CASE on EXCHANGE RATE RISK MANAGEMENT Hofflander INDUSTRIALS (copyrighted:) When Ted Bush entered his office on Saturday, April 10, 200x, he received an email indicating the acceptance of his firm’s...




When Ted Bush entered his office on

Saturday, April 10, 200x, he received an email indicating the acceptance of his

firm’s offer to supply Jerry Martin, a Swiss distributor, with approximately a

little more than US$1,000,000 of electrical equipment in the form of remote

controls for industrial garage door openers (payable in Swiss francs). The mail

also indicated that Mr. Martin would wire the required deposit of SF100,000

directly to Hofflander Industrials’ Houston bank that day. With stagnant sales

recently, this was the best news Martin got in quite some time.

Bush, president and owner of Hofflander

Industrials, had been working hard to return the firm to profitability and hoped

exports would provide the firm with that impetus. His firm had been doing very

poorly caused by a downturn in the local economy and his failure to find new

business at home. Given the decline in the construction of industrial buildings

and warehouses, business for remote controls had been very sluggish. To use

idle capacity, Bush decided to develop an export market. So far, he had made

some export sales but mostly these were small orders and the sales were all

denominated in U.S. dollars.

Encouraged by help from the Texas Chamber

of Commerce, he joined a group of businessmen in January, accompanying the

Governor to drum business in Switzerland. He met Jerry Martin in Zurich, who

indicated an interest in becoming the Swiss distributor if costs were reasonable

and invoicing was done in Swiss francs rather than U.S. dollars. He asked Bush

to prepare a firm offer.

On January 12, 200x, Bush offered to sell Martin

a shipment of industrial garage door openers for SF 1,225,000. The offer

requested the following payment schedule:

SF 100,000 as cash down payment at the time

the offer was accepted by Martin;

SF 500,000 to be paid three months after

the offer was accepted by which time half the

order would have been


SF 625,000 to be paid in six months after

the offer was accepted, by which time the

remainder of the order

should have been shipped.

Bush called his bank to check Martin’s

credit rating and was told that his rating and business were very well

respected in Switzerland and so Bush decided not to request any letter of

credit (LC) guaranty beyond the initial down payment. Bush arrived at the price

of SF 1,225,000 by first pricing the order in dollars on January 12 and then

basing it on the spot exchange rate on January 12 – SF1.2027 per dollar. He

estimated his costs on the assumption that export costs would run nearly the

same as for existing domestic sales.

When Bush received the acceptance of the

order on April 10, he noted that the dollar had already weakened against major

currencies and that day the Swiss franc was trading at SF 1.1527 per dollar. He

figured that at that rate his order of SF 1,225,000 was worth $1,062,722,

nearly $44,200 more than when the bid was made, He was happy but wondered

whether things could reverse course when he receives future payments in Swiss

francs in three and six months respectively. In making the offer to Martin, Bush

had not allowed himself a big profit margin and wondered if he could lose money

if Swiss francs depreciate rather than appreciate.

On April 10, Bush decided to consult his

bank and ask for advice about foreign exchange risk. His banker, Ms. Lewis,

suggested several courses of action:

Remain uncovered and

do nothing. If the Swiss franc does go back to

the January 12 levels, he still would not lose a lot of money.

Cover the exposure in the forward

exchange market.

Cover the exposure in the futures


Cover the exposure in the options


Cover in the money


She suggested that while the final expense

could not be determined in all outcomes before-hand, their outcomes could be

simulated over a range of potential ending exchange rates when Swiss franc

receipts arrive on July 10 and October 10, respectively. Of course, if cash

inflows in francs could be matched by outflows in francs, the problem of

hedging through derivatives would not be an issue. The alternatives are:

Remain uncovered: While this means

waiting until the sales proceeds were received, it offered the maximum

risk but also the greatest potential gain if the dollar weakens vis-à-vis

the franc as it did from January to April. However, over the same time

period, Ms. Lewis showed Bush that the Swiss franc had ranged from SF 1.1442

to SF 1.3290 per dollar. If the SF declines to SF 1.30 on July 10 and

October 10, the two future SF proceeds will amount to $384,615 and

$480,769. However if the SF appreciates to SF 1.12 per dollar, the

corresponding proceeds would be approximately $446,429 and $558,036

respectively. The rates over the last six months have fluctuated as


October 10 SF


October 20 SF


October 30

SF 1.2850

November 10 SF


November 20 SF


December 30 SF


December 10 SF


December 20 SF


December 30 SF


January 10 SF


January 20 SF


January 30 SF


February 10 SF


February 20 SF


February 29 SF


March 10 SF


March 20 SF


March 30 SF


April 10 SF


Cover in Forward Exchange Rates: If Bush were

risk averse and wished to eliminate currency exposure, he could buy

forward contracts from the bank. Ms. Lewis explained to him that in a

forward contract, one agrees to buy or sell foreign currency at a

predetermined price with delivery to be made at a specified date in the

future up to one year later. It would assure Bush of a fixed number of

dollars at a price locked in today with the bank. Ms. Lewis looked at her

screen and quoted her a three month forward rate of SF1.1377 per dollar and

a six month forward rate of SF1.1277 per dollar, which meant more dollars

in the future than at present.

