Example: Evaluation of hedging strategies

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Presentation transcript:

Example: Evaluation of hedging strategies Iris Oil Inc., a Houston-based energy company, has a large foreign currency exposure in the form of a CAD cash flow from its Canadian operations. The exchange rate risk to Iris is that the CAD may depreciate against the USD. In this case, Iris’ CAD revenues, transferred to its USD account will diminish and its total USD revenues will fall. Situation: Iris will have to transfer CAD 300M into its USD account in 90 days. Data: St =USD .8451/CAD Ft,90-day = USD .8493/CAD rUSD = 3.92% rCAD = 2.03%

Do not hedge and exchange the CAD 300M at the exchange rate on t+90. Date Spot market Forward market Money market t St = USD .8451/CAD Ft,90-day = USD .8493/CAD rUSD=3.92%; rCAD=2.03% t+90 Receive CAD 300M and transfer into USD. Hedging Strategies: Do Nothing: Do not hedge and exchange the CAD 300M at the exchange rate on t+90. 2. Forward Market: At t, sell the CAD 300M forward and at time t+90 guarantee: (300M)x(.8493) = USD254,790,000. 3. Money Market At t, a) borrow [CAD 300M]/[1+.0203(90/360)] = CAD 298,485,188, b) exchange this sum spot for (298,485,188)(.8451) = USD 252,249,832, c) invest in the MONEY MARKET to guarantee at time t+90 (252,249,832)[1 + .0392(90/360)] = USD254,721,880.

4. Option Market: At t, buy a put. Use the options market. Available re the following 90-day options X Calls Puts USD .82/CAD ---- .21 USD .84/CAD 1.58 .68 USD .88/CAD .23 --- Buy the .84 put => Cost of USD 2.04M. if St <USD .84/CAD if St >USD .84/CAD In 90 days, the CF is: (.84 – St) CAD 300M 0 Plus St CAD 300M St CAD 300M Total USD 252M St CAD 300M CF in 90 days: USD 249,960,000 for all St < USD.84/CAD or St CAD 300M – USD 2.04M for all St > USD.84/CAD

5. Collar: At time t, buy a put and sell a call. Buy the .84 put at .68 and finance it by selling the .88 call at .23. Thus, initial cost is reduced to .45 per put => Total cost: USD 1.35M St < .84 .84 < St < .88 St > .88 Put (.84) (.84 – St ) CAD 300M 0 0 Call (.88) 0 0 (.88 – St) CAD 300M Plus St CAD 300M St CAD 300M St CAD 300M Total USD 252 M St CAD 300M USD 264M CF in 90 days: USD 250.65M for all St < USD.84/CAD or St CAD 300M – USD 1.35M for all 84 < St < .88 or USD 262.65M for all St > USD.88/CAD

6. Alternative: Zero cost insurance: At time t, buy puts and sell calls with overall (or almost) matching premium. Buy the .84 put and finance it buy selling 3, .88 calls. Thus, no initial cost. In 90 days: St < .84 .84 < St < .88 St > .88 Put (.84) (.84 – St ) CAD 300M 0 0 Call (.88) 0 0 3 (.88 – St) CAD300M Plus St CAD 300M St CAD 300M St CAD 300M Total USD 252 M St CAD 300M USD 792M – 2St CAD 300M CF in 90 days: USD 252M for all St < USD.84/CAD or St CAD 300M for all 84 < St < .88 or USD 792 M – 2 St CAD 300M for all St > USD.88/CAD

In order to analyze the various possibilities, we may use the following graph: Protective put USD 264M USD 262.65M Collar Forward USD 254.79M USD 252M USD 250.65M USD 249.96M Zero-cost Collar .84 .86 .88