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Transcript of TCAS, Inc.
Later in 1988 TCAS merged with Computer and Software Systems Company to extend its services to include management information systems. Given the fierce competition and the narrow market for profit, TCAS decides to go International. Factors Influencing Exchange Rates4 1.Inflation rates: An increase in inflation means prices in the domestic country will begin to rise, relative to prices of goods and services in foreign lands, thus making foreign goods and services more affordable. 2.Interest rates: A rise in domestic interest rates relative to foreign rates, all else being equal, will cause investors in both nations to switch from foreign to domestic-denominated securities to take advantage of higher domestic rates. 3. Economic Growth Rates: Strong economic growth rates will attract investment capital seeking to acquire domestic assets. Thus, increasing demand for domestic currency and a stronger currency. 4.Political and Economic Risk: More politically and economically stable nations are more highly valued. Five Parity Conditions 1.Purchasing Power Parity: The notion that the ratio between domestic and foreign price levels should equal the equilibrium exchange rate between domestic and foreign currencies. (spot rate & inflation) 2.Fisher Effect: States that the nominal interest differential between two countries should equal the inflation differential between those two countries. (interest rate & inflation 3.International Fisher Effect: States that the interest differential between two countries should be an unbiased predictor of the future change in the spot rate. (spot rate & interest rate) 4.Interest Rate Parity: A condition whereby the interest differential between two currencies is (approximately) equal to the forward differential between two currencies. (interest rate & forward) 5.Unbiased Nature of the Forward Rate: States that the forward rate should reflect the expected future spot rate on the date of settlement of the forward contract. (spot rate & forward) Financial Performance "Go International" TCAS must decide how to finance the project given the large initial outlay expenditure and poor financial performance
Foreign Currency Exposure Management Alternatives 1.Forward contract
Currency Amount: C$ 2,610,000
Forward Rate: $1.3653 C$/US$
3/16/ 1995 Spot Rate: $1.3594 C$/US$
C$2,610,000/1.3653 = $1,911,668
C$2,610,000/1.3594 =- $1,919,965
-$8,296,925 Cash flow 2.Foreign currency loan
Currency Amount: C$ 2,610,000
Canadian Loan Prime Rate: 10.25%
US Loan Prime Rate: 8.875%
CAN Prime Rate: 12.25% (10.25% + 2.25% above prime rate)
C$2,610,000/ (1+ (.1250X (90/360)) = C$2,530,909
Arrangement Fee: C$ 31,250
Loan amount: C$2,530,909
Net LoanC$2.53-0.003125M = 2.527M
Conversion to US$: C$2.527/C$1.3594= $1.859M
Opportunity cost (debt): $1.859*(1+ (.11/4)) = $1.910M
3.Foreign Currency loan
Strike Price: 1.3888 C$/US$
Rate .7325 (1/1.3653)
C$2,160,000/1.3888= 1,879,320 US$
C$2,610,000/1.3653 = 1,911,668 US$
($40,666.41) Cash flow
Premium received: 0.0356*C$2, 610,000 = $92,916 proceeds
In the Money
C$2,610,000*(0.72+0.0356) = $1,972,000
Break-even w/rate .7325- .0356 = $0.6969
Buy Put w/Strike price of $0.72
Premium paid = 0.0225*2,610,000 = $58,725
Out of the Money
C$2,610,000*(0.72 - 0.0025) = $1,820,000
Break-even w/rate = (.7325) +0.0025 = 0.755
If expect the spot rate to > 0.755, buy a put
If between 0.6969 and 0.7566, write a call
If less than 0.697, sell forward
C$2,160,000/1.3605= 1,918,412 US$
C$2,610,000/1.3653 = 1,911,668 US$
($1,552) Cash flow
C$2,610,000 * 0.735 - 1300 = $1,917,000
5.Pre-sale of contract
Loan Amt: C$2,610,000/ (1+ (0.092/4)) - C$2.55M*0.005 = C$2.538M
Conversion to US $: C$2.538M/1.3594* (1+ (.11/4)) = $1.918M
C$2,160,000/1.4019= 1,861,759 US$
C$2,610,000/1.3653 = 1,911,668 US$
($58,206) Cash flow
Best case: 2.6M*0.7533 = $1.966M
Worst case: 2.6M*0.7133 = $1.861M
The use of the spot rate on May 16 for the determination of the Canadian dollar bid was wrong because if they had a contract for the previous price (1US$=C$1.4096) and used the price when the 1US$= C$1.3594, then the dollar cannot purchase as many Canadian dollars as it did before.
