Currency Options
Content
Problem 8.3 Warner Indonesia
Warner, the U.S.-based multinational pharmaceutical company, is evaluating an export sale of its cholesterolreduction drug with a prospective Indonesian distributor. The purchase would be for 1,650 million Indonesian rupiah
(Rp), which at the current spot exchange rate of Rp9,450/$, translates into nearly $175,000. Although not a big sale
by company standards, company policy dictates that sales must be settled for at least a minimum gross margin, in
this case, a cash settleemnt of $168,000. The current 90-day forward rate is Rp9,950/$. Although this rate appeared
unattractive, Warner had to contact several major banks before even finding a forward quote on the rupiah. The
consensus of currency forecasters at the moment, however, is that the rupiah will hold relatively steady, possibly
falling to Rp9,400/$ over the coming 90 to 120 days. Analyze the prospective sale and make a hedging
recommendation.
Assumptions
Receivable due in 3 months, in Indonesian rupiah (Rp)
Spot rate (Rp/$)
Expected spot rate in 90 days (Rp/$)
3-month forward rate (Rp/$)
Minimum dollar amount acceptable at settlement
Alternatives
Values
Rp1,650,000,000
9,450
9,400
9,950
$168,000.00
At Spot
$174,603.17
Risk
Assessment
Values
1. Remain Uncovered.
Settle A/R in 90 days at current spot rate.
If spot rate in 90 days is same as current
(Rp750,000,000 / Rp8,800/$)
$174,603.17
Risky
If spot rate in 90 days is Rp9,400/$
(Rp750,000,000 / Rp9,400/$)
$175,531.91
Risky
If spot rate in 90 days is Rp9,800/$
(Rp750,000,000 / Rp9,800/$)
$165,829.15
Risky
A/R sold forward 90 days
$165,829.15
Certain
"Cost of cover" is the forward discount on Rp
-20.1%
2. Sell Indonesian rupiah forward.
Analysis
The Indonesian rupiah has been highly volatile in recent years. This means that during the 90-day period,
any variety of economic or political or social events could lead to an upward bounce in the exchange rate,
reducing the dollar proceeds at settlement to an unacceptable level.
Unfortunately, the forward contract does not result in dollar proceeds which meet the minimum margin.
The cost of forward cover, 20.1%, is indicative of the "artificial interest rates" used by some financial
institutions while pricing derivatives in emerging, illiquid, and volatile markets.
In the end, Pfizer will have to decide whether making the sale into this specific market is worth breaking a
company policy on minimum proceeds (forward cover) or taking significant currency risk by not using
forward cover.
Problem 8.18 Tek -- Italian account receivable
Tek wishes to hedge a €4,000,000 account receivable arising from a sale to Olivetti (Italy). Payment is due in 3 months. Tek’s
Italian unit does not have ready access to local currency borrowing, eliminating the money market hedge alternative. Citibank
has offered Tek the following quotes:
Assumptions
Account receivable due in 3 months, in euros (€)
Spot rate ($/€)
3-month forward rate ($/€)
3-month euro interest rate
3-month put option on euros:
Strike rate ($/€)
Premium, percent per year
Tek's weighted average cost of capital
Values
€ 4,000,000.00
1.2000
1.2180
4.200%
1.2000
3.400%
9.800%
a)
Value
What are the costs and risk of each alternative?
b)
Certainty?
1. Do nothing and exchange euros for dollars at end of 3 months
Amount of euro receivable
If spot rate in 3 months is the same as the forward rate
US dollar proceeds of receivable would be
€ 4,000,000.00
1.2180
$4,872,000.00
Very uncertain;
Risky
Amount of euro receivable
If spot rate in 3 months is the same as the current spot rate
US dollar proceeds of receivable would be
€ 4,000,000.00
1.2000
$4,800,000.00
Very uncertain;
Risky
2. Sell euro receivable forward at the 3-month forward rate
Amount of euro receivable
forward rate
US dollar proceeds of receivable would be
€ 4,000,000.00
1.2180
$4,872,000.00
Certain;
Locked-in
3. Buy a put option on euros
Amount of euro receivable
Current spot rate ($/euro)
Premium on put option, %
Cost of put option (amount x spot rate x percent premium)
€ 4,000,000.00
1.2000
3.400%
$163,200.00
If the spot rate at end of 3-months is less than strike rate
the option is exercised yielding gross dollars of
Less cost of option (premium) plus US$ interest on premium
Net proceeds of A/R if option is exercised (this is Minimum)
$4,800,000.00
(167,198.40)
$4,632,801.60
Minimum is
guaranteed;
could be
greater.
Value
$4,800,000.00
$4,872,000.00
$4,632,801.60
Certainty?
Risky
Certain
Minimum
Summary of Alternatives
Do Nothing
Sell A/R forward
Buy Put Option
c) If Tek wishes to play it safe, it should lock in the forward rate.
d) If Tek wishes to take a reasonable risk (definining 'reasonable' is another issue), and has a directional view that the dollar is
going to depreciate versus the euro over the 3-month period, past $1.20/€, then Tek might consider purchasing the put option on
euros.
