Solution to Case 32

Hedging with Derivatives

Case 27 When in Doubt, Hedge! - Teaching

Note
Questions:
1.
2. What is meant by the term transactions exposure? What kind of transactions
exposure is The Dependable Pipe Co. faced with?
` Transactions exposure refers to the short-run financial risk faced by a firm that needs to
buy or sell goods at uncertain prices or rates in the near future. It is the risk of loss arising
from volatility of commodity prices and exchange rate volatility. The Dependable Pipe Co.
is faced with two kinds of transactions exposure. First, it has to deal with fluctuating
copper prices, and second, since 70% of its sales come from exports to the United Kingdom
(with payment being made in British Pounds), it is faced with the uncertainty of the
US$/British Pound exchange rate. A rise in copper prices along with a strengthening dollar
would result in higher cost of production and shrinking remittances from the conversion of
pounds into dollars.
3. How much variability has there been in the spot price of high-grade copper over the
past twelve months? Is it large enough to warrant the need for hedging? Please
explain.
During the past year, the mean spot price of high-grade copper was $0.68175 and the
standard deviation was $0.0486.
Overall, in the past twelve months, the spot price of high-grade copper fluctuated between
$0.618 and $0.76 per pound. For a company that needs to buy 40 million pounds of copper
within three months, the $0.142 fluctuation could mean a $5.68 million difference in cost.
This level of exposure definitely warrants the need for hedging, especially since the orders
were booked at a time when copper prices were at their lowest level.

4. What kind of hedging strategy should Matt recommend for minimizing

Dependables exposure to volatility in copper prices? Design a suitable hedge and
show what would be the result if copper prices went to 77.5 cents per lb. at the end
of three months when the company would be ordering the high-grade copper.
The strategy to minimize Dependables exposure to volatility in copper prices is to buy
copper futures contracts so that the increased cost from rising copper prices will be offset
by the profit made on the futures contracts.
Hedging strategy example:
Dependables exposure = 40 million lbs of copper
# of contracts needed to hedge exposure = 40,000,000/25,000 = 1600contracts
April 2005
Spot price of copper = $0.72 per lb
Quoted price of July Copper Futures = $0.724 per lb. (size = 25,000 lbs)
3 months later
Spot price of copper = $0.775 per lb.
Futures price = spot price = $0.775 per lb.
Outcome
Loss to company from increased cost of copper = (0.775 0.72)*40,000,000 lbs
= $2,200,000
Gain on 1600 futures contracts = (.775 - .724)*25,000*1600 = $2,040,000
Net effect on increased cost of copper = 2,040,000 2,200,000 = -$160,000
Net effect per lb of copper = $-160,000/40,000,000 = -$.004 per lb.
Note: The hedge was not perfect because of basis risk. The spot price of copper
increased by a greater percentage than the futures price did, i.e.
(.775-.720)/.720 = 7.64% versus (.775-.724)/.724 = 7.04%
5. How should Matt respond if Lance argues that there is a good chance that copper
prices could be coming down?
Matt should tell Lance that if copper prices do come down, the company would not benefit
from the cheaper cost of copper, if it went ahead with the hedge because the gain from the
cheaper cost of copper in the spot market would be offset by the loss on the futures

contracts. However, he should point out that price fluctuations could go either way and
copper prices could be considerably higher as well. The company needs to protect itself
against rising prices because it is in the business of making pipes, not speculating on
copper prices.
6. Why is Matt concerned about the dollar strengthening in value against the British
pound?
Matt is concerned about the dollar strengthening against the British pound because 70% of
the $50 million worth of sales was from British firms and was priced in British Pounds. If
the US $ strengthened in value against the British Pound, the conversion of pounds into
dollars would bring in fewer dollars for the firm resulting in a lower rate of return on the
deal.
7. What hedging strategies can Matt recommend to minimize the impact of exchange
rate volatility?
Since the main concern or risk for an exporter who is paid in a foreign currency is the
strengthening of the domestic currency vis--vis the foreign one, the strategy that could be
used to hedge the currency exposure would be to buy sufficient currency futures contracts
which mature at about the same time that the payment is due to be received. This is known
as a long hedge and the objective of such a hedge is to offset the loss in value from the
appreciation of the US$ in the spot market, by the profit from the increase in value of the
currency futures contracts.
Besides currency futures, futures options on British Pounds, currency swaps, and forward
contracts can also be recommended to minimize the impact of exchange rate volatility.

