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PHA : Hedging Transaction Exposure for DW Inc. PowerPoint Presentation
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PHA : Hedging Transaction Exposure for DW Inc.

PHA : Hedging Transaction Exposure for DW Inc.

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PHA : Hedging Transaction Exposure for DW Inc.

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  1. 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 5th • Confirmation of delivery in October • Expected delivery is Oct. 17

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

  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; Ft,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 17th: premium: USD .000345/unit X= Strike Price .0088

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

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

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

  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: St+180 Probability USD.008142 9 % USD .008663 79% USD .00925412%

  15. Part I: Exchange Rate Distribution Histogram

  16. Part I: Exchange Rate Distribution Histogram

  17. Exchange Rate DistributionSpot 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. 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 .00905USD/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 Sep 5: Rollover , Buy JPY 200M at FJune 5, Sep 5. Sell JPY 200M at St=Sep 5 Buy Dec 5 forward Sell Dec 5 forward here, and change USD for JPY at St=Nov 6 time June-5 Dec-5 Nov-11 Aug-5 Sep-5 July-5 Oct-11

  25. 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 Ft=Jun 5, Sep 5: 0.008530 USD/JPY Rollover to another 3-mo contract on Sep 5: Ft=Sep 5, Dec 5: 0.00907 USD/JPY Sell Forward contract on Nov 6 Ft=Nov 6, Dec 5: 0.009162 USD/JPY USD paid for parts 1,746,228

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

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

  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 ContractsContractsUSD Long on June 5 (Ft, Jun) 0.008679 (16) (1,735,800) Sold on Nov 6 (Ft, 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 @ St=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 (St=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 St > X) Call option A: X=0.0088, premium = 0.000345 B: X=0.0090, premium = 0.000272 SNov 6 = .00907 Exercise t June-5 Nov-11 Nov-17 Oct-11 Nov-6

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

  33. 4) OTC JPY Option • DW would have bought a call option to cover payables Variables Amount (JPY) 200,000,000 Strike Price X 0.0088 Premium Premium0.000345 Interest Rate (US) i 4.085-4.090

  34. 4) OTC Nov JPY Option • Carrying costs = Pt * 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 St > 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 SNov 6 = .00907 exercise option exercise since in-the-money t June-5 Dec-15 Nov-11 Oct-11 Nov-6

  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 Price X 0.0086 Premium Premium0.000481 Interest Rate (US) iUSD,bid-ask 4.0850-4.090

  37. 5) JPY Dec. Options (PHLX) • Carrying costs = P * interest rate * (maturity/360) Fox X=.0086 => 0.000481*.04085*124/360 = = USD .00000677 • If St > 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 SNov 6 = .0084 Premium Call option SNov 6 = .0084 X = .0086 σ = .20 (annualized) T = 39/365 rf-USA = .0409; rf-JPY = .0028 premium = USD .00014831 Total received = USD 29,662 buy on spot market try to sell option do not exercise since out-of-the-money time June-5 Dec-15 Nov-11 Oct-11 Nov-6

  39. Part II: Summary ScenarioUSD paid for parts • 3 month Forward USD1,746,228 • Dec futures USD1,718,857 • No hedge USD 1,815,00 • OTC options X=88 USD 1,829,971 X=90 USD 1,855,165 • PHLX options X=86 => USD 1,818,859 X=90=> USD 1,863,481