Great Eastern Toys is a company in Hong Kong that exports a huge percent of its total sales to the North American and European markets and hence is exposed to currency risk. Previously, the company was occupied with expanding their business and the company’s management had never given much attention to currency risk until their recent meeting with their banker. The banker pointed out that the depreciation of the European currencies during the previous two years had resulted in a substantial loss of income. The company’s management was indeed convinced that they should begin to devote more time and manage their currency position. In this report, we are going to explore the different options for Great Eastern Toys to hedge its currency exposure and recommend the best hedging strategy for them.
Currencies to Hedge
Great Eastern Toys with annual sales of over HK$245 millions (US$31 million) exported about half of its products to North American markets, close to 50% to Europe, and less than 5% in the local market. This resulted in incoming cash flows denominated in Deutsche Mark and U.S. dollar. The firm finances its operations mainly with the local currency, Hong Kong dollars, but also with Yen loans. As for loans, the firm had borrowed about HK$ 24.45 million and ￥ 120 million (HK$ 6.64 million).
As half of the sales revenue is denominated in U.S. dollars, it is necessary to examine whether or not to hedge the currency exposure from the U.S. dollar. For more than ten years, the Hong Kong dollar has been firmly pegged to the U.S. dollar. Thus the currency risk on Great Eastern Toys’ American sales was seen as practically insignificant. Even if the peg were to be removed, the Hong Kong dollar is expected to depreciate against the U.S. dollar, since the Hong Kong dollar appears to be substantially overvalued, as the annual inflation in Hong Kong is running at double the rate than in the U.S. Accordingly, we believe that Great Eastern Toys can leave open the exposure from the export sales in U.S. dollars.
A large portion of the sales revenue is received in Deutsche Marks, DEM, by Great Eastern Toys. During the recent meeting with the banker, the banker directly pointed out that the depreciation of the European currencies in the last two years had resulted in a huge loss. At this point, it seems quite vital to consider hedging strategies against the depreciation of DEM. Most European currencies had been depreciating against the dollar during the past three years, with no exception for DEM.
It might be believed that this is about time the trend will be reversed. If the Euro becomes a reserve currency after the Europeans adopt the Euro as their common currency, a strong worldwide demand will form and indeed its value will appreciate. However, at the moment, there seems to be many other factors that will limit the potential rise in the value of the European currencies. Accordingly, we have decided that Great Eastern Toys should hedge against the depreciation of the DEM.
Lastly, since the firm currently has an outstanding debt of ￥ 120 million, equivalent to HK$ 6.64 million, Yen needs to be considered as well whether or not to hedge against its currency exposure. For the past three years, the Yen has been steadily declining against the HK$ from 11￥/HK$ to currently about 18￥/HK$. To determine whether the Yen is expected to depreciate or appreciate, we have used the following expression of the international fisher parity:
[E(S￥/HK$) – S￥/HK$]/S￥/HK$ = (rN￥ – rNHK$)/(1+rNHK$)
By plugging in the relevant values into the above formula, we can compute the expected exchange rate between Yen and HK$:
[E(S￥/HK$) – 18.0]/18.0 = (5.5% – 0.4%)/(1+0.4%)
E(S￥/HK$) = 18.9 ￥/HK$
According to international fisher parity, therefore, the Yen is expected to depreciate. Based on the fact that the Yen is expected to depreciate in value as well as the fact that the loans in Yen account for a very small part of the total sales, we suggest that Great Eastern Toys will stay with its “do-nothing” approach for their Yen loans. The depreciating Yen means that the company will be required to have fewer Hong Kong dollars to pay back its loans.
Evaluation of Hedging Strategies
There are four main methods for hedging the currency exposure of DEM; Forward, Money Market, Futures and Currency Options. Each alternative has different timing of cash flows and costs.
The value of this contract is computed using the three-month HK$/DEM forward rate. There will be a cash inflow of DEM 4 million on October 15th. This amount will be hedged using the forward rate of HK$ 4.3535/DEM. By multiplying the cash inflow denominated in DEM by the forward rate, the total amount of cash inflow in HK$ is obtained, HK$ 17,414,000. Simply looking at the forward rate, we know that the DEM is expected to appreciate which Great Eastern Toys could take advantage to.
A forward contract offers a complete hedge against the currency risk; the amount and maturity date can be negotiated to fit in with Great Eastern Toys objectives. There is no additional cost for hedging, like the other strategies do. There is no extra direct transaction costs involved with this strategy: the price and time is set at time 0 and money is delivered at the time agreed. Collateral, however, is required. Since Great Eastern Toys already has short term working capital problems, tying up capital for a forward contract may not be the best hedging strategy.
The major cost of money market hedge is the interest on newly incurred debt at t=0. The interest rate is 7.875% APR, for the amount of money that is discounted back from DEM 4 million received on October 15th. As APR is annualized interest rate, we divided this cost of debt in to quarter (90 days basis) which is 1.97%. There will be an initial cash flow in of DEM 3,922,770 on July 15th. After converting this amount at the spot exchange rate of HK$ 4.3085/DEM, it will be reinvested at a 400bp above HIBOR rate (13.25%). Profit will be in total of HK$ 558,854 from this reinvestment. Total cost of debt from APR is DEM 77,230 and subtracting this from reinvestment fund will be HK$ 17,461,111.
Currency Option Contract
Choosing to hedge the currency exposure of DEM through currency option trading provides an option to choose to exercise at a strike price of HK$ 4.3103/DEM within 90 days. Therefore, in the event that the DEM depreciates, we would have the option to exercise our option and benefit from the depreciation. However, there is HK$ 0.063/DEM premium.
The maximum amount we would get, excluding the total premium of DEM 58,464 will result in the total cash flow of HK$ 16,989,200. Additionally, in order to conduct an option a marginal account setup fee and commissions need to be paid to the broker as well. Buying a put option would limit potential losses without limiting potential gains. However, options only offer a partial hedge, like insurance. The three month DEM OTC put option only gives a net value of if the exchange rate goes all the way down to zero which is a bit unrealistic.
Futures for USD hedging
Aside from three-month hedging strategies for DEM, there is a hedging tool that could have been useful for hedging against the currency exposure from the U.S. dollar. One of the limitation is that is only possible in units of DEM 125,000. As well, futures contract requires collateral from Great Eastern Toys to initiate the trade.
Thus there is an additional cost of an account fee of US$ 1,500. A futures contract is marked to market on a daily basis and any losses must be made up in cash on a daily basis while the offsetting gain will be deferred until the transaction actually occurs. Even though the position can be reversed any time, a lot of liquidity is required and because Great Eastern Toys is currently experiencing working capital problems and needs to further reduce outstanding loans due to the credit squeeze; this option would also not be viable.
In evaluation, hedging sales during times of peak which occur in the months August to November would be very beneficial to Great Eastern when more than half of annual sales are made. Hedging strategies should be set up in a way such that the maturity of our hedging strategy matches the time of revenue recognition, i.e. when the product is delivered.
Forecasting exchange rates is very difficult, but in order for Great Eastern to not make future losses, we would propose Great Eastern to hedge against the DM as it appears to be the most prominent currency risk Great Eastern is facing due to half of its annual sales being made to the European Markets and sales were hurt in the past. After analyzing each of the possible currency risk hedging strategies for Great Eastern Toys, in the short-term, money market hedging should be used against the DM to yield the best results.