finance case 10-11 pgs. introduction, main body, and conclusion along with reference and table or graph. UVA-F-1516TN

Rev. Oct. 20, 2010

-2- UVA-F-1516TN

BAKER ADHESIVES

Teaching Note

Synopsis and Objectives

Baker Adhesives (Baker) has just made its first foray into international sales and must come to grips with the impact of exchange-rate changes on the profitability of a past order. The company must also formulate a strategy for dealing with exchange-rate risks for future orders. The case is intended as an introduction to exchange-rate risk and the management of that risk. Upon receipt of payment from a past order, the firm realizes that exchange-rate movements have reduced the value of the sale. A follow-on order provides the context for exploring possible mechanisms for managing that risk. In particular, sufficient direction and information is provided to examine both a forward hedge and a money-market hedge.

The case can be used in a core finance class or dedicated international finance class to expose students to exchange risks and hedging. The case is designed to achieve the following learning objectives:

· To explore the magnitude and effect of exchange-rate risks.

· To illustrate exchange-rate risk management through two conventional hedges—a forward-contract hedge and a money-market hedge.

· To demonstrate market parity and identify how preferences arise from unique company characteristics.

· To explore issues related to pricing of international bids.

Suggested Questions for Advance Assignment to Students

1. How profitable is the original sale to Novo once the exchange-rate changes are acknowledged? How might the exchange-rate risk, which affected the value of the order, have been managed?

2. Assuming Baker agrees to the new Novo sale, determine the present value of the expected future cash inflow assuming: (1) there is no hedge, (2) the company hedges using a forward contract, and (3) the company hedges using the money market. Finding a present value is necessary for the following reason: With no hedge or a with forward-contract hedge, the cash flow will occur at the time of payment by Novo. With the money-market hedge, Baker receives a cash flow immediately.

3. Are the money markets and forward markets in parity?

4. How profitable will the follow-on order be? Would you make this new sale?

Supporting Excel Spreadsheet Files

For students: UVA- F-1516X

For instructors: UVA- F-1516TNX

Please do not share the instructors’ file with students. Note that the student and instructor spreadsheets include source data for the figure in case Exhibit 2, which shows the bid on the Brazilian real (BRL) over time.

Hypothetical Teaching Plan

A class session can be easily orchestrated through a series of questions. Below is one such sequence.

1. What was the revenue actually received from the original order, and how does it affect the profitability of that order?

The purpose is to have students understand the effects of exchange rates on cash flows. Both the magnitude and likelihood of changes are explored.

2. How might exchange-rate risk be managed?

Here the students should explore all the mechanisms for hedging. The idea is not to focus on numbers, but to bring out and explore the possibilities, including shifting the risk to the purchaser.

3. Assume Baker decides to take the follow-on order, how might the forward-contract and money-market rates be used to hedge the future expected inflow?

The class should carefully and clearly outline the forward-contract and money-market hedges suggested by the bank. This also provides a chance to introduce or review currency transaction calculations. As part of this analysis, the students will also calculate an expected amount without any hedging. The calculation implies an extremely small cost of eliminating the currency risk—a typical result and an important moment of insight for the students.

4. Why do we see a preference for the forward-market hedge over the money-market hedge?

This portion of the class can be expanded or limited depending on the guidance of the instructor during class. A discussion of parity conditions can be useful, but can also pull the class off track. The preference arises out of the unique borrowing costs presented to Baker. The bank affiliate in Brazil is charging a higher credit spread to Baker than in Baker’s domestic borrowing market. This is another important insight moment—imperfections in the markets will generate preferences.

5. With the forward or money-market hedge in place, can the company be completely sure there will be no exchange risk?

This discussion is quite important. The financial hedges are created under the assumption that the cash flow will be received by the customer on a specific date. There are, in fact, a number of residual risks that make the hedge less than perfect. This will come as a surprise to many students.

6. Should Baker accept the new order?

At first, the order appears to be only marginally profitable; however, the students can be pushed to think more carefully about the underlying economics and realize that, in fact, the order is still desirable given that the firm has excess capacity and some of the materials have a market value below cost.

