Tcas Case Analysis in Order

TCAS Case Analysis

In order to make the best choice regarding which hedging option TCAS should use, Ms. Wright will need to gather some information to get a feel for where the Canadian dollar is heading in relation to the U.S. dollar. TCAS will be receiving C$2.61 million in 90 days, and has just received $290,000. This is being weighed again costs that have been estimated in U.S. dollars, at $1,959,353. At the time of the bid, the expected profit was $97,968.20.

The bid was based on a spot rate of 1.4096. Since that time, the Canadian dollar has traded in a tight range, and generally at a rate more favorable to TCAS. The C$290,000 payment that was just received is worth at the May 16 spot of 1.3594 a total of U.S.$213,329. This represents a gain of $7,596.88 due to currency fluctuation. However, TCAS is not in a strong financial position and thus is not necessarily in position to leave the value of the remaining C$2,610,000 unhedged.

To evaluate the risk of an unhedged position, Ms. Wright will need to estimate where the Canadian dollar will be in 90 days' time. The biggest direct factor in C$/U.S.$ exchange rates is the spread between short-term interest rates in each country. In general, the greater the spread, the stronger the Canadian dollar. Because TCAS will be receiving Canadian dollars, the stronger the C$ gets, the more the contract is worth.

Short-term interest rates in Canada are being driven by economic factors such as unemployment rates and strength in interest-rate-dependent sectors such as housing construction and durable goods purchases. The Canadian economy at present was experiencing a period of fiscal tightening. There were indications, however, that the government was planning to lower interest rates thereby loosening money supply. This would cause the short-term interest rate spread to decrease. A prolonged slump in new home construction would impact unemployment figures at economic growth as a whole, so the recent string of interest rate increases should be considered a short-term measure. Moreover, there is the threat of inflation that the government would like to curtail. All things being equal, this should drive down the value of the Canadian dollar vis-a-vis the greenback. Spreads are not liable to increase as a result of Canadian fiscal policy until the broader economic indicators improve.

So the short-term outlook is not favorable for TCAS. Given this, and that they have received a boost in profit on this project based on favorable interest rate fluctuation over the bid period, it would be best to enter into a hedge in order to lock in some of these profits.

A forward contract would lock in a profit of $165,643 on the project. The risk would be fully hedged at this point.

A foreign currency loan replaces fully hedges the risk as well. The cost is the interest paid of $81,562.50 and the fee paid of $3,262.50. The profit would be based on today's spot rate, less the combined fees of $84,825. Thus, the total profit of this option would be $173,406.

Buying a put would cost $58,725 and lock in a worst-case rate of 1.3888, which yields a profit of $133,296.20. The upside is technically the full value of the contract should the Canadian dollar strengthen infinitely. Writing a call would generate $92,916 for a maximum profit of $226,212.20. There would be downside risk, however, that could significantly erode this profit. Because writing a call does not hedge the downside risk, it is not a viable option for TCAS.

A foreign currency future contract would cost $1,300, given 26 contracts. This yields a profit of $163,676, not including the remaining $10,000 that would be unhedged since each futures contract comes in an increment of $100,000.

The pre-sale of a foreign contract has a cost for the 90-day period of $60,030 plus a transaction fee of $13,050 for a total cost of $73,080. This is based on today's spot, giving a profit of $100,860.