Hedging and positioning strategies in international markets

Hedging & Positioning

George Brown is facing several different types of exposure in this transaction. Brown faces economic risk, political risk, foreign exchange risk, and credit risk. The economic risk derives from the risk that the economy in Germany follows that in the United States. In the U.S., economic and purchasing shifts could impact Zinn's ability to complete the purchase. Brown would have already begun production of the radios, and would therefore be stuck with those costs. There is political risk because of the international nature of the transaction. This exposes both firms to the risk of tariffs and other barriers than can impact the transaction. Furthermore, the Reagan administration would like to see the rate stabilize closer to 2.50.

The most important risks facing Brown are the credit risk and the currency exchange risk. Brown is exposed to credit risk, since they have essentially extended to Zinn interest free credit. Because they will be sinking money into the production of the radios, they are exposed to the risk that Zinn will be unable to make the payments owed.

That debt is entirely unsecured.

Brown is also subject to foreign exchange risk, which is in the form of transaction exposure. This is because Brown's production costs are in U.S. dollars, but the revenues are in deutschmarks. Furthermore, Brown is only receiving a small down payment up front. The bulk of the revenue for the sale is coming in two payments three and six months hence. At present, any fluctuation between the U.S.$/DM rate in that time will affect Brown. The impact may be positive, but the fact that it may also be negative represents a risk. Furthermore, the exchange rate over the past several months has proven to be volatile, increasing the risk. The rate at present is also near the most favorable level of the year, which in absence of strong underlying fundamental issues could mean that that deutschmark is set to move back towards the higher end of its range.

2) There is little that Brown can do to hedge the economic or political risks. Now that the deal has been made, there is little Brown can do about the credit risk. The time to hedge that risk was during the deal negotiation, where Brown could have requested some form of collateral, or at least interest on the credit.

Brown can, however, hedge the foreign exchange exposure. There are three options for Brown with regards to hedging the exposure. He can do nothing, which will subject the company to the full exchange rate risk. Given that the exchange rate has moved in a favorable direction in the time between pricing the offer and signing the deal, Brown is already in a profitable position, so there is some cushion in terms of adverse exchange rate movements. However, those movements are in the past, and Brown has the opportunity to lock in those gains with a hedge today.

The second option is to hedge with a forward contract. The forward would be a contract to sell deutschmarks at a future date. Brown will be forced to sell the deutschmarks when they receive them, but the forward contract locks in the price of that sale.

The third option is to hedge in the money market. This involves taking out a deutschmark loan. The loan would then be paid off with the proceeds of the sale. This essentially brings the company the income today, at the price of the interest paid. There are two options on the table for the money market - a floating rate line of credit from Frankfurt and a fixed-rate short-term loan from London.

3) the do nothing alternative has no costs, but leaves the company fully exposed. Theoretically, they could lose the entire value of the deal, but they also have near limitless upside should the value of the deutschmark continue to improve against the dollar. At present, however, they are comfortably in the money. Forwards and futures are indicating that the mark will either stay at the same level or appreciate. Political considerations also appear to point towards further strengthening of the mark. Therefore, it appears that it would take a significant situation to erase the gains Brown has already made.

The forward contracts will lock in the value of the future deutschmark payments. The three-month contract will be worth (625,000 / 2.6325) = $237,416.90. The six-month contract will be worth (775,000 / 2.615) = $296,367.11. Combined with the initial payment of DM 150,000 / 2.656 =$56, 475.00, the value of the deal would be $590,259.01. The risk under this scenario would be fully hedged, although there is some opportunity cost risk should the deutschmark improve against the dollar in the interim. However, the $590,259.01 represents an improvement of almost $56,000 over the profit that Brown had initially expected in the deal. This is also more than he would make if the exchange rate stayed stable over the next six months.

The money market option would give Brown a hedge, but would cost interest. The cost of the Frankfurt loan would be $14,390.35; the cost of the London loan would be $13,068.54. The London loan is fixed rate, which eliminates interest rate risk. The Frankfurt loan is floating, and therefore still has interest rate risk. The London loan is better.

4) for the cost of the money market hedge to be justifiable, that money must be reinvested. The reinvestment will be made to pay down the short-term debt. If Brown borrows and converts the DM today, he will receive $527, 186.42. Of this, $300,000 is to be used as working capital, leaving $227,186.42 for debt reduction. The debt as of end September, 1985 was $165,500, and the $56,475 received today will be applied to that. The rate on the debt is 11%. This is the reinvestment rate. This will save $2,998.18 in interest on the short-term loan for the first quarter. After repaying the DM625,000 (estimates based on today's exchange rate) there would be a drawdown on the line of credit of $8,208 for the second quarter, accruing interest of $275.98, assuming no rate reset. Applied to the cost, this means that the loan costs would be $10,296.34. There would also be interest on whatever Eurodollar investment that Brown is able to secure for the $118,083.43 that will be left over in the first quarter after the working capital requirements and debt service are accounted for.

As a result, I recommend the forward contract. The forward contract saves Brown $6,911.36 over today's exchange rate; the money market hedge still costs money. If the money market costs $10,296.34. Most of the DM loans will be applied to working capital, which has a reinvestment rate equivalent to Brown's ROI. However, Brown is not a profitable firm. The use of the money market hedge is dependent on Brown being able to invest that money at a higher rate than they are paying. This is not the case for the majority of the loan money. Therefore the forward contract is the better choice of hedge for this transaction.

5) Between the futures market and the options market, I would choose the options. There are fundamental problems with using the futures market. First, the hedges are imperfect. The maturity dates are a month off from where Brown needs them. This means that the company will be exposed for one month on each of the parts of the transaction. Moreover, on the second transaction, $25,000 of the last payment will remain entirely unhedged. Additionally, the futures require Brown to post margin, which will come out of the company's line of credit, adding to the cost.

The options offered by the bank, on the other hand, provide complete hedges. Both options would allow Brown to lock in some of the gains already made on his original estimates due to the strengthening of the deutschmark over the summer. The options also do not have a mark-to-market requirement. Since the point of incurring the cost of hedging is to reduce the risk of adverse movements, the option chosen would be the $0.37 strike, since the spot rate is in between the two strike prices available from the bank.

The structural imperfections of the futures hedge make it less ideal. The options will allow a perfectly-matched hedge for Brown, and allow Brown to lock in the exchange rate gain that has been accrued thus far.

6) There are other ways to hedge foreign exchange risk. One way is to offset the exposure. This is done by matching long and short positions. This can be done through business transactions, setting up foreign subsidiaries or other means. This can also be done strictly on the financial markets. In that case, the degree and direction of correlation between the two currencies should be taken into consideration.