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PHA PHA: Hedging Transaction Exposure for DW Inc. PROPOSED SOLUTION.

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Presentation on theme: "PHA PHA: Hedging Transaction Exposure for DW Inc. PROPOSED SOLUTION."— Presentation transcript:

1 PHA PHA: Hedging Transaction Exposure for DW Inc. PROPOSED SOLUTION

2 Case Background: Hedging Forwards Futures Options Open positions in advance (part 1) in hindsight (part 2)

3 Part I: DW’s Hedging Problem June DW orders parts valued at JPY 200 million Delivery in 2 months, payment within 30 days of delivery June 5 th Confirmation of delivery in October Expected delivery is Oct. 17

4 In Advance Scenario (Part 1) June-5 Nov-17 Oct-17 Order confirmation Projected delivery 30 days payment JPY 200M Time Hedge exchange rate risk with: PHLX options OTC options Forward contract Uncertainty over exact Delivery and Payment Date

5 Part I: Range Estimates of Transaction Exposure: Data Monthly USD/JPY Exchange Rate Data: 1/31/71 – 8/31/02 367 Observations Monthly Exchange Rate Percentage Changes Descriptive Statistics Std. Deviation 0.033389951 Minimum -0.109192201 Maximum 0.147448569

6 Part I: Risk Analysis of Transaction Exposure Sensitivity Analysis Worst Case Scenario JPY 200M x.008502 USD/JPY x (1 +.147449)= USD 1,951,122 Best Case Scenario JPY 200M x.008502 USD/JPY x (1 -.109192) = USD 1,514,473

7 Part I: Risk Analysis of Transaction Exposure Confid. Interval Based on Normal Distribution Upper Bound 200,000,000 JPY x.008502 x (1 +.065464) = USD 1,811,700 Lower Bound 200,000,000 JPY x.008502 x (1 -.065464) = USD 1,589,100

8 Part I: Hedging Strategies Proposed Forward Contracts PHLX Options Over-the-Counter-Options

9 Part I: Hedging Instruments : Data Spot Price (USD/JPY).008502 Forward Contracts 6-Month Forward Rate:.008668 CME Futures T=Dec; F t,Dec =.008679 PHLX Options: Dec Calls Contract: premium: USD.000481/unit. X=.0086 Contract: premium USD.000391/unit. X=.0088 Contract: premium USD.000313/unit. X=.0090 OTC (Over-the-Counter) Options T= Nov 17 th : premium: USD.000345/unit X= Strike Price.0088

10 Forward/Futures contracts June-5 Nov-17 Oct-17 t Dec-5 Sep-5 sell forward OTC CME Futures Sep.008596 Dec.008679 Forward (OTC) Contracts 1mo.008530 3mo.008585 6mo.008668

11 PHLX Options June-5 Nov-17 Oct-17 t Call option A: X=0.0088, premium = 0.000391 B: X=0.0090, premium = 0.000313 Dec-15 exercise if in-the-money sell option if not exercised

12 OTC Options June-5 Nov-17 Oct-17 t Call option X=0.0088, premium = 0.000345 European style Nov-20 borrow 200M JPY and pay bill exercise option if in-the-money and pay back credit

13 Part I: Contract Size PHLX Call Option Contracts Needed: JPY 200M/6.25M = 32 Contracts OTC Call Options Needed : 1 Contract Forward Contracts Needed: 1 Contract

14 Part I: Strategy Comparison: Additional Data Exchange Rate Distribution Using Monthly Percent Change Data Create a Frequency Histogram Probability Distribution Observed: S t+180 Probability USD.008142 9 % USD.008663 79% USD.009254 12%

15 Part I: Exchange Rate Distribution Histogram

16

17 Exchange Rate Distribution Spot Rate Forecast Calculation -.08(2) + -.04(31) = -1.40 -1.40/33 = -4.24% 33/367 = 9%.008502 * (1-.0424) =.008142 USD/JPY.00(153) +.04 (138) = 5.52 5.52/291 = 1.897% 291/367 = 79%.008502 * 1.01897 =.008663 USD/JPY.08(35) +.12(7) +.16(1) = 3.80 3.80/43 = 8.84% 43/367 = 12%.008502 * 1.0884 =.009254 USD/JPY

