Brian Butler: TBird int'l finance class 03
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Series of lectures from Brian Butler, given during fall 2008 session at Thunderbird Global MBA, Miami campus:...

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.

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Brian Butler: TBird int'l finance class 03 Presentation Transcript

  • 1. Contact Information: Brian David Butler Miami Campus Facilitator International Economics & Trade (Prof. Grosse) Email: [email_address] Cell: 786-457-0984 Blog: http://blog.globotrends.com/ Wiki: http://kookyplan.pbwiki.com/brianbutler Connect professionally: http://www.linkedin.com/in/briandbutler http://www.linkedin.com/e/gis/69362 Connect personally: http://www.facebook.com/people/Brian_Butler/293500110
  • 2. 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
  • 3.
    • Purpose of class:
    • -not to become currency traders
      • Learn how FX markets work
      • Learn prediction techniques
      • Learn NOT to use these techniques!
      • Better use HEDGING!
  • 4. 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
  • 5. 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
  • 6. 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
  • 7. Currency Options (Sept 3, 2008) US $/€ (PSX) STRIKE CALLS PUTS PRICE Sept Oct Sept Oct 1440 1.85 2.50 0.96 1.83 1450 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 puts Source: http://www.phlx.com/market/WorldCurrencyOptions.asp ? , Sept 4, 2008. Bid rates Bid rates
  • 8.
    • 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
  • 9.
    • 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
  • 10. Currency Options – how to read this chart? US $/€ (PSX) STRIKE CALLS PUTS PRICE Mar JUN Mar JUN 1440 1.85 2.50 0.96 1.83 1450 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)
  • 11.
    • 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.
  • 12. Example; Currency Options
    • 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).
    • What is the total you need to pay today? commission + premium?
    • What is NPV of this account payable in dollars?
    US $/€ (PSX) STRIKE CALLS PUTS PRICE Mar Mar 1440 1.85 0.96 1450 1.30 1.41 1460 0.86 1.96 1470 0.55 2.64
  • 13. 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?
  • 14. 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.
  • 15. 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.
  • 16. 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
  • 17. 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!
  • 18. 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)
  • 19. 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
  • 20. Market Exch Rates as of: Sept 2, 2008 Source: Financial Times , September 3, 2008, and http://www.ozforex.com.au/cgi-bin/forwardRates.asp Foreign Currency Exchange Rates (Bid) Canada dollar UK* sterling Europe* euro Switzerland franc Japan yen 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
  • 21. Market Int Rates as of: Sept 2, 2008 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 States dollar England sterling Europe euro Switzerland franc Japan yen 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
  • 22. Currency Futures Open High Low Settle Change High Low Open Interest Sources: Wall Street Journal , September 3, 2008 .9212 JAPAN YEN (CME)—12.5 million yen; $.00 per yen Sept .9200 .9299 .9164 .0010 179,278 Dec .9250 .9345 .9214 .9260 -.0010 23,866 BRITISH POUND (CME)—62,500 pounds; $ per pound Sept 1.8169 1.8170 1.7765 1.7806 -.0350 113,955 Dec 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 151,887 Dec 1.4560 1.4639 1.4389 1.4436 -.0127 7,901 MEXICAN PESO (CME)—MXN 500,000; $ per 10MXN Sept .97000 .97175 .95975 .96250 .0078 88,075 Dec .94925 .95725 .94750 .94975 .0073 18,769 (Sept 2, 2008)
  • 23. Currency Options (Sept 3, 2008) US $/€ (PSX) STRIKE CALLS PUTS PRICE Sept Oct Sept Oct 1440 1.85 2.50 0.96 1.83 1450 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 puts Source: http://www.phlx.com/market/WorldCurrencyOptions.asp ? , Sept 4, 2008. Bid rates Bid rates
  • 24. 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
  • 25. 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…)