Foreign currency risk

Foreign currency risk

You are now the
not-so-new CFO of Agri-Drone. It’s been over a year since you introduced the
Company to the idea of managing risks it confronts in doing business overseas. The
market buzz about the Company’s innovation has continued. The first foreign
customer, the French farming cooperative, has made additional purchases, and
word is spreading about the Company’s family of unique products.

As your first foray into the realm of
international sales gathers steam, you recommend and implement an immediate
hedge of the entire $1.1 million sale to the French Co-op by using a six month
forward contract.

You’ve been using that approach ever since.

As it turns out, the EUR/USD strengthens
during the six months of that first forward contract, and it sits at 1.40 at
the time Agri-Drone receives its payment in euros. Jim, the VP of Sales, isn’t
the only person to comment that Agri-Drone would have been better off in
hindsight without your forward contract in place.

You just shake your head.

The good news is that most members of the
Company’s leadership team ‘get it.’ Your initiative in protecting the Company
has been recognized, and with the endorsement of Stephanie Majors, the CEO, you
have educated the leadership team about the Company’s foreign currency risks
and what it should be doing about them. With the exception of Jim, who
continues to chide you when (and only when) currency fluctuations go in
Agri-Drone’s favor, everybody seems pretty happy.

There is one person who is truly not
satisfied, however, and that’s you.

“This is getting expensive!”

What has caused your frustration is your
need to constantly commit Agri-Drone’s borrowing capacity to support what seems
to be an ever-growing series of forward contracts that are, just now, starting
to involve multiple currencies. Your bank, behaving like banks do, insists on a
progressively growing letter of credit to back the forward contracts. Under
your loan agreement, letters of credit get subtracted from your credit line, so
your borrowing capacity gets reduced.

You, of course, can contemplate better uses
for the credit line in support of the Company’s rapid growth. Certainly, it could
be used for expanded working capital needs, but you’re also starting to hear
whispers of plant expansion ideas. Some of these certainly could be outside of
the U.S.

You know that sooner or later a more cost
efficient way of handling Agri-Drone’s currency risk issues will be needed as
the types of risk evolve.

So, you begin to explore other ways to
contain currency risk. Sure, you know about options, but you think their cost
would be a hard sell internally. You can almost hear Jim saying: “What? Two or
three percent right off the top on every international deal?” While you hate to
admit it, on this one you and Jim agree.

And so today you are wondering about two
things:

1. Is there a more
   cost-effective way to eliminate foreign currency risk?
2. Is there truly a
   need to eliminate all foreign
   currency risk?

Continue next page.

“Why didn’t I think of that sooner!”

This afternoon, as you struggle with your
dilemma, you walk into the office kitchen to make a cup of coffee. As you’re
waiting for the K-cup to brew, you see some panelists fast-talking on CNBC TV
about risk bracketing and risk arbitrage on investments in volatile stocks. One
of them shouts, “It’s almost free!” Not catching the full drift, you grab your
coffee and walk back to your office.

And then it hits you. He was talking about
option premiums being ‘almost free,’ which, of course, you know isn’t the case. Option
premiums always seem to be priced at a few percent of the underlying security
value, which is far from ‘almost free.’ That can only mean he was talking about
offsetting option premiums.

And you sit up and gasp as a revelation hits
you.

Problem 1

How
could option premiums be offsetting? Explain in a narrative way.

Note: The space
expands as you write.

“Now we’re getting somewhere!”

You figure out how offsetting option
premiums can be achieved, and now you turn your attention to how to use them at
Agri-Drone. Your objective is the same: protect the Company against its foreign
currency risks on major sales to foreign customers. However, with the increased
volume of activity, you seek to explore ways to eliminate something less than
100 percent of the risk and you broach that idea to Stephanie Majors, the CEO. She
encourages you to continue your research. And so, as is your nature, you start playing
with some numbers.

Assume
the following facts:

Current EUR/USD spot rate –		1.30
6 mo. forward contract pricing		-0.0100
6 mo. EUR/USD Call strike 1.3000 premium 3%		6 mo. EUR/USD Call strike 1.3200 premium 2%
6 mo. EUR/USD Put strike 1.3000 premium 4%		6 mo. EUR/USD Put strike 1.2800 premium 2%

Problem 2

What
pairing of options would come closest to achieving the same risk management attributes
of a EUR/USD six month forward contract? Why?

Note: The space
expands as you write.

“Finally,
I may have a better answer!”

Your
deepening understanding of option strategies has CEO Majors quite impressed. She’s
asked for a simple demonstration, which you prepare and deliver.

Problem 3

Assuming
only the fact-set presented, what strategy would you suggest to limit most of
the currency risk on a substantial sale to a European customer, while at the
same time minimizing transaction costs to the Company?

Problem 4

Assume
the sale price is set at $1,000,000 and the contract specified payment of
769,231 Euros in six months upon delivery. Using your suggested strategy,
prepare a calculation of the ultimate dollar revenues received, net of option
costs, assuming the six month EUR/USD actually ends up being 1.25, 1.30 and
1.35. Also, present a side calculation of what would occur if no mitigation
strategy was used.

 

 

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