18 Option Carrying Cost Calculation OTC Call Option (.0088 Strike Price) Carrying Cost: USD.000345 *.040850 * 180/360 = USD.00000705/unit PHLX Call Option (.0086 Strike Price) Carrying Cost: USD.000481 *.04085 * 180/360 = USD.00000982/unit PHLX Call Option (.0090 Strike Price) Carrying Cost: USD.000272 *.04805 * 180/360 =.USD.00000555/unit

19 Potential Spot Price 180 (USD/JPY) Premium /unit Carrying Cost Exercise Option ? Total Price /unit Prob.0081415.0086633.0092536 OTC 88 N.000345.000007047 NO YES.008494.009015.009152 Exp=.008985 9% 79% 12%.0081415.0086633.0092536 PHLX 86 D.000481.000009824 NO YES.008632.009091 Exp=.00905 9% 79% 12%.0081415.0086633.0092536 PHLX 90 D.000272.000005556 NO YES.008419.008941.009278 Exp=.008934 9% 79% 12% OTC vs. PHLX Options

20 Part I: Instrument Comparison Forward Purchase JPY 6 Months (.008668USD/JPY) * JPY 200M = USD 1,733,600 OTC Nov Option Strike Price.0088.008985 USD/JPY * JPY 200M = USD 1,796,955 PHLX Dec Option Strike Price.0086.00905 USD/JPY* JPY 200 M = USD 1,809,912 PHLX Dec Option Strike Price.0090.008755145. USD/JPY* JPY 200M = USD 1,786,857

21 Part I: Recommendation OTC Nov Option Strike Price.0088.008985 USD/JPY * JPY 200M = USD 1,796,955 Why? - Exact Date - Option flexibility, especially good with uncertain arrival date. - Caps expenses at.009152 USD/unit * JPY 200M = USD 1,830,409

22 Part II:Comparisons November 6 Japanese parts arrived Oct. 11 Payment due in 5 days (Nov 11) Exchange rate:.00907 USD/JPY The cost to DW, Inc. will vary depending on the hedging approach undertaken…

23 Hindsight: Hedging Evaluation 3-mo forward contract (Rollover on Sep) Dec futures No Hedge OTC Options CME Dec Options

24 1) 3-mo Forwards June-5 Nov-11 Oct-11 time Dec-5 July-5 Aug-5 Sep-5 Sell Dec 5 forward here, and change USD for JPY at S t=Nov 6 Sep 5: Rollover, Buy JPY 200M at F June 5, Sep 5. Sell JPY 200M at S t=Sep 5 Buy Dec 5 forward

25 1)3-month forward contracts DW would have taken a long position in the forward contract, to offset their short position Amount to be paid for parts JPY 200,000,000 F t=Jun 5, Sep 5 : 0.008530 USD/JPY Rollover to another 3-mo contract on Sep 5: F t=Sep 5, Dec 5 : 0.00907 USD/JPY Sell Forward contract on Nov 6 F t=Nov 6, Dec 5 : 0.009162 USD/JPY USD paid for parts 1,746,228

26 1) 3-mo forward June-5 Nov-11 t Dec-5 Oct-11 sell forward

27 2) Dec Futures June-5 Nov-11 Oct-11 time Dec-15 Nov-6 buy Dec future sell 39 day future Dec Futures Long Dec futures at F t=June 5,,Dec =0.008679 USD/JPY, On Nov 6, Dec futures F t=Nov 6,,Dec = 0.009162 USD/JPY S Nov 6 =.00907

28 2) December futures contract DW would have taken a long position in the futures contract, to offset their short position: 16 Dec contracts long. (=200M/12.5M) June 5 - Bought Dec futures @.008679 USD/JPY Nov 6 - Sold Dec futures @.009162 USD/JPY

29 2) December futures contract (Continued) Gain/(Loss) on Futures ContractsContracts USD Long on June 5 (F t, Jun ) 0.008679 (16)(1,735,800) Sold on Nov 6 (F t, Nov ) 0.009162 16 1,832,400 => Gain/Loss on Futures (0.000483) 96,600 Gain Discounted Back 30 Days: 96,600/(1 +.0409 * 39/360) 96,174 Borrow JPY 200M @ S t=Nov 6 = 0.00907 USD/JPY x JPY 200M = 1,814,000 Net cost = (1,814,000-96,174)*(1+.0409*5/360) = USD 1,718,857 USD paid for parts USD 1,718,857

