Executive Summary We are discussing the case study of Merton Electronics Corporation (MEC). Although company is doing well as far as sales is concern but their net profit is dipping. This is due to increasingly difficult market conditions as well as fluctuation in international currency prices. Patricia Merton is president and majority shareholder of MEC. MEC is exposed to three currencies Japanese Yen, US Dollar & Taiwanese Dollar. Major concern of MEC is volatility of Yen and Taiwanese Dollar.
With over 60 percent of purchases are subjected to currency fluctuation, company is suffering from heavy monetary losses. We are discussing various hedging methods available in front of MEC to get a shield from exchange rate fluctuation. 1. Currency Risk Exposure Currency risk is the type of risk that arises because of change in prices of one currency against other. Any company which have business or assets in different countries they are exposed to currency risk unless they hedged their position. Currency risk exists regardless of whether you are investing domestically or abroad.
If you invest in your home country, and your home currency devalues, you have lost money. Any and all stock market investments are subject to currency risk, regardless of the nationality of the investor or the investment, and whether they are the same or different. The only way to avoid currency risk is to invest in commodities, which hold value independent of any monetary system. Currency risk exposure is the dollar amount that is at risk if exchange rates move in an unfavorable direction. A company has currency exposure when the currencies for its expenditures and revenues are not the same.
Future payments or distributions payable in foreign currency carries the risk that the foreign currency will depreciate in value before the foreign currency payment is received and converted into US dollars. Although there is a chance for profit, most businesses and lenders give up that chance in order to eliminate the risk of currency exchange loss. It is measured as the amount in receivables or payables the company has committed to, for which the exchange rate has not been determined (http://www. vsb. org/publications/valawyer/june_july01/kelley. pdf).
A currency is exposed to exchange rate fluctuations to the extent that it is used to conduct transactions with external markets. The greater the proportion of “inter-currency” exchange to total monetary transactions for a given market, the greater the exposure to changes in exchange rates. Businesses conducting international trade are exposed to exchange rate fluctuations in proportion to their total volume of transactions. As the magnitude of “inter-currency transactions” increases relative to aggregate transactions, a business unit realizes greater exposure to exchange rate fluctuations.
When a firm conducts transactions in different currencies, it exposes itself to risk. The risk arises because currencies may move in relation to each other. If a firm is buying and selling in different currencies, then revenue and costs can move upwards or downwards as exchange rates between currencies change. If a firm has borrowed funds in a different currency, the repayments on the debt could change or, if the firm has invested overseas, the returns on investment may alter with exchange rate movements — this is usually known as currency risk exposure. For example if you are a U. S. nvestor and you have stocks in Japan, the return that you will realize is affected by both the change in the price of the stocks and the change of the Japanese Yen against the U. S. dollar. Suppose that you realized a return in the stocks of 10% but if the Japanese Yen depreciated 10% against the U. S. dollar, you would make a small loss. Transaction risk is the risk that exchange rates will change unfavourably over time. It can be hedged against using forward currency contracts; Translation risk is an accounting risk, proportional to the amount of assets held in foreign currencies.
Changes in the exchange rate over time will render a report inaccurate, and so assets are usually balanced by borrowings in that currency. 2. Hedging: It is a position established in one market in an attempt to offset exposure to price fluctuation in some opposite position in another market with the goal of minimizing one’s exposure to unwanted risk. There are various types of hedging techniques e. g. forward-contract hedge, currency-futures hedge, currency-options hedge etc. Forward-contract hedge: Forward contract hedging is a method used to hedge oneself against exchange risk i. . uncertainty regarding the future movement of the exchange rate. By entering into a forward contract the customer locks in the exchange rate at which he will buy or sell the currency. If Merton Electronics were to not hedge their currency risk exposure, the value of their payables will fluctuate with the value of the Yen. As can be seen in the graph below, if the Yen appreciates against the dollar, Merton will lose money due to their exposure. If the Yen depreciates, Merton will make a profit due to their exposure. [pic]
By entering into a forward contract hedge, Merton could lock in the exchange rate that they will pay in three months, now. This exchange rate would be $0. 7952 per ? 100. Therefore, Merton could eliminate the risk of the Yen appreciating. However, if the Yen depreciated, Merton has forfeited these possible gains. [pic] If Merton were to use the money market hedge, it would need ? 297,200,642. 5 in order to have ? 300,000,000 in 90 days. This means that Merton will need to put $2,332,727. 84 into a Yen money market account. The interest on this loan will be $51,591.
