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

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

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

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

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

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

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

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

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

Forward/Futures contracts June-5 Nov-17 Oct-17 t Dec-5 Sep-5 sell forward OTC CME Futures Sep Dec Forward (OTC) Contracts 1mo mo mo

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

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

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

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 % USD % USD %

Part I: Exchange Rate Distribution Histogram

Exchange Rate Distribution Spot Rate Forecast Calculation -.08(2) (31) = /33 = -4.24% 33/367 = 9% * ( ) = USD/JPY.00(153) +.04 (138) = /291 = 1.897% 291/367 = 79% * = USD/JPY.08(35) +.12(7) +.16(1) = /43 = 8.84% 43/367 = 12% * = USD/JPY

Option Carrying Cost Calculation OTC Call Option (.0088 Strike Price) Carrying Cost: USD * * 180/360 = USD /unit PHLX Call Option (.0086 Strike Price) Carrying Cost: USD * * 180/360 = USD /unit PHLX Call Option (.0090 Strike Price) Carrying Cost: USD * * 180/360 =.USD /unit

Potential Spot Price 180 (USD/JPY) Premium /unit Carrying Cost Exercise Option ? Total Price /unit Prob OTC 88 N NO YES Exp= % 79% 12% PHLX 86 D NO YES Exp= % 79% 12% PHLX 90 D NO YES Exp= % 79% 12% OTC vs. PHLX Options

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

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

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

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

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

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 : USD/JPY Rollover to another 3-mo contract on Sep 5: F t=Sep 5, Dec 5 : USD/JPY Sell Forward contract on Nov 6 F t=Nov 6, Dec 5 : USD/JPY USD paid for parts 1,746,228

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

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 = USD/JPY, On Nov 6, Dec futures F t=Nov 6,,Dec = USD/JPY S Nov 6 =.00907

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 USD/JPY Nov 6 - Sold Dec USD/JPY

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

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 ) USD/JPY Borrow JPY 200M = USD/JPY x JPY 200M = = USD 1,814,000 Cost of loan = USD 1,814,000 x ( *5/360)= USD 1,815,030 USD paid for parts USD 1,815,00

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 = B:X=0.0090, premium = S Nov 6 =.00907

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 = B:X=0.0090, premium = S Nov 6 =.0084

4) OTC JPY Option DW would have bought a call option to cover payables Variables Amount (JPY)200,000,000 Strike PriceX PremiumPremium Interest Rate (US)i XS t=Nov 6 (USD/JPY PremiumExercise?Total USD Cost USD Paid JPY 200M Yes ,829, Yes ,855,165

4) OTC Nov JPY Option Carrying costs =P t * interest rate * (maturity/360) Fox X=.0088 => *.04085*124/360 = = USD 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 ( *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 ( *5/360)= USD 1,856,219

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

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 PriceX PremiumPremium Interest Rate (US)i USD,bid-ask XS t=Nov 6 (USD/JPY PremiumExercise?Total USD Cost USD Paid for JPY 200M Yes ,817, Yes ,863,481

5) JPY Dec. Options (PHLX) Carrying costs =P * interest rate * (maturity/360) Fox X=.0086 => *.04085*124/360 = = USD 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 ( *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 ( *5/360)= USD 1,864,539

PHLX Options (Alternative Scenario: option out-of-the-money) Call option A:X=0.0086, premium = B:X=0.0090, premium = 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 Total received = USD 29,662

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