extra benefits. Therefore, in an attempt to maximize shareholders’ interests, payment in twelve months’ time is better.
· Decreasing default risk.The duration of the selling contract is one year. Therefore, if the bank chooses to pay in twelve months, the contrast is almost finished when the payment is made. If there are any default troubles, HSBC has the advantage of negotiating with USASuperCars, which will decrease the default risks thereafter.
In summary, the rational choice for HSBC is to choose the option for payment in twelve months’ time.
Other options for banks beyond converting all currencies into dollars
In order to maximize benefits toshareholders and to minimize the risks to which HSBC is exposed, revenue in local currencies may be converted to dollars in part or not at all. In respect of other options, hedging is taken as a common way to manage risks. Making good use of hedging can minimize risks effectively even to zero. On the other hand, the predicibility of future cashflows for this contract can be increased through the tool of hedging. And there are also some techiniques under the management of hedging.
· Borrowing.The technique of borrowing is used to minimize the risk of depreciation of dollars. More specifically, HSBC can borrow the foreign curriencies at spot price and then convert them in dollars. In twelve months, HSBC can use the revenue in local currencies to pay back the debt instead of converting them into dollars.
· Forward contracts. The HSBC can also employ the technique of forward contrats to minimize loss due to flucations of the exchange rate. In other words, HSBC can sell the foreign currencies at a predetermined price in the future. Therefore, no matter how the exchange rate changes, HSBC can guarantee future profit.
· Currency options. Similar to the forward contracts, the technique of currency options involves selling the currencies at a predetermined price. However, the HSBC has the choice to exercise thisoption or not. For example, if the dollar isstronger than other foreign currencies, HSBC can choose not to exercise its option.
Recommendations for HSBC
Based on the discussion above, several recommendations are made:
· If the offer is accepted, HSBC will face risks in addition to those associated with the exchange rate.
· In order to minimize these potential risks, HSBC can consider adopting hedging techniques rather than converting all currency into dollars.
· The option for payment in twelve months’ time is more beneficial to HSBC.
Conclusion
To sum up, the offer of a fixed sum provided by HSBC is not a good one for the USASuperCars company, because there is a high possibility that the company would receive revenue exceeding the fixed sum of $2,150,000. On the other hand, if the offer is accepted, the option for payment in three months’ time is preferred by USASuperCars and the one for payment in twelve months’ time is preferred by HSBC. In addition, exchange rate risk will be transferred to HSBC, as will be other risks including credit risk, sovereign risk and operational risk. Therefore, it is better for HSBC to adopt hedging techniques to minimize these risks, such as borrowing, currency options and forward contracts.
References
Economic Forecasts. 14th December 2012.[Online]. Available at: http://myweb.rollins.edu/wseyfried/forecast.htm.Accessed15th December 2012.
Chinadaily Homepage. 10th August 2011.US to Keep Near Zero Interest Rate for 2 Years. [Online]. Available at: http://www.chinadaily.com.cn/world/2011-08/10/content_13081331.htm.Accessed 18th, November 2013.
The Financial Forecast Centre. 1 Year U.S. Treasury Securities Yield Extended Forecast. [Online]. Available at:
http://www.forecasts.org/subscribe/sample/index.htm.Accessed 18th November 2013.
Economy Watch. 30th June 2010. Risks in International Trade. [Online]. Available at: http://www.economywatch.com/international-trade/risks.html.Accessed 18th November 2013.
Appendix : Answers table
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Questions |
Answers |
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Expected Revenue each country= Quantity*Selling price*mean Expected Revenue=E (UK) +E (Japan 1) +E (Japan2) +E (Canada 1) + E (Canada 2) +E (South Africa) +E (USA) =$2,192,868 Variance each country=Quantity^2*SellingPrice^2*Standard Deviation^2 Standard Deviation=√(UK Quantity)2(Selling price)2(Standard deviation)2+[(Japan1Quantity) (Selling price) (Standard deviation)+(Japan2Quantity) (Selling price) (Standard deviation)]2+[(Canada1Quantity) (Selling price) (Standard deviation)+(Cananda2Quantity) (Selling price) (Standard deviation)]2+ (South Africa Quantity)2(Selling price)2(Standard deviation)2+(USA Quantity)2(Selling price)2(Standard deviation)2=$44,668
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Formula: Z=(X-µ)/δ Z= ($2,200,000-$2,192,868)/ $44,668=0.1597 P(X>$2,200,000) =P (Z>0.1597) = 43.66% Z= ($2,225,000-$2,192,868)/ $44,668= 0.7194 P(X>$2,225,000) =P (Z>0.7194) = 23.59%
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Z= ($2,150,000-$2,192,868)/ $44,668=-0.9597 P(X<$2,150,000) = P (Z<-0.9597) = 16.86% Z= ($2120,000-$2,192,868)/ $44,668=-1.6313 P(X<$2,120,000) =P (Z<-1.6313) = 5.14%
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It is not a good offer for USASuperCars company. |
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Sales manager is more risk-adverse |
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Except for the exchange rate risk, HSBC also needs to take risks involved in the international trade. Such as credit risk, sovereign risk and operational risk.
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The future value and present value of these two payment methods are different. The USASuperCars company will prefer payment in three months’ time and HSBC prefers payment in twelve month’s time.
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P=P(X<$2,150,000) =16.86% |
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Expected profit= Expected revenue – cost = $2,192,868- $2,150,000= $42,868 VaR= (Expected revenue -1.65*δ)-$2,150,000=$ (30,834.2)
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The bank can choose use hedge techniques instead of converting all the foreign currencies into dollars. Such as, borrowing, currency forward and currency option. |
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