By doing this, Merton can again eliminate the risk of the yen appreciating before payment is due but takes the risk that the yen will depreciate. [pic] If Merton uses the yen futures hedge, it would need to purchase 24 contacts. If the Yen depreciates, Merton can wait until the futures mature and take the yen to pay suppliers. If the Yen appreciates, Merton will have to pay their suppliers more than three months earlier but the cost will be offset by the gain in Merton’s futures. Therefore, again Merton can eliminate the risk of the yen appreciating but runs the risk of the yen depreciating and not benefiting.
If Merton purchases April options on the CME, it would incur a cost of $62,400. However, this is the most that Merton could lose. If the yen appreciates, Merton will exercise the call options and take delivery of the yen used to pay its suppliers. If the yen depreciates, Merton will let the options mature unexercised, and buy yen on the spot market. For this higher up front cost, Merton has eliminated most of its risk. [pic] Merton could also purchase 90-day yen call options over the OTC market. These options would cost $74,700 and would work the same as the CME options.
If the yen were to appreciate, Merton would exercise the options at an exchange rate of $0. 7968 and take delivery of the yen to pay suppliers. If the yen depreciates, Merton would not exercise the options but buy the yen on the spot market in three months. [pic] 3. The (LIBOR) London International bank offer rate is the rate that large international banks trade with each other. There is a chance that a bank borrowing money may default. However, the risk of default is quite small; hence the LIBOR rate is generally higher than the Treasury rates.
LIBOR rates are often used as the risk-free rates when derivatives are valued. Eurodollar futures are frequently used to estimate LIBOR forward rates for the purpose of constructing a LIBOR zero curve. [pic] from here we know that Fo = So^rt 100 = 97. 5e^r(. 25) solve for r 100 97. 5 = e^r(. 25) r(. 25) = 4ln(100) 97. 5 r = 10. 127 we continue this bootstrap method to calculate out our zero rates and zero curve |Years |Zero Rate | |0. 25 |10. 27 | |0. 50 |10. 469 | |1. 0 |10. 536 | |1. 5 |10. 681 | |2 |10. 808 | [pic] Forward interest rates are the rates of interest implied by the zero rates for periods of time in the future. [pic] the 10. % per annum rate for two years means that, in return for an investment of $100 today, the investor receives 11e^. 105×2 = $123. 37 in two years. It is important for a company to understand their risks and how much of it they are comfortable with. Companies typically buy insurance to guard against a variety of hazards. This allows a company to transfer risks to insurance companies. The insurance company would have some advantages in bearing this risk because it is their core competency. 4. Sometimes a company may set up a hedge to help manage their risks.
As time moves on the conditions change so as their exposure is either shorter or longer than the hedge, or the amount of risk change. In this situation the company has some choices to make. One way would be to consider a rollover. This allows a company to take the same position in a futures contract with a later delivery date. When a company does this they will face basis risk each time they roll the hedge forward. A company that has a specified beta of risk to maintain will set up an optimal hedge ratio. The optimal hedge ratios allow the company to buy the correct number of contracts.
This Merton Electronics Financial Institution Clark University Trust may be of consideration for Merton because currently sixty percent of their purchases subject to currency fluctuations. Merton’s current approach is to hedge everything. Merton should consider what level of risk is appropriate for them and then hedge to meet that level of risk. By entering into an option contract this would allow Merton to set an upper bound the cost of yen and allow them to take advantage is the yen becomes cheaper. This approach can be valuable when the exposure is either shorter or longer than the hedge; however these options come at a cost. . Merton’s sales have risen by 12% in the current year as compared to the previous year, but their margins have been squeezed due to high competition and the amount of money that they have lost in unfavorable hedging decisions. Their earnings fell by almost 40%, making their present situation difficult. Since margins have become flat the last three years, Merton has had to take on short term financing, which they have to bear the cost of interest up to 8. 75%. This arrangement is done just to maintain the working capital requirements of the company.