Case Analysis

This section explores the issues raised in the case and might arise during the case discussion presented above. Because class discussions can proceed in various directions, and because the instructor may wish to tailor the class to particular objectives, the analysis is organized as discrete points rather than a continuous and integrated narrative. This ensures the greatest degree of flexibility. The exhibits are intended as examples of how material might be organized on the board and are designed to be a quick reference for the instructor.

This note also provides some additional supplemental data on market conditions at the time of the case. These data, which are consistent with what is presented in the case, can be used by the instructor to provide additional insight into the relationship between parity conditions and transaction costs. This discussion, however, is most likely only appropriate if the students have already had exposure to currency markets.

Original order

The students will have to make the appropriate adjustment to the Brazilian-real-denominated receivable to acknowledge the new exchange rates. Both bid and ask rates are given, and students have to make the correct choice. A review of the terminology and market structure underlying this bid and ask can take substantial time. This is especially true with currency markets where one can state a transaction as either selling a given currency or buying another (in this case, it is equivalent to say Baker is buying dollars or to say Baker is selling reais). One shortcut is to point out to the students that the market-maker in any market must profit on trades—which means one way to decide whether this transaction will occur at the bid or ask is simply to identify the trade that makes Baker worse off. In this case, because we are given bids and asks on the real and Baker is selling reais, one would use the bid. This, of course, is the quote that provides the lowest revenue to Baker.

An analysis of the order is shown in Exhibit TN1. Here we see the change in revenue as well as the change in profitability of the order. The profit from the order declined by $2,923, or about 56%. The change in revenue, of course, directly reflects a change in the value of the real. Comparing the exchange rate used to budget the order (0.4636 USD/BRL—which we can assume was a spot rate at that time) with the realized bid rate (0.4368 USD/BRL) shows that the real depreciated by almost 6%. This sudden decline in the value of the real affected the value of the order. It is also worth noting that the proportional change in profits far exceeds the proportional change in the exchange rate. The fact that costs are in USD, and therefore fixed with respect to the exchange rate change, leverages up the exchange rate change.

A historic context for a change of this magnitude can be gleaned from case Exhibit 2. First, one can readily observe the sudden decline in the value of the real during May. Students can be asked whether a change in the exchange rate (and hence the value of the order) was an especially unusual event. A number of sudden declines can be observed in the graph. Also, the volatility of monthly changes was 3.36% in 2005 and had risen to 6.53% during 2006. Thus, the change experienced by Baker over three months was not unusual. This discussion should highlight the magnitude of exchange-rate risk.

Currency risk management

The purpose of this discussion is to highlight various operating and financial decisions that would address the currency risk. Typical possibilities include:

· asking Novo to pay in dollars;

· increasing the price to cover the risk;

· choosing forward hedges or money-market hedges;

· using other currency contracts such as options.

The first is the most obvious, but not as easy as students might think. This is a matter for negotiation, especially in contexts without standardized contracts, but Baker is not in a particularly good bargaining position. It is a small company; it needs the work.

The second point is usually suggested in a number of ways. The students understand there is a risk-and-return trade-off and therefore conclude one can price the risk into the contract. The instructor can push the students on this point by asking whether all potential suppliers will face this risk. Also, one might press students to decide whether this is a diversifiable risk and therefore should be priced. The instructor has to be careful not to spend too much time on this issue. The conclusion should be simply that competition may limit the ability to price the risk. Sophisticated students will probably be aware that hedging this risk might not be very costly.

The forward and money-market hedges are discussed in detail below. At this point, it is sufficient to acknowledge that these financial contracts do mitigate the risk. Other suggested contracts are beyond the scope of this case, but should be acknowledged.

