Merton Electronics Corp
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By Alexzander Downs
Michael Jordan
Kevin Grant
Takshal Bhansali
Outline
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Current Situation
Currency risk exposure
Each hedging method defined
What happens if
Hedging if and when
speculation
conclusion
Current Situation
• Merton’s sales has grown by 12% but the
earnings fell by 40%.
• The competition is intensifying due price
cutting by the competitors.
• More then 60% of the total sales are
imported from Asia.
• Payments have to be made in either yen or
Taiwanese dollars.
• In last 18 months Merton has hedged at the
future rates.
• Why is this a problem?
Currency risk exposure
if left unheadged the dollar value of the payable is subject to
fluctuations in the value of the Yen
value at the current forward price is $2,385,600
April Yen Call Option [CME]
Profit
$0.06
$0.04
$0.02
$0.00
St
$0.77
($0.02)
($0.04)
$0.79
$0.81
$0.83
$0.85
Each hedging method
defined
• According to the banker there were
two basic choices
Options Contract
Lock in profits today
Currecy Futures Contract Forward Contract
[OTC]
Money Market Transaction
[CME]
Each hedging method
defined
• Forward Contract Hedge
• Merton has committed themselves to pay ¥300,000,000 in 90 days
¥300,000,000 x $.7952 = $2,385,600
100
Oppurtunity
Profit
April Yen
$0.06
$0.04
$0.02
$0.00
St
$0.77
($0.02)
($0.04)
$0.79
$0.81
$0.83
$0.85
Each hedging method
defined
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Money Market Hedge
Buy yen today on the spot market and place in a yen time deposit
until needed to pay suppliers.
¥300,000,000 = So e^(.0375) (.25)
So = ¥297,200,642.50
Convert ¥297,200,642.50 into dollars
¥297,200,642.50 x $.7849 = $2,332,727.84
100
Each hedging method
defined
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We now need to know how much it is going to cost Merton to
borrow $2,332,727.84 for 90-days.
Fo = $2,332,727.84 e^(.0875)(.25)
Fo = $2,384,318.48
Oppurtunity
Profit
April Yen
$0.06
$0.04
$0.02
$0.00
St
$0.77
($0.02)
($0.04)
$0.79
$0.81
$0.83
$0.85
Each hedging method
defined
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[OTC] 90-day [OTC] 90-day Yen Call Option
¥300,000,000 x .0249 = $74,700
100
Max (St – K, 0)
$74,700 (St .7852, 0)
90-Day Yen Call Option [OTC]
Profit
$0.06
$0.04
$0.02
$0.00
St
$0.77
($0.02)
($0.04)
$0.79
$0.81
$0.83
$0.85
Each hedging method
defined
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Yen Futures Hedge [CME]
¥300,000,00 = 24 contracts
12,500,000
Max (St - $.80, 0)
24 contracts x .0208 = $62,400
100
April Call Option [CME]
Profit
$0.06
$0.04
$0.02
$0.00
St
$0.77
($0.02)
($0.04)
$0.79
$0.81
$0.83
$0.85
What happens if
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What happens if the company hedges a particular exposure but
subsequently finds that the period at risk changes (the exposure is
shorter or longer than the hedge, or the amount of risk changes)?
Optimal Hedge Ratio
Roll hedge forward
N* = (β) P
A
N* = number of contracts to be hedged
β = beta
P = Current Value of Portfolio
A = Current value of stocks underlying one futures contract
example: 1.5 x ¥5,000,000 = 30
250,000
Therefore 30 futures contracts should be shorted to hedge the portfolio
What happens if
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If it turns out that Merton needs the forward contract for a longer
period they can roll hedge forward. Each time they roll it forward
Merton will face basis risk.
Basis = spot price of an asset – its future price
Basis risk therefore is the the uncertainty as to what the basis will
be at maturity.
What happens if
• Swaps
• Interest rate Swaps
• Currency Swaps
Interest Swap
Fixed
Floating
9.93%
Merton
Electronics
10%
LIBOR
Financial
Institution
9.97%
Clark
University
Trust
LIBOR
LIBOR +1
Speculation
• Companies should have a
comparative advantage to profit from
speculation.
• Nonfinancial companies do not have
a comparative advantage at
predicting currency and interest rate
movements.
speculation
• A nonfinancial company may want to
try to profit from movements in
commodity prices.
• However, the company should be
aware of the risks.
– Example: Energy Traders
Conclusion
• Should prepare budgets monthly due
to nature of currency risk.
• Merton has a 90 day currency risk
exposure so they should hedge when
the order is placed.
• The extra cost of the options is worth
eliminating the risk.
• QUESTIONS