Cover in the futures market:On Bush’s

insistence of alternate choices, Ms. Lewis showed him her computer screen

focusing on futures contracts. She explained to him and pros and cons of

using the futures contracts vis-à-vis the forwards. She mentioned the fact

that if his shipment was delayed and the corresponding SF payments delayed

as well, the forward contract would create problems for Martin. The

futures traded on CME on April 10 (spot rate SF1.1527/$) showed the

following quotes for Swiss francs in cents per SF:

Swiss Franc (CME) – Francs 125,000 francs: $ per franc

Open Close Change

September 0.8440 0.8518 +0.0078

December 0.8677 0.8702 +0.0025

She explained to Bush that to use the

futures market, he would have to open an account with a broker and tie up some

funds in a margin account. This would then be debited or credit due to daily

marking to the market. If his account fell, he could get margin calls but he

could also withdraw money from the margin account if the account had a balance

exceeding the required maintenance margin. Work with settle prices (day’s close


Cover in the options market:Ms. Lewis

also pointed out to Martin the advantages of buying an insurance policy in

the form of OTC options contracts, available from the bank itself. She

explained that while options are traded on the Nasdaq OMX Stock exchange,

she could arrange an option contract tailored to meet Bush’s customized

requirements and asked her derivatives desk to show the various

possibilities to Bush. She also explained the pros and cons of using

options and futures to hedge.


Date: April 10, 200x:

Amount SF 500,000 Amount SF625.000

Expiration date: July 10 Expiration date: October 10



Call Put Call Put

0.865 $0.0145/SF $0.0089/SF $ 0.0165/SF $0.0100/SF

0.870 $0.0115/SF $0.0119/SF $ 0.0135/SF $0.0140/SF

0.875 $0.0105/SF $0.0129/SF $ 0.0115/SF $0.0160/SF

Cover in the Money Market:As if Bush

was not confused already, Ms. Lewis laid out a five option to him. She

said that her bank could arrange for Hofflander Industrials to borrow

Swiss francs from its Swiss or New York office. The loan would be in the

form of an overdraft in Swiss francs and would be at a fixed rate for both

three-month and six-month maturities at 100 basis points above Swiss franc

LIBOR. She again went to her computer screen and found the following

quotes for SF LIBOR and $ LIBOR on April 10.

3 months 6




2.6% 3.0%

$ LIBOR 3.4% 3.8%

Bush mentioned

to Ms. Lewis that since he had not done well in business over the last six

months of the recession, he would need money for working capital to finance the

production of the product over the next six months. He figured he needed $450,000

for working capital. Ms. Lewis told him that given his low credit rating

presently and the credit crunch in the market due to the recession, the cost of

borrowing $450,000 for working capital might cost him 150 basis points over the

six month $ LIBOR.Ms. Ray told him that she could not promisebut

given his past business relationship with the bank, she could arrange for a six

month $ loanat 5.3% (which

is 150 basis points over the six month LIBOR of 3.8%). She could also arrange

to invest his money at the $ LIBOR in London if he so chose.

Other Considerations: Ms. Lewis converted the down payment of SF100,000 at the spot rate

of SF1.1527 to net him approximately $86,753 in cash. These funds could be used

to finance his working capital or pay off other short-term loans, which might

have been at a higher rate.

Mr. Bush walked out of Ms. Lewis’s office

a confused man. He was amazed at the options available to him. He suddenly runs

into you (a family friend) and finds out that you are doing your MBA

specializing in Finance. He hires you instantaneously to present a comparative

analysis for him of all the available choices by the end of the day, outlining

a strategy for him to pursue. Prepare a consulting report/strategy for Bush and

make your suggestions to him as to which line of action should he pursue.

Evaluate and

compare all five choices listed above:

1. Remain unhedged

2. Forward hedge

3. Futures hedge

4. Options hedge

5. Money market hedge.


Make any reasonable assumptions you need.

Some suggested assumptions and hints:

1. Forecast the expected spot rate for July 10 and October 10. There

are several ways to do this. You could run a regression with time trend and

forecast it. Or you could use a moving average approach. Or you could use a

probability distribution approach to forecast the future spot rates on those


2. Assume Hedge Ratio = 1 in futures case. This means change in spot

rate will be equal to change in futures price on July 10 (for September

maturity) and October 10 (for December maturity). Let us take the September maturity

for example. On April 10, you are given the spot rate and the futures price for

September contract. On July 10, you will receive the money and do not need the

hedge. So you offset the hedge by offsetting the futures contract at t* (July 10)

for September contract. But you do not know this. However, you do know the expected

future spot rate on July 10. So, if you assume that the Hedge ratio = 1, you

can find the futures price at t* for September maturity since change in spot =

change in futures.

3. Use only one exercise price for options. I suggest you use the closest

to at-the-money option exercise price.

4. Issue of working capital

is important but not the main focus of this case. Discuss it if it helps your


May 16, 2022

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