Finance Case Study

Minicase: Michael Smith’s Hedging Strategies

Case Instruction: The case write-up should be about 4-5 pages (double-spaced). Your write-up

should begin with an opening paragraph that defines the main problem in the case and your

recommended solution. The remainder of your paper should support your conclusion and

recommendations. This support should be based on your definition of the problem and

inferences that you draw from the facts of the case. Structure is important for your argument to

be lucid and transparent. The grading will be based on the quality of your analysis and writing.

Points will be deducted for grammar mistakes and typos.

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Michael Smith’s Hedging Strategies

It is Thursday afternoon, February 14, 2019. Michael Smith, Assistant Treasurer at American

Digital Graphics (ADG), sits in his office on the thirty-fourth floor of the building that dominates

Rockefeller Plaza’s west perimeter. It’s Valentine’s Day, and Michael and his wife have dinner

reservations with another couple at Balthazar at 7:30. I must get this hedging memo done, thinks

Smith, and get out of here. Foreign exchange forward contracts or option contracts? I had better

get the story straight before someone in the Finance Committee starts asking questions. Let’s see,

there are two ways in which I can envision us using options now. One is to hedge a €1 million

dividend to be received on September 15th from ADG Germany. The other is to hedge our

upcoming payment to Matsumerda for their spring RAM chip statement. With the yen at 110 and

decreasing, I’m getting nervous. An option to buy yen on June 10 might be just the thing.

Before we delve any further into Michael Smith’s musings, let us learn a bit about ADG and about

foreign exchange options. American Digital Graphics is a $12 billion sales company engaged in,

among other things, the development, manufacture, and marketing of microprocessor-based

equipment. Although 30 percent of the firm’s sales are currently abroad, the firm has full-fledged

manufacturing facilities in only three foreign countries, Germany, Canada, and Brazil. An

assembly plant in Singapore exists primarily to solder Japanese semiconductor chips onto circuit

boards and to screw these into Brazilian-made boxes for shipment to the United States, Canada,

and Germany. The German subsidiary has developed half of its sales to France, the Netherlands,

and the United Kingdom, billing in euros. The firm needs to convert the €1 million dividend to US

dollars by September 15th. The firm has an agreement to buy three hundred thousand RAM chips

at ¥6000 each semi-annually, and it is this payment that will fall due on June 10th.

The conventional means of hedging exchange risk are forward or future contracts. These, however,

are fixed and inviolable agreements. In many practical instances the hedger is uncertain whether

foreign currency cash inflow or outflow will materialize. In such cases, what is needed is the right,

but not the obligation, to buy or sell a designated quantity of a foreign currency at a specified price

(exchange rate). This is precisely what a foreign exchange option provides.

A foreign exchange option gives the holder the right to buy or sell a designated quantity of a

foreign currency at a specified exchange rate up to or at a stipulated date. The terminal date of the

contract is called the expiration date (or maturity date). If the option may be exercised before the

expiration date, it is called an American option; if only at the expiration date, a European option.

The party retaining the option is the option buyer; the party giving the option is the option seller

(or writer). The exchange rate at which the option can be exercised is called the exercise price or

strike price. The buyer of the option must pay the seller some amount, called the option price or

the premium, for the rights involved.

The important feature of a foreign exchange option is that the holder of the option has the right,

but not the obligation, to exercise it. He will only exercise it if the currency moves in a favorable

direction. Thus, once you have paid for an option, you cannot lose (except for the option’s

premium), unlike a forward contract, where you are obliged to exchange the currencies and

therefore will lose if the movement is unfavorable.

The disadvantage of an option contract, compared to a forward or futures contract is that you have

to pay a price for the option, and this price or premium tends to be quite high for certain options.

