Hedging Transaction Exposure. Popescu, Hagi & Associates Presented by: Frank Naglieri and Kariuki Ndegwa

Problem In June 2009, DW ordered Japanese parts valued at JPY 200,000,000. Delivery is due in two months. Payment is due within 30 days of delivery. The exact delivery date could not be guaranteed, but an informal telephone call from Japan stated the expected delivery date to be October 17.

Time Line Parts Ordered worth JPY 200MM June ‘09 Delivery Due Date Aug ‘09 Payment due (200MM) October 2009

Measuring the Transaction Exposure (TE) Net Transactional Exposure: JPY 200MM * = $1,965,800.

Range Estimates of Transaction Exposure Using ad-hoc method: +/- 10% of Net Transactional Exposure $1,965,800 + $196,580 = $2,162,380 $1,965,580 - $196,580 = $1,769,000 Using sensitivity analysis: Max daily change 3.47% and Min daily change -5.58% from Jan 2001 $1,965,800 * ( ) = $ 2,034,013 $1,965,800 * (1 – ) = $1,856,108

Range Estimates of Transaction Exposure Another sensitivity analysis: Max Daily Forex Rate and Min Daily Forex Rate JPY200,000,000 * = $2,317,200 JPY200,000,000 * = $1,484,200 Using random forex rates with a normal distribution

PHLX Options 1 options contract in USD/JPY = JPY 100MM Therefore JPY200MM / JPY100MM = 200 contracts are needed to hedge the short position. For OTC options: ( strike price) * 200MM = $110,420 ( strike price) * 200MM = $131,240 For Exchange Traded Options: ( strike price) * 200MM = $119,560 ( strike price) * 200MM = $140,180 OTC options are cheaper than PHLX options.

Forward Contract vs. Options Hedge Cash Flow from Forward Contract Cash Flow from OTC Call Options

K USD MM USD MM ST 6 mnth Forward Contract Nov 17 OTC Call.0096

Recommendation I would recommend that Mr. Mirman to use the OTC options for the following reasons: The expiry date of the OTC options match exactly the date the company needs to make payment to their supplier ( November 17th 2009) The OTC options guarantee that the company does not pay more than ( * JPY 200MM - $110,420) while allowing the company to also benefit from the upside in case the Yen declines relative to the USD.

It is now November 6 th and the Parts were delivered October 11 th. Payment due November 11 th Spot Rate USD/JPY Forward Rates 1 month month U.S. Int. Rates: < 2 months Deposit Rate:.2909 Borrowing Rate:.3165 CME Dec. Futures PHLX Dec JPY Options – Nov. JPY DecCallsPuts PHLX Dec JPY Options – June JPY DecCallsPuts OTC JPY Options – Exp. Nov. 17 Strike PriceCallsPuts

Effective Total Cost in USD if we had advised … 1) 3-month Forward Contract 2) Using December Futures 3) Left the Position Open 4) Using the OTC JPY Option 5) Using PHLX JPY Dec Options

Effective Cost of Using 3 Month Forward June 6 th  Sept 6 th 3 Month Forward: 200M JPY x = $1,797,000 Sept 6 th  Dec 6 th - Rollover 3 Month Forward 200M JPY x = $1,797,000 Using 3 month forward contracts between June and September and then rolling it over again the cost is a zero sum and the hedge is perfect. June 6 th  Sept 6 th 3 Month Forward: 200M JPY x = $1,797,000 Sept 6 th  Oct 6 th - 1 Month Forward Contract 200M JPY x = $1,796,900 USD Oct 6 th  Nov. 6 th - Rollover 1 Month Forward Contract 200M JPY x = $1,796,900 USD The difference in USD we would have to pay ultimately is: $1,797,000 - $1,796,900 = $100 in costs

Effective Cost of Using December Futures Dec. Futures (Nov. Info) – 200M JPY x = $1,797,400 USD Dec. Futures (June Info) – 200M JPY x = $1,974,600 USD Nov. Spot Rate – 200M JPY x = $1,797,000 USD Dec Futures (Nov. Info) vs. Nov. Spot Rate: $1,797,400 - $1,797,000 = $400 USD in Costs Dec Futures (Nov. Info) vs. Dec. Futures (June Info): $1,974,600 USD - $1,797,400 USD = $177,200 USD in Costs Using the December Futures given to us in November or June is not a cost effective hedging tool. Compared to the November Rate the December Futures given to us in November would cost an extra $400 of USD in order to hedge the 200M JPY. If you compared the December Futures given to us in June and November you would see there is a $177,200 of extra USD we would pay to hedge the 200M JPY.

Effective Cost of Leaving Position Open ( 200M JPY * ) – (200M JPY * ) = 1,952,800 – 1,797,000 = ($168,800)USD Costs If we let the exchange rates take their course we would be better off waiting to convert the funds in November rather than June because the Spot Rate is more favorable in November vs. June. June ConversionNovember Conversion

Effective Cost of Using OTC JPY Option OTC JPY Options – Exp. Nov 17 Strike PriceCallsPuts We assume we bought the call back in June with the Strike Price of Since the Spot Rate is favorable compared to the Strike Price we shouldn ’ t exercise the call. So our costs would be the premium of buying the call back in June but not exercising the option. 200M JPY * = 13,124,000/100 = ($131,240) USD Costs

Effective Cost of Using JPY Dec Option PHLX Dec JPY Options – From Nov. JPY DecCallsPuts PHLX Dec JPY Options – From June JPY DecCallsPuts We still assume we buy a call option at the.0096 in June. Since in both cases we wouldn't exercise the option since the Spot Rate is more favorable than the Strike Price we would compare the 2 premiums we pay for not exercising the calls in June and November. June Premium 200M JPY * = $14,018,000/100 = ($140,180) USD Costs November Premium 200M JPY * = ($110,000) USD Costs If we used the Dec. option in November instead of June we would have saved $40,180 in premium payments. $140,180 - $ 110,000 = $40,180