Zap A

Risk Management and Financial
Instruments
Cases and Practices
Content
1. Decision Case: Zapa Chemical and Buba
2. Delphi’s Currency Swap
3. Ikea’s Yen Exposure
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Professur für BWL, insb. nternationale Wirtschaft
International Financial Management 2
1. Decision Case: ZAPA Chemical & Buba
Eiteman, Stonehill & Moffett, pp. 237-242

Zapa Chemical and Buba
a. What is Zapa Chemical’s original exposure?
• Sale proceeds of approximately DM 7.6 million
• Effect of exchange rate movements
– if the DM depreciates, the equivalent dollar value decreases
as well (and vice versa)
• Problem
– date for repatriation of funds is initially unclear – only vague
estimate: “sometime in November”
Hedging decision – to hedge or not to hedge, which

hedging instrument
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b. What are the hedge alternatives for Zapa
Chemical’s exposure?
• Remain uncovered
– Maximum risk approach (full exposure)
– Spot exchange rate: DM1.4649/$
$ 5,188,067
• Forward cover
– Sell DM forward
– 120-day forward rate: DM1.4957/$ (annual discount of 6.2%)
$ 5,081,233
• Foreign currency option
– Buy put option on DM
– Strike price: DM1.5152/$ (or $0.66/DM) [out of the money]
– Premium: 1.40 cents per DM (0.0140/0.66 = 2.1%)
– Total outlay for protection: $106,400 (= $0.014 * 7.6 million)
Worst Case: $ 4,908,264 (=7.6 million/1.5152 – $106,400*(1+(0.033125%*120/360))
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Hedge Alternatives
US dollars Uncovered
(millions)
Forward cover
5.1
5.0
4.9 Put option on
DM
1.60 1.50 1.40 DM/$
Steph decides to buy the put-option in order to be able to participate in

exchange rate currency gains.
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c. Should Stephanie Mayo sell the put option
protection already in place?
• Background
– First, US dollar declined rapidly (01.09.92: all-time low DM1.39/$)
– Then, US dollar appreciated (16.09.92: DM1.51/$)
– Volatility still high
• Sale of put option would expose ZAPA to adverse XR
movements
– 3 months until repatriation in December
– Increased option value reflects not only the favorable XR
movement, but also the increased volatility (risk!)
– Possible solution to avoid exposure:
sell put and enter into forward agreement
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Comparison of different hedging strategies
(DM/$ ) Sep 18th (DM/$ ) Dec 15th
No change of (1.5015 ) $5,061,605 (1.5152) $5,015,839

hedging strategy Worst Case
(1.5255) $4,981,973 (1.5255) $4,981,973

Sale of option & Sale of + $ 148,200 Sale of + $ 149,427
enter into forward put put
[$148,200*(1+0.033125
option option
*90 /360)]
$5,130,173 $5, 131,400
•Sale of put option & forward hedge (at DM 1.5255/$) lead to higher
outcome than option hedge in the worst case as well as at the
current spot rate.
•Forward hedge does not allow to benefit from falling US dollar.
•Why not uncovered position or replacing option?
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Professur für BWL, insb. nternationale Wirtschaft 1)
106,400*(1+(0.033125%*120/360);
International Financial Management see slide no. 5 8
d. How have the events of September altered
Stephanie’s view of the DM/$ exchange rate?
• Initially, Stephanie expected the dollar to fall further:
– Buba was driving interest rates up to slow monetary growth
– Interest rate differentials (US: 3.3125%; Germany: 9.750%)
• September turbulence:
– Uncertainty in Europe due to French vote on Maastricht Treaty
– Stress in the EMS (devaluation pressure on LIT and GBP);
GBP and LIT withdrawn from ERM
– Spanish peseta devalued 5%
• After the dollar had fallen, risen, and fallen again, she
wished to reevaluate her put option position.
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e. How has the volatility of the put option changed
between August and September?
• Volatility of the put option has increased
– August: premium oscillated between $0.5 and $1.50 per DM
– September: premium oscillated between $0.5 and $2.50 per DM
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f. What benchmarks would you use to measure the hedging
effectiveness? How would this alter Stephanie’s hedging?
• ZAPA considers Treasury a cost center (not a profit center!).
– Primary responsibility: conservative management of exposure.
– “Management was appreciative when the expenses of running the cost
center were lower” (p. 239).
• Consequence:
– Cost as a benchmark to measure hedging effectiveness
– Standard portfolio theory:
maximize the expected value µ, minimize the variance ( σ = risk )
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Cost center benchmark: minimize risk

- Steph might prefer “cheaper” and less speculative forward hedge
- Yet company policy: “because of losses caused by forward contracts
in the past, F/E options were used whenever possible” (p.239)
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2. Delphi‘s Currency Swap
Eiteman/Stonehill/Moffett, p. 394-395
Delphi’s Currency Swap
Delphi:
• US based MNE operating in many countries in

pursuit of a more diversified sales base
• Wishes to diversify the currency of the denomination

of its debt portfolio
Decision:
• Enter into cross-currency interest rate swap

• 7 years maturity, notional principle of $50 million
• Pay euro, receive dollars
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a. What would be the annual swap payments on a
$50 million notional principal, 7 year maturity
currency swap?
Interest
Interestto
to
receive
receiveinin$$
Interest
Interestto
to
pay
payininEuro
Euro
Exhibit 14.8, p.386