In general, the option’s price will be higher the greater the risk to the seller (and the greater the

value to the buyer because this is a zero-sum game). The risk of a call option will be greater, and

the premium higher, the higher the forward rate relative to the exercise price; after all, one can

always lock in a profit by buying at the exercise price and selling at the forward rate. The chance

that the option will be exercised profitably is also higher, the more volatile is the currency, and the

longer the option has to run before it expires.

Returning to Michael Smith in his Rockefeller Center office, we find that he has been printing spot,

forward and currency options, from the company’s Bloomberg terminal.

The option prices are quoted in U.S. cents per euro. Yen are quoted in hundredths of a cent.

Looking at these prices, Michael realizes that he can work out how much the euro or yen would

have to change to make the option worthwhile.

“I’ll attach these numbers to my memo,” mutters Michael, but the truth is he has yet to come to

grips with the real question, which is when, if ever, are currency options a better means of hedging

exchange risk for an international firm than traditional forward exchange contracts (or future’s

contracts).

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Please assist Mr. Smith in his analysis of currency hedging for his report to ADG’s Finance

Committee. In doing so, you may consult the market quotes from Bloomberg in the exhibits below.

In your case write-up, please address the following questions.

(1) For the €1 million dividend to be received on September 15 (7 months from now), should Mr. Smith hedge with forward contracts or options contracts? You should calculate the

dollars received under each hedging strategy and draw a graph with Excel to show the

relation between the dollar amount received and future spot rate 7 months from now. You

may make your suggestion based on what your graph shows. Suppose the interest rate is

very low and you do not need to compute the effect of time value of money on options

premium in your calculation.

(2) For the ¥1800 million to be paid on June 10th (4 months from now), should Mr. Smith hedge with forward contracts or options contracts? You should calculate the dollars paid

under each hedging strategy and draw a graph with Excel to show the relation between the

dollar amount paid and future spot rate 4 months from now. You may make your suggestion

based on what your graph shows. Suppose the interest rate is very low and you do not need

to compute the effect of time value of money on options premium in your calculation.

Currency group Spot Exchange Rates

2/14/19 Rate: Spot

USD EUR JPY

JPY 110.5000 125.3000 ------------

EUR 0.8819 ------------ 0.00798

USD ------------ 1.1339 0.00905

Currency group Forward Exchange Rates

2/14/19 Rate: 4 Month

USD EUR JPY

JPY 105.8201 117.0899 ------------

EUR 0.9038 ------------ 0.00854

USD ------------ 1.1065 0.00945

Currency group Forward Exchange Rates

2/14/19 Rate: 7 Month

USD EUR JPY

JPY 104.6025 114.0167 ------------

EUR 0.9174 ------------ 0.00877

USD ------------ 1.0900 0.00956

Currency Options

Dollar/Euro (direct quote for euro)

23 Sep 19 23 Sep. 19

Ticker Bid Ask Strike Ticker Bid Ask

1) XEU2C C 6.10 6.44 109 1) XEU2P C 4.03 4.28

2) XEU2C C 5.52 5.82 110 2) XEU2P C 4.44 4.67

3) XEU2C C 4.97 5.25 111 3) XEU2P C 4.89 5.09

4) XEU2C C 4.45 4.73 112 4) XEU2P C 5.35 5.56

5) XEU2C C 3.94 4.21 113 5) XEU2P C 5.84 6.06

Currency Options

Dollar/Yen (direct quote for Japanese yen)

17 Jun 19 17-Jun-19

Ticker Bid Ask Strike Ticker Bid Ask

1) XNM2C C 2.09 2.40 93.5 1) XNM2P C 1.50 1.75

2) XNM2C C 1.82 2.11 94.0 2) XNM2P C 1.80 2.08

3) XNM2C C 1.57 1.84 94.5 3) XNM2P C 2.10 2.35

4) XNM2C C 1.33 1.57 95.0 4) XNM2P C 2.38 2.58

5) XNM2C C 1.10 1.35 95.5 5) XNM2P C 2.60 2.85

Calls

Calls Puts

Puts