You are now the not-so-new CFO of Agri-Drone. It’s been over a year since you introduced the Company to the idea of managing risks it confronts in doing business overseas. The market buzz about the Company’s innovation has continued. The first foreign customer, the French farming cooperative, has made additional purchases, and word is spreading about the Company’s family of unique products.
As your first foray into the realm of international sales gathers steam, you recommend and implement an immediate hedge of the entire $1.1 million sale to the French Co-op by using a six month forward contract.
You’ve been using that approach ever since.
As it turns out, the EUR/USD strengthens during the six months of that first forward contract, and it sits at 1.40 at the time Agri-Drone receives its payment in euros. Jim, the VP of Sales, isn’t the only person to comment that Agri-Drone would have been better off in hindsight without your forward contract in place.
You just shake your head.
The good news is that most members of the Company’s leadership team ‘get it.’ Your initiative in protecting the Company has been recognized, and with the endorsement of Stephanie Majors, the CEO, you have educated the leadership team about the Company’s foreign currency risks and what it should be doing about them. With the exception of Jim, who continues to chide you when (and only when) currency fluctuations go in Agri-Drone’s favor, everybody seems pretty happy.
There is one person who is truly not satisfied, however, and that’s you.
“This is getting expensive!”
What has caused your frustration is your need to constantly commit Agri-Drone’s borrowing capacity to support what seems to be an ever-growing series of forward contracts that are, just now, starting to involve multiple currencies. Your bank, behaving like banks do, insists on a progressively growing letter of credit to back the forward contracts. Under your loan agreement, letters of credit get subtracted from your credit line, so your borrowing capacity gets reduced.
You, of course, can contemplate better uses for the credit line in support of the Company’s rapid growth. Certainly, it could be used for expanded working capital needs, but you’re also starting to hear whispers of plant expansion ideas. Some of these certainly could be outside of the U.S.
You know that sooner or later a more cost efficient way of handling Agri-Drone’s currency risk issues will be needed as the types of risk evolve.
So, you begin to explore other ways to contain currency risk. Sure, you know about options, but you think their cost would be a hard sell internally. You can almost hear Jim saying: “What? Two or three percent right off the top on every international deal?” While you hate to admit it, on this one you and Jim agree.
And so today you are wondering about two things:
Is there a more cost-effective way to eliminate foreign currency risk?
Is there truly a need to eliminate all foreign currency risk?
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“Why didn’t I think of that sooner!”
This afternoon, as you struggle with your dilemma, you walk into the office kitchen to make a cup of coffee. As you’re waiting for the K-cup to brew, you see some panelists fast-talking on CNBC TV about risk bracketing and risk arbitrage on investments in volatile stocks. One of them shouts, “It’s almost free!” Not catching the full drift, you grab your coffee and walk back to your office.
And then it hits you. He was talking about option premiums being ‘almost free,’ which, of course, you know isn’t the case. Option premiums always seem to be priced at a few percent of the underlying security value, which is far from ‘almost free.’ That can only mean he was talking about offsetting option premiums.
And you sit up and gasp as a revelation hits you.
How could option premiums be offsetting? Explain in a narrative way.
Note: The space expands as you write.
“Now we’re getting somewhere!”
You figure out how offsetting option premiums can be achieved, and now you turn your attention to how to use them at Agri-Drone. Your objective is the same: protect the Company against its foreign currency risks on major sales to foreign customers. However, with the increased volume of activity, you seek to explore ways to eliminate something less than 100 percent of the risk and you broach that idea to Stephanie Majors, the CEO. She encourages you to continue your research. And so, as is your nature, you start playing with some numbers.
Assume the following facts:
Current EUR/USD spot rate –
6 mo. forward contract pricing
6 mo. EUR/USD Call strike 1.3000 premium 3%
6 mo. EUR/USD Call strike 1.3200 premium 2%
6 mo. EUR/USD Put strike 1.3000 premium 4%
6 mo. EUR/USD Put strike 1.2800 premium 2%
What pairing of options would come closest to achieving the same risk management attributes of a EUR/USD six month forward contract? Why?
Note: The space expands as you write.
“Finally, I may have a better answer!”
Your deepening understanding of option strategies has CEO Majors quite impressed. She’s asked for a simple demonstration, which you prepare and deliver.
Assuming only the fact-set presented, what strategy would you suggest to limit most of the currency risk on a substantial sale to a European customer, while at the same time minimizing transaction costs to the Company?
Assume the sale price is set at $1,000,000 and the contract specified payment of 769,231 Euros in six months upon delivery. Using your suggested strategy, prepare a calculation of the ultimate dollar revenues received, net of option costs, assuming the six month EUR/USD actually ends up being 1.25, 1.30 and 1.35. Also, present a side calculation of what would occur if no mitigation strategy was used.