HEDGING TRANSACTION EXPOSURE

Jennifer NguyenCarlos Castillo

Case Background

Popescu, Hagi & Associates (PHA)Consulting firmDeals in specialized derivatives

DW, Inc.Computer manufacturerNo previous consistent hedging programHires PHA to implement a plan

Part I: The Hedging Problem

June 1996:DW orders Japanese parts valued at JPY 200,000,000Delivery due in 2 monthsPayment due 30 days from delivery

July 5, 1996Notification of October deliveryNo date set, but expected October 28Spot rate = .009062 USD/JPY

Historical Data

Based on percentage changes in monthly USD/JPY exchange rates from January 1971 to June 1996

306 observationsMean = .004423St Dev = .032948Minimum = -0.09844 on 11/30/1978Maximum = .134453 on 02/28/1973

Sensitivity Analysis

Best Case ScenarioJPY 200,000,000 x .009062 USD/JPY x (1 - .09844) = USD 1,633,982

Worst Case ScenarioJPY 200,000,000 x .009062 USD/JPY x (1 + .134453) = USD 2,056,082VAR interpretation: DW should have USD 2,056,082 to cover the payment

Distribution Assumption90% CI

VAR Upper JPY 200m x .009062 USD/JPY x 1.058458

USD 1,918,348

Lower JPY 200m x .009062 USD/JPY x 0.950388

USD 1,722,484

95% CI

VAR Upper JPY 200m x .009062 USD/JPY x 1.069001

USD 1,937,458

Lower JPY 200m x .009062 USD/JPY x 0.939845

USD 1,703,375

99% CI

VAR Upper JPY 200m x .009062 USD/JPY x 1.081192

USD 1,959,552

Lower JPY 200m x .009062 USD/JPY x 0.927654

USD 1,681,280

Distribution Assumption

VAR Interpretation95% CI: DW should have USD 1,918,349 to cover the payment97.5% CI: DW should have USD 1,937,458 to cover the payment99.5% CI: DW should have USD 1,959,552 to cover the payment

Standard – 97.5% confidence interval

PHLX Options - Calls

Calculating number of contracts:PHLX standard size of JPY 6,250,000 Underlying position = JPY 200,000,000Contract size = JPY 200,000,000/6,250,000 = 32 contracts

Premium CostJPY Dec 93 @ .75 = USD 15,000JPY Dec 96 @ .42 = USD 8,400

PHLX Cost Scenarios: JPY Dec 93

Strike Premium

Upfront Cost Opportunity Cost

.0093 .000075 USD 15,000 USD 424

Possible S

Exercise?

Expiration Cost

Total Cost

.0090 No USD 1,800,000 USD 1,815,424

.009062 No USD 1,812,400 USD 1,827,824

.0091 No USD 1,820,000 USD 1,835,424

.0093 No USD 1,860,000 USD 1,875,424

.0096 Yes USD 1,860,000 USD 1,875,424

.0098 Yes USD 1,860,000 USD 1,875,424

PHLX Cost Scenarios: JPY Dec 96

Strike Premium

Upfront Cost Opportunity Cost

.0096 .000042 USD 8,400 USD 238

Possible S

Exercise?

Expiration Cost

Total Cost

.0090 No USD 1,800,000 USD 1,808,638

.009062 No USD 1,812,400 USD 1,821,038

.0091 No USD 1,820,000 USD 1,828,638

.0093 No USD 1,860,000 USD 1,868,638

.0096 No USD 1,920,000 USD 1,928,638

.0098 Yes USD 1,920,000 USD 1,928,638

OTC Call Cost ScenariosStrike Premiu

mUpfront Cost Opportunity

Cost

.0091 .000096 USD 19,200 USD 453

Possible S

Exercise?

Expiration Cost

Total Cost

.0090 No USD 1,800,000 USD 1,819,653

.009062 No USD 1,812,400 USD 1,832,053

.0091 No USD 1,820,000 USD 1,839,653

.0093 Yes USD 1,820,000 USD 1,839,653

.0096 Yes USD 1,820,000 USD 1,839,653

.0098 Yes USD 1,820,000 USD 1,839,653

Forward Cost Scenario

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

Comparison: Total Cost in USDPossible S

PHLX 93 PHLX 96 OTC 91 Forward

.0090 1,815,424 1,808,638 1,819,653 1,860,000

.009062 1,827,824 1,821,038 1,832,053 1,860,000

.0091 1,835,424 1,828,638 1,839,653 1,860,000

.0093 1,875,424 1,868,638 1,839,653 1,860,000

.0096 1,875,424 1,928,638 1,839,653 1,860,000

.0098 1,875,424 1,928,638 1,839,653 1,860,000

Recommendation

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

Part II: Effective Total Cost

November 22, 1996Parts arrived on October 27th

Payment is due in five daysSpot Rate = .008973 USD/JPY

I: 3 month forward?July 5, 1996:

3 month Forward Point: .000109Spot rate = .009062Long position in forward contract

At Forward Expiration:JPY 200,000,000 x (.009062 USD/JPY + .000109 pts) = USD 1,834,200The 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.

II: December Futures?

July 5, 1996:Dec IMM Futures = .009241Long position in futures contract

November 22, 1996:Dec IMM Futures = .008993Spot rate = .008973Short the futures contract

II: December Futures?

Effective Total Cost:Long July cost = USD 1,848,200Short Nov gain = USD 1,798,600Net loss of futures = USD 49,600• Discount loss from Dec to Nov = USD 234

Bought JPY 200,000,000 on November 22 @ .008973 = USD 1,794,600Total Effective Cost = 1,745,234

III: Unhedged

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

IV: OTC Option

Call Option Strike Price .0091 @ .96Premium Cost = USD 19,200Opportunity 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

V: PHLX Dec Call Options

JPY Dec 93Premium Cost = USD 15,000Opportunity 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

V: PHLX Dec Call Options

JPY Dec 96Premium Cost = USD 8,400Opportunity 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

Effective Total Cost Summary

Strategy Effective Total Cost

3-mo Forward USD 1,834,200

Dec Futures USD 1,745,234

Unhedged USD 1,794,600

OTC Nov Option USD 1,814,253

JPY Dec 93 PHLX USD 1,793,824

JPY Dec 96 PHLX USD 1,800,238

Hedging Transaction Exposure

Q & A?