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Transcript of Baker Adhesives
5 options for risk management:
1. Do nothing at all
2. Hedge in the forward market
3. Hedge in the money markets
4. Trade in the futures market**
5. Hedge with options** How to mitigate the risk? Currency Hedging Currency hedging is the act of entering into a financial contract in order to protect against unexpected, expected or anticipated changes in currency exchange rates when conducting business internationally
Provides protection against possible loss
Locks in the profit
Can save time Company Summary Circumstances Novo was able to secure the following agreements with Baker:
Forward option: Baker Adhesives’ bank had agreed to offer a forward contract for Sept. 5, 2006 at an exchange rate of 0.4227 USD/BRL.
Money market option: Affiliate of the bank located in Brazil was willing to provide Baker with a short-term real loan, secured by the Novo receivable at 26% Hedge in the Forward Market
Guaranteed exchange rates for the future exchange of currencies
Contract specified a date, an amount to be exchanged & a rate
Bank fees would be built into the rate
Can eliminate any risk due to currency fluctuations
Would know the exchange rate to be traded today
Market is open 24/7 Hedge in the Money Markets Makes a currency exchanges at the known current spot rate
Convert future expected cash flows into current cash flows
Borrow today in a foreign currency
Amount to be borrowed or deposited depends on the interest rates in the foreign currency
Baker would need to borrow in BRLs against the future inflow from Novo Ali Kraker
Wes McDonough Baker Adhesives In specialty market for adhesive industry
Just made first international sale to Brazilian toy company “Novo”
International sales were the key to the future
Change in exchange rates lowered the value of both orders Trade in Futures Market Currency futures contracts- contracts specifying a standard volume of a particular currency to be exchanged on a specific settlement date.
They differ from forward contracts in the way they are traded
Currency speculators trade futures contracts in hopes of capitalizing on their expectations of exchange rate movements
Liquid market and highly leveraged
they are traded on the CME or through brokerage firms
Considered fairer than other markets Recommendations Disadvantages of Futures Market:
Unable to tailor to precise amounts of currency or preferred dates
Contains a brokerage fee
Contains an initial margin, which is a deposit that must be made
Tracked daily: in the event of daily losses, a trader has to pay daily marginal losses, which is known as the Variation Margin
Offers only a partial hedge
Disadvantages of Hedge using Options:
Not much liquidity
Offers only a partial hedge Example of Forward Market Example of Money Markets Thank you!
Any questions? Exchange Rates Brazil is one of the world's most open nations in terms of international trade increasing exchange rate risk exposure.
The depreciation of BRL (Brazilian Reias) against the dollar, results in Baker receiving less money in transaction. Hedge Using Options Example of Hedging using Options In a downward trend, buy put options.
Buyer has the right to sell the option at the strike price.
If the BRL appreciates against the dollar, the option will not be exercised and premium is max loss.
Options are flexible and carry little downside risk.
No initial margin nor a daily variation margin, only premiums. How Firms Use Currency Futures Contracts Purchasing Futures contracts to Hedge Payables
Locks in the price at which a firm can purchase a currency
Baker adhesives would purchase Brazilian reias future contracts today, thereby locking in the price to be paid for Brazilian reias at a future settlement date.
By holding futures contracts, Baker would not have to worry about changes in the spot rate of the Brazilian real over time
Selling Futures to Hedge Receivables
Locks in the price at which a firm can sell a currency
By selling a futures contract, Baker would lock in the price at which it will be able to sell reias as of the settlement date.
This would be most appropriate since Baker expects the Brazilian real to depreciate against the American dollar Currency Hedging Recommendations
Offers a complete hedge
Can be written for any amount or term
Guaranteed not to lose money, but could lose an opportunity cost
Baker has a positive relationship with the bank The hope is that by minimizing the exposure of the investor to unfavorable shifts in the money market, a reasonable return on the investment will be achieved even if the currency involved takes a fall Example-Selling Futures to Hedge Receivables