Hedging

Before exploring the two hedges, it is useful to ask students what the present value of the expected cash flow from the new order would be if Baker remains unhedged.[footnoteRef:1] The case provides information on market expectations that allows this calculation. This amount is a useful benchmark to the extent that there may be trade-off between risks and expected cash flows. [1: Students may question the need to calculate a present value. The instructor can point out that later, the class will find the cash flow obtained from a money-market hedge and that cash flow will be a current cash flow. Thus, one will either have to calculate present values or future values to make comparisons—and the present value is more naturally interpreted.]

Baker will have a foreign-currency-denominated inflow in three months if it accepts the new order. The receivable will be equal to BRL163,622. Baker will transact at the expected future bid rate of 0.4234 USD/BRL. At that rate, the firm expects to receive USD69,278 in three months. To find the present value of this amount, the appropriate discount rate is the Baker borrowing rate of 8.52%. As footnoted in the case, this implies a 2.1452% rate over three months. The present value of the expected future receipt is, therefore, USD67,823. The details are presented in Exhibit TN2.

The appropriate discount rate can be a source of confusion. It is tempting to think these cash flows should be discounted at the firm’s cost of capital. But the discount rate must be appropriate for the riskiness of the cash flows. In this case, the cash flow is a receivable. It is not as risky as typical cash flows. The point can be debated, but because this is a contracted cash flow the risk level is arguably close to that of debt. Hence, the borrowing rate is appropriate.[footnoteRef:2] [2: A student might also point out that the cash flow from the original order was going to be used to pay down the line of credit. This implies a practical link between the cash flows and the borrowing (essentially an opportunity cost), but this is a flawed argument—it is the risks of the cash flows, not their uses, that dictates the discount rate.]

In this context, the instructor may ask students how this calculation might inform their determination of an appropriate price for the adhesives. In effect, the students should be encouraged to think about how anticipated changes in the exchange rate might affect pricing. For example, case Exhibit 2 shows a steady appreciation of the real. What might Baker have expected at the time it accepted the original order? This can be a subtle but important point. Students should realize that pricing should probably acknowledge any expected change in the value of the real. For example, if the real was expected to depreciate, the order should have been priced higher. Of course, most pricing practices do not explicitly account for anticipated changes, though some implicit recognition might inform standard practices.[footnoteRef:3] In Baker’s case, exchange-rate changes are not likely to have been implicitly acknowledged. Also, anticipated changes in exchange rates can be of greater magnitude and volatility than other changes in costs. An appropriate price for the order may have required some attempt to forecast exchange rates. [3: This can lead to an interesting discussion about pricing in general. Firms typically do not explicitly acknowledge the time value of money when setting prices unless substantial time periods are involved. Thus, they do not build in an explicit premium when payments are received in the future. Because most firms sell on identical terms to most customers, the economic impact of this delay is likely to have been built into the profit margins (either by the firm or just by common practice and competition) or be of trivial significance. Furthermore, currency changes could not be built into margins because currencies may be expected to move either in favor of or against a firm, depending on the sale.]

The case provides sufficient detail to analyze forward and money-market hedges. The case is also quite explicit about interest rates, so there should be no confusion related to compounding periods. We ask the students to develop the hedges assuming the new order is accepted and to hedge that new order. The analysis of both hedges is given in Exhibit TN2, along with the unhedged analysis. A useful diagram of the cash flows for the two hedges is shown in Exhibit TN3.

With a forward-market hedge, one simply enters into a contract with a bank that requires a conversion of a specified amount at a specified rate.[footnoteRef:4] For Baker, the company will enter a contract with the bank to convert BRL163,622 to dollars at a rate of 0.4227 USD/BRL. This will give Baker a known inflow of USD69,163 in three months. [4: Futures markets can be used to generate what is effectively the same contract; however, the organizational details of a futures market are substantially different. Futures markets trade at standardized amounts, times, and rates. One purchases a desired number of contracts, and the gains and losses are marked to market each day. Margins are required. The critical economic difference between the forward and futures markets is that with a futures market, the contract will not exactly match the underlying exposure and there will be cash flows over the life of the contract rather than at the time a foreign currency inflow or outflow occurs. The futures market is generally inferior. But forward contracts are not typically available for small amounts, and the futures market is then the only available market.]

