foreign exchange exposure should be hedged.

The main issue that should be looked at is how far into the future should WD hedge.Liquid markets for options and futures contracts existed only for maturities of 2 years or less. Even if the problem with forward contracts is similar, WD obtained an indication of long-dated currency forward rates from its banks. Assuming that hedging is desirable, WD can choose among the following alternatives:

• Foreign Exchange Forward Contracts - WD can sell a currency forward contract and will be entitled to sell a specified amount in a specified currency (in this case ) for a stated price on a specified date.

To hedge the home currency value of future receivables in a foreign currency, the firm may sell a currency forward contract for the currency it will be receiving. Therefore, the firm knows how much of its home currency it will receive after converting the foreign currency receivables into its home currency. By locking in the exchange rate at which it will be able to exchange the foreign currency for its home currency, the firm insulates the value of its future receivables from fluctuations in the foreign currency’s spot rate over time.Forward contracts are negotiated between a company and a commercial bank and specify the currency, the exchange rate and the date of the forward transaction. Problems: available at low cost only until 2 year maturity (see Exhibit 5) due to the high bid-ask spread; even if a quote is available, the dealers could not be willing to transact in any substantial size.

 Currency Futures - Like forward contracts, futures contracts can be used to lock in the future exchange rate

at which a company can buy or sell a currency.A forward contract hedge is very similar to a futures contract hedge, except that forward contracts are commonly used for large transactions and can be executed for any quantity for any maturity date, thus they are not as liquid as the futures, which are standardized contracts representing a fixed number of units for each currency.

Currency Options - A firm must assess whether the advantages of a currency option hedge are worth the price – premium – paid for it. WD can hedge its receivables with currency put options. A currency put option provides the right to sell a specified amount in a particular currency at a specified price – the exercise price – within a given period of time. WD can use a currency put option to hedge future receivables in , since it guarantees a certain price at which the future receivables can be sold.

The currency put option does not obligate its owner to sell the currency at that specified price. If the existing spot rate of the foreign currency is above the exercise price when the firm receives the foreign currency, the firm can sell the currency received at the spot rate and let the put option expire.

 Balance sheet hedge (without swaps), such as domestic bonds, Euro- bonds or long term loan (problems: WD could issue a long term loan or a bond but the Japanese market may not be ready for such a deal because WD is a single- A rated company and the process of issuing a bond or loan requires an underwriter and coordination with the bond issuing committee).

Currency swaps into

using existing dollar debt or using new debt (in answer 3 we qualitatively elaborate on why this is the best option for WD). In broad terms, a currency swap is an agreement between two companies to exchange specified amounts of currency now and to reverse the exchange at some point in the future.

The only risk in a currency swap is that the companies must exchange the foreign currency in the foreign exchange market at the new exchange rate. Other issues WD should consider in determining its policy for hedging exchange risk:

1. To the extent that WD is contemplating on creating a liability (directly or indirectly) in it needs to be fairly certain of the stream of royalty payments. If it does not have the offsetting cash flows in the form of royalty payments in, it may end up with an unwanted foreign exchange risk exposure.
2. How much to hedge? For example, with the current royalty payments of 8 billion it is contemplating on hedging 15 billion , roughly two years worth of royalty payments.

It might appear that this is relatively small compared to the exposure that is likely to unravel over a long period of time. One possible explanation is that WD is a relatively new firm to the Japanese market in terms of raising a bank loan in and hence may not be able to find a bank willing to give a larger loan than the 15 billion at attractive interest rates.

Question 3.
WD needs financing and French utility needs ECU Debt in exchange for its ? debt. Comparative advantage ECU WD9. 256%7.61% French utility9. 16%6. 717% 0. 096 %0. 893%

Total comparative advantage: 0.893% -

0. 096% = 0. 797% or 79. 7 basis points.