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a. Calculate the annual cash flows associated with
the currency swap:
Swap Year 0 Year 1 – 6 Year 7

annually
Notional
5.86
5.86%% 105.86
105.86%%
principal ($50,000,000)
($50,000,000) $2,930,000 $52,930,000
$ Cash Flow $2,930,000 $52,930,000
(to receive)
Exchange rate $1.16/€

$1.16/€
Notional
principal 4.05
4.05%% 104.05
104.05%%
(€43.103.448)
(€43.103.448)
€ Cash Flow €1,745,690
€1,745,690 €44.849.138
€44.849.138
(to pay)
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b. What is the net present value of the swap
agreement when unwinding Delphi’s currency
swap after 3 years?
• Assumptions:
– Change of interest rates
¾ Four-year fixed rate of interest in Euros: 5.35% (previously 4.05%)
¾ Four-year fixed rate of interest in Dollar: 4.40% (previously 5.86%)
– Change of exchange rate
¾ from $1.16/€ to $1.02/€
• Necessary Calculations:
– PV of remaining cash flows in Dollar
– PV of commitment in Euro
– Settlement
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b. Net present value of the swap
Swap Year 4 Year 5 Year 6 Year 7 Total

$ Present
Value $2,930,000/
$2,930,000/ $2,930,000/
$2,930,000/ $2,930,000/
$2,930,000/ $52,930,000/
$52,930,000/
(to receive) 1.044 1 1.044 2 1.044 3 1.044 4 $52,625,033
$52,625,033
1.0441 1.0442 1.0443 1.0444
Int.rate: 4.40%
Delphi
Delphireceives
receivesaanet
netpayment
paymentof
of$10,669,840
$10,669,840(due
(dueto
to ++
changes 10,669,840
changesinininterest
interestrates
ratesand
andDollar
Dollarappreciation)
appreciation) 10,669,840
€ Present
41,132,542
41,132,542€€
Value €1,745,690/ €1,745,690/ €1,745,690/ €44.849.138/
€1,745,690/ €1,745,690/ €1,745,690/ €44.849.138/ xx$1.02/€
$1.02/€
1.0535 1 1.0535 2 1.0535 3 1.0535 4
(to pay) 1.0535 1 1.0535 2 1.05353 1.05354 ==
Int. rate: 5.35% $41,955,193
$41,955,193
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3. Ikea’s Yen Exposure
Eiteman/Stonehill/Moffett, pp. 766-767

Ikea’s Yen Exposure
General Definition of a Range Forward
• Definition of a range forward in the case of a long

position:
– Buying a put option with a strike rate below the
forward rate, for the full amount of the long
currency exposure (100% coverage)
– Selling a call option with a strike rate above the
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• Ikea’s purchase is invoiced in Japanese yen
• Exposure: 90-day account payable of ¥2.7 billion
• Use of currency option to manage exposure
• Need to finance option purchases by writing offsetting
positions Ö construction of a range forward
• Current market conditions
– Spot exchange rate: ¥ 108.20/$= $0.009242/ ¥
– 90-day forward rate: ¥ 107.88/$= $0.009270/ ¥
– 90-day Eurodollar deposit rate: 3.3750%
– 90-day Euroyen deposit rate: 2.1875%
– 90-day yen/dollar volatility quote: 11.8%
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Range Forward in the Ikea Case
• Definition of a range forward in the case of a short

position:
– Buying a call option with a strike rate above the
forward rate, for the full amount of the short
– Selling a put option with a strike rate below the
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Construct and diagram a range forward that is +/-2%
(+/- 3.5%) around the forward rate
• Alternative a) +/- 2%
– Forward rate: ¥107.88/$= $0.009270/ ¥
- Upper bound: ¥105.72/$= $0.009459/ ¥ (Strike price Call)
- Lower bound: ¥110.04/$= $0.009088/ ¥ (Strike price Put)
• Alternative b) +/- 3.5%

- Forward rate: ¥107.88/$= $0.009270/ ¥
- Upper bound: ¥104.10/$= $0.009606/ ¥ (Strike price Call)
- Lower bound: ¥111.66/$= $0.008956/ ¥ (Strike price Put)
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Range Forward Diagram
US$ Uncovered
Account
payable
Buy a call
-25,935,807
-25,542,251 Sell a put
-25,027,809
Range forwards
-24,540,738
-24,181,712 2%
Forward cover
3.5%
0.0089 0.0091 0.0093 0.0095 0.0097 $/¥