It is useful to be very clear about the steps that need to be taken for a money-market hedge. In particular, because many students may have seen covered-interest arbitrage calculations, it is important to note that the money-market hedge is not a covered-interest transaction. Hence, one will either borrow in a foreign currency (to hedge a foreign currency inflow) or invest in a foreign currency (to hedge a foreign currency outflow). There will be no domestic currency borrowing or investing. The confusion can arise because the discounting that is done to arrive at the present value when comparing money-market and forward hedges can be easily mistaken for borrowing or investing.

For a money-market hedge, the steps appear in Table 1.

Table 1. Money-market hedge.

Foreign Currency Outflow

(payable)

Foreign Currency Inflow

(receivable)

· Convert on spot market to foreign currency

· Invest in money market

· Pay outflow with maturing investment

· Borrow on money market

· Convert on spot market to domestic currency

· Use inflow to pay off loan when due

Source: Created by case writer.

In both cases, one needs to discount the future cash flow at the appropriate discount rate to find the amount to invest or borrow today so that in the maturing investment or borrowing, repayment is exactly equal to the future foreign currency cash flow.

Given that Baker has an expected BRL163,622 inflow, the company will need to borrow in Brazilian reais. Given the interest rate made available by the bank, the company will borrow BRL153,636 and convert that on the spot market to obtain USD67,108. In three months, the principal and interest due on the borrowing will exactly equal the BRL163,622 receipt.

Now the USD67,108 received immediately from the money-market hedge cannot be compared directly to the USD69,163 received from the forward hedge in three months. As with the unhedged cash flow, the appropriate discount rate, which would allow a comparison of the present values of these inflows, is 8.52% (2.1452% rate over three months). The present value of the forward hedge cash flow is, therefore, equal to USD67,711. Based on this analysis, the forward hedge is preferred over the money-market hedge.

We can compare the two hedged cash flows (in present value terms) to the unhedged (expected) cash flow. The unhedged cash flow provides the largest expected cash inflow—it is equal to USD67,823 in present value terms. There is, in general, no standard procedure for weighing the benefits of hedging risks. It is a judgment call; however, the difference is just over $100, and the students will very likely consider the avoidance of currency risk in this context to be well worth the cost!

Students should not be left with the impression that the difference between the unhedged and forward market (the best of the two otherwise identical hedges) is due simply to transaction costs. In fact, there are two issues at play. First, the implicit transaction cost of the bank (built into the rate it has given Baker) may, in fact, be higher than on the future spot market. But another issue is that the forward rate may not equal the expected future spot rate. A detailed discussion of violations of parity conditions is beyond the scope of this note, but suffice it to say that empirically there is substantial disagreement between expected spot rates and forward rates.

Market parity

If all the markets were in parity (the law of one price held across all markets), there would be no preference for a forward hedge over the money-market hedge. This is essentially the conclusion that is reached from an analysis of covered-interest arbitrage. The deviation could result from differences in transaction costs. But the instructor can press the students to consider the possibilities in greater detail. First, it is useful to distinguish between the markets in general and Baker in particular.

The case data allow one to explore the extent to which the markets are in parity. The interest rate parity condition is accurately stated as:

1 + rdomestic

=

Forward

1 + rforeign

Spot

where the rates are quoted as the domestic price of the foreign currency. The rates must be for the same duration as the forward contract (in this case, three months). We can use effective three-month rates calculated from the annual effective interbank rates. Also, because the forward rate from the bank is essentially a bid quote, to be consistent, we use a bid quote for the spot rate. We can verify that the markets are essentially in parity:[footnoteRef:5] [5: It is also common to evaluate parity by asking whether the forward premium or discount offsets the interest differential. The premium or discount is calculated as:

where the number of months is the time to execution of the forward contract. We see that the Brazilian real is selling at a 12.91% discount [(0.4227 − 0.4368)/0.4368 × 12/3]. From the interest rates, we see that the real rate is lower than the dollar rate by 19.47% − 5.08% = 14.39%. These are not particularly close. There are two reasons. First, unlike the ratio analysis presented above, this comparison is not exact. Second, the forward discount ignores compounding over time.]

