Merton Electronics Corp

By Alexzander Downs Ferdinand Hilton Kevin Grant Takshal Bhansali

Outline
Current Situation Currency risk exposure Each hedging method defined What happens if Hedging if and when speculation conclusion

Current Situation
Mertons 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 $0.77 ($0.02) ($0.04) $0.79 $0.81 $0.83 $0.85 St

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 $0.77 ($0.02) ($0.04) $0.79 $0.81 $0.83 $0.85 St

Each hedging method defined

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

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 $0.77 ($0.02) ($0.04) $0.79 $0.81 $0.83 $0.85 St

Each hedging method defined

[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 $0.77 ($0.02) ($0.04) $0.79 $0.81 $0.83 $0.85 St

Each hedging method defined

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 $0.77 ($0.02) ($0.04) $0.79 $0.81 $0.83 $0.85 St

What happens if
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* = () P A N* = number of contracts to be hedged = 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
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 9.93% Merton Electronics 10% LIBOR Financial Institution 9.97% Clark University Trust LIBOR LIBOR +1 Floating

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