Analysis of Currency Hedging

Assignment One:

It is Tuesday afternoon, February 14, 2012. Alexander Lucas, Assistant Treasurer at
American Digital Graphics (ADG), sits in his office on the thirty-fourth floor of the building that
dominates Rockefeller Plaza’s west perimeter. Its Valentine’s Day and Alexander and his wife
have dinner reservations with another couple at Balthazar at 7:30.
“I must get this hedging memo done,” thinks Lucas, “and get out of here. Foreign
exchange options? I had better get the story straight before someone in the Finance
Committee starts asking questions. Let’s see, there are two ways in which I can envisage us
using options now. One is to hedge a dividend due on September 15th from ADG Germany.
The other is to hedge our upcoming payment to Matsumerda for their spring RAM chip
statement. With the yen at 78 and increasing I’m glad we haven’t covered the payment so far,
but now I’m getting nervous and I would like to protect my posterior. An option to buy yen on
June 10 might be just the thing.
Before we delve any further into Alexander Lucas’s musings, let us learn a bit about
ADG, and about foreign exchange options. American Digital Graphics is a $12 billion sales
company engaged in, among other things, the development, manufacture, and marketing of
microprocessor-based equipment. Although 30 percent of the firm’s sales are currently
abroad, the firm has full-fledged manufacturing facilities in only three foreign countries,
Germany, Canada, and Brazil. An assembly plant in Singapore exists primarily to solder
Japanese semiconductor chips onto circuit boards and to screw these into Brazilian-made
boxes for shipment to the United States, Canada, and Germany. The German subsidiary has
developed half of its sales to France, the Netherlands, and the United Kingdom, billing in
euros. ADG Germany has accumulated a cash reserve of €900,000, worth $1,178,100 at
today’s exchange rate. The Hamburg office has automatic permission to repatriate €3 million
September 15th

. The firm has an agreement to buy three hundred thousand RAM chips at

¥8000 each semi-annually, and it is this payment that will fall due on June 10th
.

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Alexander Lucas in his Rockefeller Center office has been printing spot, forward and
currency options and futures quotations from the company’s Bloomberg terminal. (See the
other pages for quotes and the highlighted market quotes.)
The option prices are quoted in U.S. cents per euro. Yen are quoted in hundredths of
a cent. Looking at these prices, Richard realizes that he can work out how much the euro or
yen would have to change to make the option worthwhile. Richard makes a mental note that
ADG can typically borrow in the Eurocurrency market at LIBOR + 1% and lend at LIBID.
“I’ll attach these numbers to my memo,” mutters Lucas, but the truth is he has yet to
come to grips with the real question, which is when, if ever, are currency options a better
means of hedging exchange risk for an international firm than traditional forward exchange
contracts or future’s contracts. Please assist Mr. Lucas in his analysis of currency hedging for
his report to ADG’s Finance Committee.
HINT: Show which hedging is better (forward, money market or option). Why? Detail
calculation and explanation required.

 

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