30 3) Not hedged DW would bought JPY at the prevailing Spot Rate when the payment was due. Amount to be paid for parts JPY 200,000,000 Spot rate at Nov. 6 (S t=Nov 6 ) 0.00907 USD/JPY Borrow JPY 200M = 0.00907 USD/JPY x JPY 200M = = USD 1,814,000 Cost of loan = USD 1,814,000 x (1+.0409*5/360)= USD 1,815,030 USD paid for parts USD 1,815,00

31 4) OTC options (Situation S t > X) June-5 Nov-11 Oct-11 t Nov-17 Nov-6 Exercise Call option A:X=0.0088, premium = 0.000345 B:X=0.0090, premium = 0.000272 S Nov 6 =.00907

32 4) OTC options (Situation S t < X) June-5 Nov-11 Oct-11 t Nov-17 Nov-6 don’t exercise option buy on spot market Call option A:X=0.0088, premium = 0.000345 B:X=0.0090, premium = 0.000272 S Nov 6 =.0084

33 4) OTC JPY Option DW would have bought a call option to cover payables Variables Amount (JPY)200,000,000 Strike PriceX0.0088 PremiumPremium0.000345 Interest Rate (US)i4.085-4.090 XS t=Nov 6 (USD/JPY PremiumExercise?Total USD Cost USD Paid JPY 200M 880.009070.000345Yes0.0091451,829,971 900.009070.00272Yes0.0092761,855,165

34 4) OTC Nov JPY Option Carrying costs =P t * interest rate * (maturity/360) Fox X=.0088 => 0.000345*.04085*124/360 = = USD.00000485 Carrying cost is so small, for practical purposes can be ignored => only USD 970! If S t > X => Exercise: Both Options: Exercise! For X=.0088 => Borrow to buy JPY = USD 1,829,971 Cost of loan = USD 1,829,971 x (1+.0409*5/360)= USD 1,831,010 For X=.0090 => Borrow to buy JPY = USD 1,855,165 Cost of loan = USD 1,855,165 x (1+.0409*5/360)= USD 1,856,219

35 5) PHLX Options Call option A:X=0.0086, premium = 0.000481 B:X=0.0090, premium = 0.000313 S Nov 6 =.00907 exercise since in-the-money June-5 Nov-11 Oct-11 t Dec-15 Nov-6 exercise option

36 5) JPY Dec. Options (PHLX) DW would have bought a call option to cover payables Same procedure as the OTC Options Variables Amount (JPY)200,000,000 Strike PriceX0.0086 PremiumPremium0.000481 Interest Rate (US)i USD,bid-ask 4.0850-4.090 XS t=Nov 6 (USD/JPY PremiumExercise?Total USD Cost USD Paid for JPY 200M 860.009070.000481Yes0.0090881,817,554 900.009070.000313Yes0.0093171,863,481

37 5) JPY Dec. Options (PHLX) Carrying costs =P * interest rate * (maturity/360) Fox X=.0086 => 0.000481*.04085*124/360 = = USD.00000677 If S t > X, Do Exercise For X=.0086 => Borrow to buy JPY = USD 1,817,554 Cost of loan = USD 1,817,554 x (1+.0409*5/360)= USD 1,818,859 For X=.0090 => Borrow to buy JPY = USD 1,863,481 Cost of loan = USD 1,863,481 x (1+.0409*5/360)= USD 1,864,539

38 PHLX Options (Alternative Scenario: option out-of-the-money) Call option A:X=0.0086, premium = 0.000481 B:X=0.0090, premium = 0.000313 S Nov 6 =.0084 do not exercise since out-of-the-money try to sell option June-5 Nov-11 Oct-11 time Dec-15 Nov-6 buy on spot market Premium Call option S Nov 6 =.0084 X =.0086 σ =.20 (annualized) T = 39/365 r f-USA =.0409; r f-JPY =.0028 premium = USD.00014831 Total received = USD 29,662

39 Part II: Summary Scenario USD paid for parts 3 month ForwardUSD 1,746,228 Dec futures USD 1,718,857 No hedge USD 1,815,00 OTC optionsX=88 USD 1,829,971 X=90 USD 1,855,165 PHLX optionsX=86 => USD 1,818,859 X=90 => USD 1,863,481

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