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HEDGING TRANSACTION EXPOSURE Jennifer Nguyen Carlos Castillo.

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Presentation on theme: "HEDGING TRANSACTION EXPOSURE Jennifer Nguyen Carlos Castillo."— Presentation transcript:

1 HEDGING TRANSACTION EXPOSURE Jennifer Nguyen Carlos Castillo

2 Case Background Popescu, Hagi & Associates (PHA) Consulting firm Deals in specialized derivatives DW, Inc. Computer manufacturer No previous consistent hedging program Hires PHA to implement a plan

3 Part I: The Hedging Problem June 1996: DW orders Japanese parts valued at JPY 200,000,000 Delivery due in 2 months Payment due 30 days from delivery July 5, 1996 Notification of October delivery No date set, but expected October 28 Spot rate =.009062 USD/JPY

4 Historical Data Based on percentage changes in monthly USD/JPY exchange rates from January 1971 to June 1996 306 observations Mean =.004423 St Dev =.032948 Minimum = -0.09844 on 11/30/1978 Maximum =.134453 on 02/28/1973

5 Sensitivity Analysis Best Case Scenario JPY 200,000,000 x.009062 USD/JPY x (1 -.09844) = USD 1,633,982 Worst Case Scenario JPY 200,000,000 x.009062 USD/JPY x (1 +.134453) = USD 2,056,082 VAR interpretation: DW should have USD 2,056,082 to cover the payment

6 Distribution Assumption 90%CI VARUpperJPY 200m x.009062 USD/JPY x 1.058458USD 1,918,348 LowerJPY 200m x.009062 USD/JPY x 0.950388USD 1,722,484 95%CI VARUpperJPY 200m x.009062 USD/JPY x 1.069001USD 1,937,458 LowerJPY 200m x.009062 USD/JPY x 0.939845USD 1,703,375 99%CI VARUpperJPY 200m x.009062 USD/JPY x 1.081192USD 1,959,552 LowerJPY 200m x.009062 USD/JPY x 0.927654USD 1,681,280

7 Distribution Assumption VAR Interpretation 95% CI: DW should have USD 1,918,349 to cover the payment 97.5% CI: DW should have USD 1,937,458 to cover the payment 99.5% CI: DW should have USD 1,959,552 to cover the payment Standard – 97.5% confidence interval

8 PHLX Options - Calls Calculating number of contracts: PHLX standard size of JPY 6,250,000 Underlying position = JPY 200,000,000 Contract size = JPY 200,000,000/6,250,000 = 32 contracts Premium Cost JPY Dec 93 @.75 = USD 15,000 JPY Dec 96 @.42 = USD 8,400

9 PHLX Cost Scenarios: JPY Dec 93 StrikePremiumUpfront CostOpportunity Cost.0093.000075USD 15,000USD 424 Possible SExercise?Expiration CostTotal Cost.0090NoUSD 1,800,000USD 1,815,424.009062NoUSD 1,812,400USD 1,827,824.0091NoUSD 1,820,000USD 1,835,424.0093NoUSD 1,860,000USD 1,875,424.0096YesUSD 1,860,000USD 1,875,424.0098YesUSD 1,860,000USD 1,875,424

10 PHLX Cost Scenarios: JPY Dec 96 StrikePremiumUpfront CostOpportunity Cost.0096.000042USD 8,400USD 238 Possible SExercise?Expiration CostTotal Cost.0090NoUSD 1,800,000USD 1,808,638.009062NoUSD 1,812,400USD 1,821,038.0091NoUSD 1,820,000USD 1,828,638.0093NoUSD 1,860,000USD 1,868,638.0096NoUSD 1,920,000USD 1,928,638.0098YesUSD 1,920,000USD 1,928,638

11 OTC Call Cost Scenarios StrikePremiumUpfront CostOpportunity Cost.0091.000096USD 19,200USD 453 Possible SExercise?Expiration CostTotal Cost.0090NoUSD 1,800,000USD 1,819,653.009062NoUSD 1,812,400USD 1,832,053.0091NoUSD 1,820,000USD 1,839,653.0093YesUSD 1,820,000USD 1,839,653.0096YesUSD 1,820,000USD 1,839,653.0098YesUSD 1,820,000USD 1,839,653

12 Forward Cost Scenario 6 month Forward point:.000238.009062 +.000238 =.0093 JPY 200,000,000 x.0093 USD/JPY = USD 1,860,000 Forward rate is regardless of spot rate at expiration

13 Comparison: Total Cost in USD Possible SPHLX 93PHLX 96OTC 91Forward.00901,815,4241,808,6381,819,6531,860,000.0090621,827,8241,821,0381,832,0531,860,000.00911,835,4241,828,6381,839,6531,860,000.00931,875,4241,868,6381,839,6531,860,000.00961,875,4241,928,6381,839,6531,860,000.00981,875,4241,928,6381,839,6531,860,000

14 Recommendation Based on the Total Cost associated with each derivative, we would recommend DW partake in the OTC option with strike price of.0091

15 Part II: Effective Total Cost November 22, 1996 Parts arrived on October 27 th Payment is due in five days Spot Rate =.008973 USD/JPY

16 I: 3 month forward? July 5, 1996: 3 month Forward Point:.000109 Spot rate =.009062 Long position in forward contract At Forward Expiration: JPY 200,000,000 x (.009062 USD/JPY +.000109 pts) = USD 1,834,200 The JPY 200,000,000 could then be invested with a short term interest rate in Japan to recoup costs between October expiration and November payment date.

17 II: December Futures? July 5, 1996: Dec IMM Futures =.009241 Long position in futures contract November 22, 1996: Dec IMM Futures =.008993 Spot rate =.008973 Short the futures contract

18 II: December Futures? Effective Total Cost: Long July cost = USD 1,848,200 Short Nov gain = USD 1,798,600 Net loss of futures = USD 49,600 Discount loss from Dec to Nov = USD 234 Bought JPY 200,000,000 on November 22 @.008973 = USD 1,794,600 Total Effective Cost = 1,745,234

19 III: Unhedged November 22, 1996 Spot rate =.008973 JPY 200,000,000 x.008973 USD/JPY = USD 1,794,600

20 IV: OTC Option Call Option Strike Price.0091 @.96 Premium Cost = USD 19,200 Opportunity Cost = USD 453 At November Expiration: Exercise? No, because spot price is below strike Effective Total Cost: (JPY 200,000,000 x.008973 USD/JPY) + USD 19,653 = USD 1,814,253

21 V: PHLX Dec Call Options JPY Dec 93 Premium Cost = USD 15,000 Opportunity Cost = USD 424 On November 22, 1996: Sell calls at.81 = USD 16,200 Effective Total Cost: (JPY 200,000,000 x.008973 USD/JPY) + USD 15,424 – USD 16,200 = USD 1,793,824

22 V: PHLX Dec Call Options JPY Dec 96 Premium Cost = USD 8,400 Opportunity Cost = USD 238 On November 22, 1996: Sell calls at.15 = USD 3,000 Effective Total Cost: (JPY 200,000,000 x.008973 USD/JPY) + USD 8,638 – USD 3,000 = USD 1,800,238

23 Effective Total Cost Summary StrategyEffective Total Cost 3-mo ForwardUSD 1,834,200 Dec FuturesUSD 1,745,234 UnhedgedUSD 1,794,600 OTC Nov OptionUSD 1,814,253 JPY Dec 93 PHLXUSD 1,793,824 JPY Dec 96 PHLXUSD 1,800,238

24 Hedging Transaction Exposure Q & A?

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