2,057,320*1.4096 = C$2,899,998.272
2,057,320*1.3594 = C$2,796,720.808 The Canadian dollar for the year ahead as of August 16 was forecasted at $1.3475by using Purchasing Power Parity (PPP). PPP has been extensively used by central banks and it is often used by managers to forecast future exchange rates. (1 + .019)1 / (1 + .028)1 x 1.3594 = C$1.3475. The original mark-up was 5% and the spot rate was 1US$= Canadian $1.4096 on March 21st. The bid was accepted on May 15th, and on May 16th, the dollar was at 1US$= C$1.3594. In other words, the Canadian dollar, appreciated in relation to the US dollar (and vice-versa, the US dollar depreciated in relation to the Canadian dollar by 3.6%). The real mark-up bid would be 8.6% (5% + 3.6%) if the new exchange rate would hold steady for the next 90 days. Forward Contract
A forward contract is a contract that you agree to buy or sell an amount currency in the future at a price decided today. The price in this case is actually the exchange rate. In this case TCAS will purchase forward contract at 90 day forward rate of 1US$=C$1.3653. TCAS will be delivering Canadian $2,610,000. To find the post hedge cash flow, we must get the size of the contract and divide by the 90 day forward rate. (Canadian $2,610,000/ C$1.3653=$1,911,667.765). The post hedge cash flow for the forward contract is =$1,911,667.765.
Foreign Currency Loan
A foreign currency loan is just taking out a loan in a foreign currency and converting it to your currency today. There are fees and you must pay back the loan with interest in the future. In this case TCAS will create a C$ loan for 90 days. In this foreign currency loan any gains and losses on receivables will be offset by equivalent losses and gains on the loan. There are fees and cost to his hedge including a prime rate (the best possible interest rate available) of 10.25% Canadian and 8.875% US, a spread (interest rate you pay in addition to the prime rate) of 2.125% and an arrangement fee (fee the bank charges you for their administration costs) of 0.125%. The loan will be Canadian $2,610,000 and the current exchange rate is 1US$=C$1.3594. To find the post hedge cash flow we get the loan size and divide it by the current exchange rate. (Canadian $2,610,000 / C$1.3594=$1,919,964.69). The post hedge cash flow not including costs will be =$1,919,964.69.
Foreign Currency Option
A foreign currency option is having the right to buy or sell but not the obligation to buy or sell the security at a certain price in the future. In order to have this right, you must pay a premium. In this case TCAS will purchase put option at the rate of 1US$=C$1.3888. The put premium on this foreign currency option is US dollar 0.0225/Canadian dollar. The size of this option will be Canadian $2,610,000. To find the post hedge cash flow we the size of the option and divide it by the rate. (Canadian $2,610,000/ C$1.3888=$1,879,320.276). The post hedge cash flow before cost will be $1,879,320.276.
Foreign Currency Futures
A foreign currency future is just like a forward contract in that it’s an agreement to deliver to someone s given amount at a designated future date. The difference is that the contract can only be in set increments like $100,000 each. In this case TCAS will purchase August futures at the rate of 1US$=C$1.3605. In this foreign currency future each Canadian dollar future contract represents Canadian $100,000 and each contract will cost US $50.00. The size of this foreign currency future will be Canadian $2,610,000. In order to find the post hedge cash flow you get the size of this foreign currency future and divide by the August futures rate. (Canadian $2,610,000/ C$1.3605=$1,918,412.348). The post hedge cash flow before cost will be $1,918,412.348.
Pre-sale of a Foreign Contract
A pre-sale of a foreign contract is purchasing or selling a contract at a discount. You are able to collect on the contract by selling to a third party. In the case the pre-sale of a foreign contract, TCAS will sell the Canadian contract at a discount rate of 7.375%. The contract size will be Canadian $2,610,000 and the current exchange rate is 1US$=C$1.3594. In order to find the post hedge cash flow, we need to calculate the contract value which is the contract size divided by the current exchange rate. (Canadian $2,610,000 / C$1.3594=$1,919,964.69). The contract value is $1,919,964.69. Now in order to get the post hedge cash flow of the pre-sale of a foreign contract, we get the contract value and subtract it from the total of the contract value multiplied by the discount rate. ($1,919,964.69-($1,919,964.69*7.375%) =$1,778,367.294). The post hedge cash flow is $1,778,367.294.
A tunnel forward is basically a forward contract but instead of negotiating a set exchange rate, a range of where the exchange rate may fall is negotiated. In the tunnel forward, TCAS will purchase a contractual agreement that sets a exchange range, the Canadian dollar put set at 1US$=C$1.4019. The size of the contract will be Canadian $2,610,000. The post hedge cash will equal the size of the contract divided by the exchange rate. (Canadian $2,610,000/ C$1.4019=$1,861,759.041). The post hedge cash flow will be $1,861,759.041.
A bid was tendered by fax on March 21st, the spot exchange rate for March 21st was CD1.4096/USD, the firm received 10% of the purchase price and the rest was to be received in 90 days upon delivery and installation of the system. Also TCAS was required to secure a performance bond of 75% of the outstanding contract value. So TCAS is in need of a hedging strategy that will protect its interest in this contract, and also is in need of funds that could be cheaply obtained to fulfill the bond obligation.