0.00927 forward rate
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a. What precisely would Ikea like the spot rate to be at
the end of the 90-day period?
• Strike price of the lower bound of the collar
– $0.009270/¥* 0.980 = $0.009088/¥ (=¥110.04/$) (-2%)
– $0.009270/¥* 0.965 = $0.008956/ ¥ (¥111.66/$) (-3.5%)
b. If the ending spot exchange rate were $0.0096/¥,

what would be the net proceeds of Ikea?
• Calculate option premiums with currency option model
(ch. 24, appendix A, pp. 769-772)
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Calculation of Option Premiums
• Currency Option Pricing Theory
European call option C = [FN (d1) − EN (d 2)]e − rd T
European put option P = [F ( N (d1) − 1) − E ( N (d 2) − 1)]e − rd T
⎛ F ⎞ ⎛σ ⎞
2
ln⎜ ⎟ + ⎜⎜ ⎟⎟T
⎝E⎠ ⎝ 2 ⎠ d 2 = d1 − σ T
d1 =
σ T
• Premium payments
Strike -2% Strike + 2% Strike - 3,5% Strike + 3,5%
Call $/¥ 0,000315 0,000136 0,000402 0,00009126
Put $/¥ 0,000135 0,000324 0,00009117 0,000425
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b. (ctd.) US dollar proceeds if ending spot exchange
rate is $0.0096/ ¥ ~ 104.17 ¥/$ Call Option Strike Rate
¥104.10/$= $0.009606/ ¥
+/- 2% +/-3.5%
Call Option Strike Rate Call Call
Calloption
Calloption
option not
option
exercised
¥105.72/$= $0.009459/ ¥ exercised not exercised
exercised
Dollar proceed -$ 25,538,580 -$ 25,920,000
~~¥2.7 billion*$0.009459/¥
¥2.7billion *$0.009459/¥ ==¥2.7 billion*$0.0096/¥
¥2.7billion *$0.0096/¥
Outlay for call option - $ 367,246 -$ 246,415
~~¥2.7
¥2.7billion
billion* *¢0.0136/
¢0.0136/¥¥ ~~¥2.7
¥2.7billion
billion* *¢0.009126/
¢0.009126/¥¥
Writing of put option $ 363,575 $ 246,161

~~¥2.7
¥2.7billion
billion* *¢0.0135/
¢0.0135/¥¥ ~~¥2.7
¥2.7billion
billion* *¢0.009117/
¢0.009117/¥¥
Net dollar proceed -$25,542,251 -$25,920,254
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c. Minimum US dollar proceeds
Call Option Strike Rate
¥104.10/$= $0.009606/ ¥
+/- 2% +/-3.5%
Call Option Strike Rate Call Call
Calloption
Calloption
option option
exercised
¥105.72/$= $0.009459/ ¥ exercised exercised
exercised
Dollar proceed -$ 25,538,580 -$ 25,935,553
~~¥2.7 billion*$0.009459/¥
¥2.7billion *$0.009459/¥ ~~¥2.7 billion*$0.009606/¥
¥2.7billion *$0.009606/¥
Outlay for call option - $ 367,246 -$ 246,415
~~¥2.7
¥2.7billion
billion* *¢0.0136/
¢0.0136/¥¥ ~~¥2.7
¥2.7billion
billion* *¢0.009126/
¢0.009126/¥¥
Writing of put option $ 363,575 $ 246,161

~~¥2.7
¥2.7billion
billion* *¢0.0135/
¢0.0135/¥¥ ~~¥2.7
¥2.7billion
billion* *¢0.009117/
¢0.009117/¥¥
Net dollar proceed -$25,542,251 -$25,935,807

As
Asininpart
partb)
b) $15,553
$15,553more
morethan
than
ininpart b)
part b)
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Risk Management and Financial

1. Decision Case: Zapa Chemical and Buba

2. Delphi’s Currency Swap

3. Ikea’s Yen Exposure

Eiteman, Stonehill & Moffett, pp. 237-242

Hedging decision – to hedge or not to hedge, which

1.60 1.50 1.40 DM/$

Steph decides to buy the put-option in order to be able to participate in

No change of (1.5015 ) $5,061,605 (1.5152) $5,015,839

(1.5255) $4,981,973 (1.5255) $4,981,973

$5,130,173 $5, 131,400

Cost center benchmark: minimize risk

• US based MNE operating in many countries in

• Wishes to diversify the currency of the denomination

• Enter into cross-currency interest rate swap

Exhibit 14.8, p.386

Swap Year 0 Year 1 – 6 Year 7

Exchange rate $1.16/€

Swap Year 4 Year 5 Year 6 Year 7 Total

Eiteman/Stonehill/Moffett, pp. 766-767

• Definition of a range forward in the case of a long

• Definition of a range forward in the case of a short

• Alternative b) +/- 3.5%

0.0089 0.0091 0.0093 0.0095 0.0097 $/¥

b. If the ending spot exchange rate were $0.0096/¥,

European put option P = [F ( N (d1) − 1) − E ( N (d 2) − 1)]e − rd T

Writing of put option $ 363,575 $ 246,161

Net dollar proceed -$25,542,251 -$25,920,254

Writing of put option $ 363,575 $ 246,161

Net dollar proceed -$25,542,251 -$25,935,807

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