8. Using the data given for British Pound futures contracts design a suitable hedge that
would minimize Dependables exposure to fluctuations in the exchange rate between
the US$ and the British Pound. Explain the results of the hedge if by September
2005, when payment is received from the British wholesalers, the exchange rate goes
to $1.350 per British Pound.
April 2005
US$/British Pound exchange rate = $1.42/1 British Pound (BP)
September BP Futures contract price = $1.423 per BP
Trading unit = 62,500 BP
Dependables exposure = $50 million * 70% = $35 million *1/1.42
= 24,.647.,887.32million BP
Number of contracts needed to be bought
= 24,647,887.32/62,500
= 394.contracts (rounded)
September 2005
Assume US$/BP exchange rate = $1.35/1 BP = Futures Price
Loss on conversion of BP into US$ = BP24, 647,887.32*($1.42-$1.35) =($1,725,352.11)
Gain on 394 currency futures contracts = 62,500*$(1.423-1.35)*394 = $1,797,625
Net effect of currency hedge = $1,797,625 - $1,725,352.11 = $72,272.89
Thus, they would end up with a small gain instead of a loss.

9. Lance questions Matt, What about forward contracts? Why not use forward
contracts instead? How should Matt respond?
Matt should remind Lance that although Dependable could use forward contracts to hedge
its transaction exposure, the market for forward contracts is not supervised and organized
like the futures and options markets. Parties can and have defaulted and credit risk can be a
major problem. Besides, forward contracts are pretty much custom- designed unlike
futures contracts which are standardized as far as grade of the underlying commodity,
maturity month, and size of the contract are concerned. Liquidity and safety are major
issues to consider when dealing in forward contracts, especially with the size of the deal
that Dependable in is involved in.
10. During their meeting, Lance told Matt that the firm had been forced to use floatingrate loans for expansion due to their low credit rating. Although long-term rates
were higher, the firm would have preferred to match the maturity of the debt with
the duration of their financing need. Besides, short-term rates had been rising and
were expected to continue going up due to rising inflation espectationsexpectations.
The firm currently had borrowed $2 million at a floating rate of prime plus 1%
(currently 6.5%). Longer-term, fixed rate debt was available at 9% per year. Lance
had heard about interest rate swaps and asked Matt to explain to him how
Dependable could use a swap to minimize their interest rate risk. How should Matt
respond?
Matt should let Lance know that they could contact a swap dealer who would find another
firm that was looking for a floating-rate loan. Lets call it Co. B and assume that it could
borrow at a fixed rate of 9% per year or a floating rate of prime plus 2%. Dependable
would borrow the $2m at a rate of prime plus 1% and offer to pay the swap dealer say
9.75% (lets say that it would have cost them 10.25% for a fixed-rate loan due to their low
credit rating). Co. B, which had borrowed money at the rate of 9% per year, could offer to
pay the swap dealer say prime plus 1.5% in exchange for the swap dealer making the fixed
rate payments.

9.75%(fixed)
Dependable

9%(fixed)
Swap Dealer

Prime+1%

Company
B
Prime+1.5%

Prime + 1%
(floating)

9% (fixed)

Debt Market

Debt Market

As a result of the deal, Dependable swaps its floating rate loan for a 9.75% fixed rate loan,
thereby saving 0.5% per year due to the arrangement. Co. B is able to convert its fixed rate
loan into a prime+1.5% floating rate loan, saving 0.5% per year as a result and the swap
dealer makes 1.25% per year on the deal.
11. Besides an interest rate swap, what other strategies could Matt recommend to Lance
to help minimize the companys exposure to interest rate risk?
Lance could recommend the use of interest rate futures and options to hedge interest rate
risk. For example, the firm could sell interest rate futures (Treasury bond or T-bill futures
contracts) so that if rates went up and the companys cost of borrowing increased, the price
of the futures contract would decrease (since bond prices are inversely related to interest
rates) and the profit on the futures contracts would offset the higher cost of borrowing.
With options, the firm could buy puts on T-bond futures so that as rates rise and bond prices
fall, the puts make money and offset the higher cost of borrowing.