If Merton can avoid this then they can save a lot of money and automatically their profits margins will go up a significant amount. As far as the hedging is concerned, Merton lost around $900,000 due to wrong hedging decisions. Instead of hedging Taiwanese dollars, they hedged Japanese yen, which devalued compared to U. S. dollars. Merton should have locked the Taiwanese dollar at a particular rate with the bank while they should have purchased the Japanese yen at the spot rate from the market. Since they are exposed to a 90-day currency risk, we believe they should hedge at the time when the order is placed.
We are recommending this specifically taking in to consideration Merton’s current financial conditions. Looking at the Merton balance sheet (exhibit2), it is quite evident that the amount of Accounts payable ($ 3,670,000) in foreign currency is quite high. It means that if they don’t hedge their funds and buy the yen at the spot rates, then at that time there is a fair amount of uncertainty tied with it. In case the yen becomes stronger in comparison to dollars then they will have to pay a huge amount of money, which will further squeeze profit margins and they will be left with little funds.
If they hedge their funds then they at know how much they have to pay. Even when we consider their assets and the cash that they have in their hands, it is not very large. This means that they often revert back to their short term financing to match their working capital with the accounts payable requirements. Instead of locking in the funds at the forward rates, they should go for the “yen future hedge” traded on the Chicago Mercantile Exchange (CME) or the Over the Counter (OTC). This will give them the flexibility to trade their instrument if yen is forecasted to appreciate in the near future.
We as a team recommend that Merton should do their budgeting once a month if possible or at least as frequently as possible. This is very important as they buy most of their goods from Asia and they have to make all their payments in foreign currency. Since the currency market is highly volatile, they will have to keep track of the past trends in Japanese yen and the Taiwanese dollar. If they fail to do this they will fall into a big trap as they have already had huge losses in the present situation.
It is important to mention here that the losses they have made of $900,000 dollars exactly match their pre-tax profits (exhibit 2). If they can come up with right kind of mix of hedging and buying the currency at the spot rates, Merton can double their profits and they will not have to worry about the future competition in the market. On the question of whether they should go for a full hedging strategy or just hedge part of the total foreign currency payments greatly depends on the company’s objective. If the risk in the near future is very high and the political situation in a particular country, (e. . Japan) is not stable then they should certainly hedge the yen as it is a safe bet rather than to expose themselves to the uncertain risk of having a significant loss. Review of the currency market is of supreme importance as it changes with even a single piece of information. Chances are there that a nonfinancial company with limited competence in this area will lose often rather than make profits. So Merton will have to be careful in choosing the right type of hedging from the various options available to them. 6) Speculation regarding derivatives is usually risky.
However, companies with a comparative advantage can make profits speculating because they have an edge over the other market participants. This edge may come in the form of expert traders, superior models, or some other advantage. Therefore, nonfinancial companies should not try to speculate in order to make money from currency or interest rate movements. They do not have the needed advantage to make money or a proper understanding of the risks involved. Speculating in derivatives is also probably beyond the acceptable risk of the company’s owners.
If they were interested in trading derivatives, they could do so themselves or invest in an investment bank that speculates on currency or interest rate movements. A nonfinancial company may want to try to speculate in order to profit from movements in commodity prices. If the company produces, distributes, or deals with the commodity in another way, it may have knowledge of the commodity that will give it an edge and enable it to make profits from commodity derivatives. However, the company should be aware of the risks involved with speculating.
For example, many energy producers and distributors recently became involved with trading energy and energy derivatives. Many of these companies have had trouble measuring the risks involved with speculating. In summary, a company should not speculate about movements in currencies, interest rates, or commodities unless it has a comparative advantage over the other market participants and fully understand the risks. This is difficult for nonfinancial companies because financial companies have many resources such as skilled traders and sophisticated models that give them the edge.