1. WD – ECU loan Cash flows at year 0 (1985) are 78. 499 million ECU. We get this number by multiplying 80 million ECU at price of the par, which is 100. 25%, and we get 80. 2 Million ECU.
By btracting a 2% fee (1. million ECU) and expenses (75,000$/0. 7420 $/ECU = 101,078. 167 ECU) we get 78. 499 million ECU. Taking into account 10 year annual compounding, we can calculate the yield to maturity, using yearly cash flows using data from Exhibit 6: 78. 499 = 7. 3/(1 + r) + 7.3/(1 +r)2 + 7. 3/(1 +r)3 + 7. 3/(1 +r)4 + 7. 3/(1 +r)5 + 23.300/(1 +r)6 + 21. 840/(1 +r)7 + 20. 380/(1 +r)8 + 18. 920/(1 +r)9 17.46/(1+r)10

We solve the equation for r = 9. 47%. Knowing that this is the annual rate, but we have to take into account semi-annual compounding and this brings us to yield to maturity of 9. 56% The following formula for 6 month compounding will be used through out the case study: [v(1 + rannual) –

75/(1+r) + 3. 75/(1+r)2 +... + 103. 75/(1+r)20 r = 3. 804% solves the equation and since we are already using semi-annual compounding yield to maturity equals 2 times 3. 04% = 7. 61%.

French utility - ECU loan In Exhibit 8 we can see that the ECU issue date 1985 (Feb) and maturity 1995 (Mar) has yield to maturity with annual compounding 9. 37%. With semi-annual compounding we get 9. 16%. 4. French utility – loan In Exhibit 8 there is also a ? loan with maturity in 1995

(Jan) and yield to maturity 6. 83% annually.

With semi-annual compounding this is equal to 6. 717%. Why is the swap worth doing for WD, French utility and Industrial bank of Japan (IBJ). Before the swap WD’s cost of financing was 7. 61%. After the swap the cost of financing ? re lower i. e. only 6. 89% and that is the reason why they engage in the swap in the first place. We get 6. 89% from figures from Exhibit

Company gets 14,455. 153 million and has to pay yearly amounts that are discounted with yield to maturity, which can be calculated from: 14,455. 153 = 483. 226/(1+r) + 483. 226/(1+r)2 +… + ... + 1520. 45/(1+r) 20 We solve the equation with r = 3. 445% and since we are already using semi-annual compounding, the WD’s cost of financing after the swap equals 2 times 3. 445% = 6. 89%.

Total savings for WD are 7. 61% – 6.89% = 0. 2% or 72 basis points Even though the French utility is not issuing new ECU debt, the existing interest rate on its ECU debt (yields to maturity from Exhibit

can be used as a benchmark for comparison. Before the swap French utility’s cost of ECU financing were equal to 9.16%.

The payments of 80 million ECU and 14,445. 153 million ? in the first row of columns C and D in exhibit 7 are “notional” figures. These principal payments are not exchanged. They are only shown there because Goldman Sachs and IBJ used them for calculations (see footnote b in Exhibit 7).The French utility receives (figures from Exhibit 7) yearly amounts: 483.226 million in six months, 483.

226 million in 1 year, . . 1,520.226/(1 + 0. 06717/2)2 . . + 1520. 45/(1 + 0. 06717/2)20 = 14,592 million

French utility receives 14,592 million ? which is equal to 79 35% and taking into account semi-annual compounding, the French utility’s cost of financing is 9. 14% Total savings for French utility are: 9. 16% - 9. 14% = 0. 02%From Exhibit 7 we can see how much does IBJ receive every year by subtracting figures between columns A and C. Beside the expenses of 75. 02 million ECU in the ninth year, and 0. 01 million ECU in the tenth year. If we put this in relative terms and first calculate per annum receipts of the bank (discounted) and then sum them up for 10 years and add the expenses, then divide by total amount of currency swap, then this is roughly equal to 6 basis points of the size of the currency swap.

Therefore total compensation to IBJ equals approximately 0. 06%. Total comparative advantage of all parties, participating in the swap equals 0. 797% (approximately 0. 80%). The structure of savings and compensations is the following: + 0. 72% (savings WD) + 0. 02% (savings French utility) + 0. 06% (compensation IBJ) = 0. 80% (approximately) From these calculations we can conclude that a swap with French utility is the best solution for WD for hedging its currency exposure.