Finance Case Study: Hedging Strategies for Receivables and Payables

This case study analyzes hedging strategies for American Digital Graphics (ADG), focusing on managing foreign exchange risk associated with a Euro-denominated receivable and a Yen-denominated payable. The analysis compares the effectiveness of forward contracts and options contracts i...Read More

Hedging Contracts
Introduction
Michael Smith, Assistant Treasurer at American Digital Graphics (ADG) is planning to
hedge foreign receivable and payable that may accrue to ADG in near future. The company
has always been hedging its receivable and payable by using traditional instruments like
future contracts and forward contracts. Recently, Mr. Smith has been considering alternative
option for the purpose of hedging the receivable and payable. The receivable of the company
are in the form of dividend and amount stands at Euro 1 Million which needs to be repatriated
to United States in dollars, while on the other hand there is payment outstanding for yen
amounting to Yen 6000 per chip for 0.3 Million chips. The dates of the above amounts stand
at September 15 and June 10 respectively.
Analysis
The company has been contemplating to use option to hedge the receivable and payable
based on following rationale:
The important feature of a foreign exchange option is that the holder of the option has the
right, but not the obligation, to exercise it. He will only exercise it if the currency moves in a
favorable direction. Thus, once you have paid for an option, you cannot lose (except for the
option’s premium), unlike a forward contract, where you are obliged to exchange the
currencies and therefore will lose if the movement is unfavorable.
Accordingly an analysis has been conducted between traditional method and options to draw
inference about the best method to hedge the concerned receivable and payable.
Receivables
The following query has been raised with regard to receivables:
For the €1 million dividend to be received on September 15 (7 months from now), should Mr.
Smith hedge with forward contracts or options contracts? You should calculate the dollars
received under each hedging strategy and draw a graph with Excel to show the relation
between the dollar amount received and future spot rate 7 months from now.
Response
For the purpose of hedging the following data has been made available:
Currency group Spot Exchange Rates
2/14/19 Rate: Spot
USD EUR JPY
JPY 110.5000 125.3000 ------------
EUR 0.8819 ------------ 0.00798
USD ------------ 1.1339 0.00905
Currency group Forward Exchange Rates
2/14/19 Ra te: 4 Month
USD EUR JPY
JPY 105.8201 117.0899 ------------
EUR 0.9038 ------------ 0.00854
USD ------------ 1.1065 0.00945
Currency group Forward Exchange Rates
2/14/19 Ra te: 7 Month
USD EUR JPY
JPY 104.6025 114.0167 ------------
EUR 0.9174 ------------ 0.00877
USD ------------ 1.0900 0.00956

As given
Spot Rate : 1 Euro= 1.1339 USD
Forward Rate : 1Euro= 1.0900
If forward contract is used, Value to be received in September = Euro 1 Million * 1.09= USD
1.09 Million
For options the following data is provided
Currency Options
Dollar/Euro (direct quote for euro)
23 Sep 19 23 Sep. 19
Ticker Bi d As k Stri ke Ticker Bi d As k
1) XEU2C C 6.10 6.44 109 1) XEU2P C 4.03 4.28
2) XEU2C C 5.52 5.82 110 2) XEU2P C 4.44 4.67
3) XEU2C C 4.97 5.25 111 3) XEU2P C 4.89 5.09
4) XEU2C C 4.45 4.73 112 4) XEU2P C 5.35 5.56
5) XEU2C C 3.94 4.21 113 5) XEU2P C 5.84 6.06
Currency Options
Dollar/Yen (direct quote for Japanese yen)
17 Jun 19 17-Jun-19
Ticker Bi d As k Stri ke Ticker Bi d As k
1) XNM2C C 2.09 2.40 93.5 1) XNM2P C 1.50 1.75
2) XNM2C C 1.82 2.11 94.0 2) XNM2P C 1.80 2.08
3) XNM2C C 1.57 1.84 94.5 3) XNM2P C 2.10 2.35
4) XNM2C C 1.33 1.57 95.0 4) XNM2P C 2.38 2.58
5) XNM2C C 1.10 1.35 95.5 5) XNM2P C 2.60 2.85
Calls
Calls Puts
Puts
Company based on above data may buy put option at 1.13 whereby any fall below 1.13 will
be compensated by option. The premium cost for the said strategy shall work out to 6.06* 1
Million Euro= .0606 Million Euros= 0.0687 US Dollar.
Further, the spot value of the currency as on the date of maturity stands at $ 1.10 (assumed).
Based on above, the amount received at maturity
Pay off from conversion of Euro to $= 1.10* 1 Million= 1.10 Million USD
Payment form option= (1.13-1.1)*1 Million= .03 Million USD
Cost of option= .0687 Million USD
Net : 1.0613 Million USD
Further, values have been computed at different spot price using the same method:

Spot Rate Forward Option
1.1 10900000 10613000
1.2 10900000 11312857
1.3 10900000 12312857
1.4 10900000 13312857
1.5 10900000 14312857
1 10900000 10612857
Based on above, the graph has been plotted as under:
1.1 1.2 1.3 1.4 1.5 1
0
2000000
4000000
6000000
8000000
10000000
12000000
14000000
16000000
Comparison at different spot rate
Spot Rate Forward Option
SPOT
USD
On basis of the above, it may be inferred that the strategy of options are feasible if the spot
rate is $1.16 as the cost of options is very high in the concerned case.
The following query has been received in regard to payables:
For the ¥1800 million to be paid on June 10th (4 months from now), should Mr. Smith hedge with
forward contracts or options contracts? You should calculate the dollars paid under each hedging
strategy and draw a graph with Excel to show the relation between the dollar amount paid and
future spot rate 4 months from now.
As given
Spot Rate : 1 USD= 110.5 JPY
Forward Rate : 1USD= 105.8201
If forward contract is used, Value to be paid in June = 1800/105.8201= USD 17.01 Million
If Options are used, the company will buy put option at strike price of 95.5 at the rate of 2.85.
Further, the spot value of the currency as on the date of maturity stands at Yen100 (assumed).
Based on above, the amount received at maturity
Pay off to be made = 1800/ 100 = 18 Million USD
Payment form option= 0 Million USD

Cost of option= 1800*.0285/110.5=0.464253 Million
Net : 18.464Million USD
Further, values have been computed at different spot price using the same method:
Spot Rate Forward Option
80 170100009 193124209
90 170100009 193124209
100 170100009 184642534
110 170100009 168278898
120 170100009 154642534
130 170100009 143104072
Based on above, the graph has been plotted as under:
80 90 100 110 120 130
0
50000000
100000000
150000000
200000000
250000000
Comparison at different spot rate
Forward Option
On basis of the above, it may be inferred that the strategy of options are feasible if the spot
rate is above Yen 110 as the cost of options is very high in the concerned case.
Conclusion
On the basis of above analysis it may be concluded that options seems a feasible only when
there is a large variation from the spot price in a short period of time which is less likely.
Hence the traditional method may be opted currently.