(1 + 0.0508)0.25

=

0.9684

and

0.4234

=

0.9693

(1 + 0.1947)0.25

0.4368

This leads naturally to the discussion of what is unique to Baker. After some discussion, it becomes clear that the key is the interest rates. The rate at which Baker is borrowing in Brazil (through the bank affiliate) is 9.18% higher than the interbank rate. In the United States, on the other hand, Baker is paying only 3.78% more (this is Baker’s credit spread). Thus, the money-market hedge requires Baker to borrow at a rate higher than what would be expected. This is a central reason the money-market hedge is less desirable.

The rates used in this case arise from an internally consistent set of rates, which are presented for the benefit of the instructor in Exhibit TN4. This exhibit illustrates a number of features of the underlying market. First, the forward rates and expected spot rates (based on averages of bid and ask quotes) are not aligned. Second, the bank spread is, in fact, higher than the general market spread. The bank’s spread is quite high, but this is essentially because the dollar amount of the transaction is fairly low. The dollar fee built into the bank spread is actually quite appropriate.[footnoteRef:6] Third, one can see that covered-interest arbitrage is not possible between these rates given transaction costs. In fact, at the expected (no fee) rates, markets are essentially in parity. [6: A point of comparison for the students is that the spreads at airport currency exchanges, which are for very small amounts, range from 10% to 50% depending on the currency.]

Residual risks

The clarity and precision of the calculations will often lead students to be overly confident as to how well Baker can manage the exchange risk. To get to the next important point, the instructor can lead students by asking what other factors might lead to variation in the amount or timing of future cash flows. Students will identify a number of possible issues including:

· delay in shipment leading to delay in payment;

· delay in payment even if shipping is on time;

· default by Novo;

· dispute over the quality of goods leading to a price adjustment.

The list can be extensive. The point, however, is that any variation in the amount or timing of the cash flow receipt from Novo will cause a problem for Baker and its hedge. For example, if payment is received later than expected, Baker will find itself obliged to satisfy its forward contract with the bank. This will mean a renegotiation (at a fee) or the transfer of money into reais on the spot market (for a fee). And the amount of the receipt will now be subject to exchange risk until it is received.

The point of this discussion is that these contracts may be able to mitigate the exchange risk, but there are other risks that matter, and the exchange risk may not be fully eliminated.

New order

With a hedging strategy now in place, one might ask the students whether they should accept the new order. If the costs outlined in the case are adjusted for the increased size of the order, at the agreed upon price and with the newly anticipated exchange rate, the new order appears to be just barely profitable. This analysis is shown in Exhibit TN5.[footnoteRef:7] [7: We do not make allowances for the time value of money in that analysis.]

There are, however, costs built into the cost analysis that might not be relevant. They include the overhead charges (the firm is below capacity) and the cost of materials the firm would have sold at a loss (market value is below book value). Just the overhead costs alone total USD9,000. The case indicates the costs of materials listed at book value were expected to be sold at a substantial loss, suggesting the market value (opportunity cost) is well below book value. Thus, the order is quite desirable even at the old price. Further orders may allow for some price increases.

Exhibit TN1

BAKER ADHESIVES

Analysis of Original Order

(all figures in U.S. dollars unless otherwise specified)

Change in Revenue

Size of order (gallons)

1,210

Price (in BRL)

90.15

Previous price (in BRL)

109,082

Realized exchange rate (USD/BRL)

0.4368

(Use bid quote, not ask)

Realized dollar revenue

47,647

Anticipated dollar revenue

50,570

(Invoice × Original rate)

Change in revenue from expectation (USD)

-2,923

Change in Profit

Anticipated revenue

50,570

Cost estimate

44,500

Anticipated profit

6,070

Realized dollar revenue

47,647

Cost estimate

44,500

Realized profit relative to cost estimate

3,147

Change in profit

-2,923

Percentage change in profit

-48.16%

Change in Exchange Rate

Budgeted exchange rate (USD/BRL)

0.4636

Realized exchange rate (USD/BRL)

0.4368

Percentage change in value of real

−5.78%

Source: Created by case writer.