Warner, the U.S.-based multinational pharmaceutical company, is evaluating an export sale of its cholesterolreduction drug with a prospective Indonesian distributor. The purchase would be for 1,650 million Indonesian rupiah
(Rp), which at the current spot exchange rate of Rp9,450/$, translates into nearly $175,000. Although not a big sale
by company standards, company policy dictates that sales must be settled for at least a minimum gross margin, in
this case, a cash settleemnt of $168,000. The current 90-day forward rate is Rp9,950/$. Although this rate appeared
unattractive, Warner had to contact several major banks before even finding a forward quote on the rupiah. The
consensus of currency forecasters at the moment, however, is that the rupiah will hold relatively steady, possibly
falling to Rp9,400/$ over the coming 90 to 120 days. Analyze the prospective sale and make a hedging
recommendation.
Assumptions
Receivable due in 3 months, in Indonesian rupiah (Rp)
Spot rate (Rp/$)
Expected spot rate in 90 days (Rp/$)
3-month forward rate (Rp/$)
Minimum dollar amount acceptable at settlement
Alternatives
Values
Rp1,650,000,000
9,450
9,400
9,950
$168,000.00
At Spot
$174,603.17
Risk
Assessment
Values
1. Remain Uncovered.
Settle A/R in 90 days at current spot rate.
If spot rate in 90 days is same as current
(Rp750,000,000 / Rp8,800/$)
$174,603.17
Risky
If spot rate in 90 days is Rp9,400/$
(Rp750,000,000 / Rp9,400/$)
$175,531.91
Risky
If spot rate in 90 days is Rp9,800/$
(Rp750,000,000 / Rp9,800/$)
$165,829.15
Risky
A/R sold forward 90 days
$165,829.15
Certain
"Cost of cover" is the forward discount on Rp
-20.1%
2. Sell Indonesian rupiah forward.
Analysis
The Indonesian rupiah has been highly volatile in recent years. This means that during the 90-day period,
any variety of economic or political or social events could lead to an upward bounce in the exchange rate,
reducing the dollar proceeds at settlement to an unacceptable level.
Unfortunately, the forward contract does not result in dollar proceeds which meet the minimum margin.
The cost of forward cover, 20.1%, is indicative of the "artificial interest rates" used by some financial
institutions while pricing derivatives in emerging, illiquid, and volatile markets.
In the end, Pfizer will have to decide whether making the sale into this specific market is worth breaking a
company policy on minimum proceeds (forward cover) or taking significant currency risk by not using
forward cover.
Problem 8.18 Tek -- Italian account receivable
Tek wishes to hedge a €4,000,000 account receivable arising from a sale to Olivetti (Italy). Payment is due in 3 months. Tek’s
Italian unit does not have ready access to local currency borrowing, eliminating the money market hedge alternative. Citibank
has offered Tek the following quotes:
Assumptions
Account receivable due in 3 months, in euros (€)
Spot rate ($/€)
3-month forward rate ($/€)
3-month euro interest rate
3-month put option on euros:
Strike rate ($/€)
Premium, percent per year
Tek's weighted average cost of capital
Values
€ 4,000,000.00
1.2000
1.2180
4.200%
1.2000
3.400%
9.800%
a)
Value
What are the costs and risk of each alternative?
b)
Certainty?
1. Do nothing and exchange euros for dollars at end of 3 months
Amount of euro receivable
If spot rate in 3 months is the same as the forward rate
US dollar proceeds of receivable would be
€ 4,000,000.00
1.2180
$4,872,000.00
Very uncertain;
Risky
Amount of euro receivable
If spot rate in 3 months is the same as the current spot rate
US dollar proceeds of receivable would be
€ 4,000,000.00
1.2000
$4,800,000.00
Very uncertain;
Risky
2. Sell euro receivable forward at the 3-month forward rate
Amount of euro receivable
forward rate
US dollar proceeds of receivable would be
€ 4,000,000.00
1.2180
$4,872,000.00
Certain;
Locked-in
3. Buy a put option on euros
Amount of euro receivable
Current spot rate ($/euro)
Premium on put option, %
Cost of put option (amount x spot rate x percent premium)
€ 4,000,000.00
1.2000
3.400%
$163,200.00
If the spot rate at end of 3-months is less than strike rate
the option is exercised yielding gross dollars of
Less cost of option (premium) plus US$ interest on premium
Net proceeds of A/R if option is exercised (this is Minimum)
$4,800,000.00
(167,198.40)
$4,632,801.60
Minimum is
guaranteed;
could be
greater.
Value
$4,800,000.00
$4,872,000.00
$4,632,801.60
Certainty?
Risky
Certain
Minimum
Summary of Alternatives
Do Nothing
Sell A/R forward
Buy Put Option
c) If Tek wishes to play it safe, it should lock in the forward rate.
d) If Tek wishes to take a reasonable risk (definining 'reasonable' is another issue), and has a directional view that the dollar is
going to depreciate versus the euro over the 3-month period, past $1.20/€, then Tek might consider purchasing the put option on
euros.