Exhibit TN2

BAKER ADHESIVES

Expected Cash Flows from Hedges and Remaining Unhedged

Data

Cash inflow (BRL)

163,622

(Original size × 1.5 × Original price)

Spot rate (USD/BRL)

0.4368

(Use bid rate)

Forward rate

0.4227

(Bank provided)

Expected spot rate

0.4234

U.S. line of credit

0.0852

Three-month effective rate

0.0215

(Given in case footnote)

Real rate to borrow

0.2650

Three-month effective rate

0.0650

(Given in case footnote)

Unhedged

Inflow in three months (BRL)

163,622

Convert to dollars

69,278

(163,622 × 0.4234)

Present Value (USD)

67,823

(69,278 ÷ 1.021452)

Forward Hedge

Inflow in three months (BRL)

163,622

Convert to dollars

69,163

(163,622 × 0.4227)

Present Value (USD)

67,711

(69,163 ÷ 1.021452)

Money-Market Hedge

Inflow in three months (BRL)

163,622

Amount to borrow in reais

153,636

(163,622 ÷ 1.065)

Convert at Spot Rate (USD)

67,108

(153,636 × 0.4368)

Source: Created by case writer.

Exhibit TN3

BAKER ADHESIVES

Diagram of Cash Flows

Forward Market Hedge

USD

BRL

Now

69,163 ÷ (1 + 0.021452) = 67,711

(find present value)

3 Months

163,622 × 0.4227 = 69,163

163,622

(convert with fwd contract)

(receive payment)

Money-Market Hedge

USD

BRL

Now

153,636 × 0.4368 = 67,108

163,622 ÷ (1 + 0.065) = 153,636

(convert on spot market)

(borrow)

3 Months

163,622

(Pay loan with received payment)

Source: Created by case writer.

Exhibit TN4

BAKER ADHESIVES

Supplemental Data and Arbitrage Analysis

Money Market

Baker

Credit

Interbank

Effective

Spread

BRL

19.47%

28.647%

9.177%

USD

5.08%

8.861%

3.781%

Currency Market

Expected

Spot

Forward

Spot

Bank bid

0.42270

Market bid

0.43680

0.42300

0.42340

Average

0.43695

0.42315

0.42365

Market ask

0.43710

0.42330

0.42390

Bank ask

0.42400

Arbitrage Calculations

Borrow USD

Average

Market

Bank

Unhedged

Borrow

1,000

1,000

1,000

1,000

Convert

2,289

2,288

2,288

2,288

Invest

2,393

2,392

2,392

2,392

Need

1,012

1,012

1,012

1,012

Transfer

2,393

2,394

2,395

2,391

Profit

−0.01

−1.68

−3.38

0.58

Borrow BRL

Average

Actual

Bank

Unhedged

Borrow

1,000

1,000

1,000

1,000

Convert

437

437

437

437

Invest

442

442

442

442

Need

1,045

1,045

1,045

1,045

Transfer

442

443

443

443

Profit

0.00

−0.31

−1.04

−0.93

Source: Created by case writer.

Exhibit TN5

BAKER ADHESIVES

Analysis of New Order

(all figures in U.S. dollars unless otherwise specified)

Increase in order size

50%

Real price (BRL)

163,622

Forward rate

0.4227

Dollar receipt

69,163

Labor

9,000

Materials original cost

48,750

Manufacturing overhead

6,000

Administrative overhead

3,000

Total costs

66,750

Profit

2,413

Margin

3.49%

Source: Created by case writer.

This teaching note was prepared by Associate Professor Marc Lipson. Copyright 2008 by the University of Virginia Darden School Foundation, Charlottesville, VA. All rights reserved. To order copies, send an e-mail to sales@dardenbusinesspublishing.com. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means—electronic, mechanical, photocopying, recording, or otherwise—without the permission of the Darden School Foundation.